NEW YORK – Wall Street is facing a paradox of sorts right now as the damage from the credit crisis continues—the more investors find out about the problems caused by billions of dollars in failed mortgages and investments, the more unknowns seem to crop up. The Street is hoping that this week, the Federal Reserve and the wounded Bear Stearns Cos. provide more answers than new, baffling questions.
The Fed has been using the various tools at its disposal—even creating some that investors have never seen before—to try to mend the ailing financial markets. Just last week, the Fed said it would pump up to $200 billion into the system by taking mortgage-backed securities as collateral, and then with the aid of JPMorgan Chase & Co. created a plan to lend funds to the Bear Stearns after the investment bank ran short of cash.
On one hand, Wall Street has been relieved the Fed has proved it is willing to act aggressively. But on the other, investors are more anxious than they've been in years; many didn't believe the credit crisis that began last year due to spiking mortgage defaults would reach this magnitude.
"We're sort of in uncharted waters here," said Brandon Thomas, chief investment officer for Portfolio Management Consultants, the investment arm of Envestnet. "Usually the market does a really good job discounting things that are unknown. Now it seems like the unknown is too unknown—they don't know how to discount it."
No one—probably neither the Fed nor Bear Stearns itself—knows exactly how sick Bear Stearns is, and whether it will be able to operate again without the Fed's and JPMorgan's support.
"It's not clear whether this is just a liquidity crunch or an insolvency issue," said Ali Samad-Khan, head of operational risk management consulting for the Enterprise Risk Management practice at Towers Perrin. "There's a fine line between an insolvency problem and a liquidity problem."
A bank that is simply illiquid will be able to pay all its obligations once the tight credit markets return to normal. An insolvent one, however, has fundamental damage and little chance of ever repaying its debts.
Another big unknown is how problems at Bear Stearns will trickle through the rest of the financial industry. If Bear Stearns cannot pay its obligations, its counterparties—mostly banks and hedge funds—will suffer losses.
Bear Stearns may not actually be insolvent, but the stock market has been burned before and adopted a leery stance after news of the bailout on Friday—especially given the quarterly earnings due this week from Bear Stearns, Lehman Brothers Holdings Inc., Goldman Sachs Group Inc., and Morgan Stanley.
When Bear Stearns releases its first-quarter results Monday, investors will to want to hear what the investment bank's next step is—sell itself, shed its assets and become a smaller company, or keep seeking out cash as it waits out the credit crisis.
Last week was a fitful one for Wall Street. After soaring early in the week on news that the Fed was taking new steps to try to end the near paralysis in the credit markets, stocks pulled back Friday on news that Bear Stearns had to be bailed out. The major indexes finished the week little changed. The Dow rose 0.48 percent, the Standard & Poor's 500 index slipped 0.40 percent, and the Nasdaq composite index ended flat.
The Fed said it will lend as much as $200 billion to banks and brokerages to try to create a market for mortgage-backed assets, which no one wants to buy right now.
However, the Fed's loan plan is only a temporary solution. "The banks will eventually recognize their losses," said Swiss Re chief U.S. economist Kurt Karl. "It will be a tough year for everybody except maybe those manufacturers exclusively devoted to exporting."
"It's hard to see how we're not going to have a recession," Karl said. "We could scrape by with a non-technical recession ... but it's pretty ugly."
The Fed is expected to take another step this week to help the economy—on Tuesday, it holds a regularly scheduled meeting on interest rates. The Fed is going to have to make a big rate move and a powerful statement to reassure the markets, and most analysts expect at least a half-point reduction in the key fed funds rate, which now stands at 3 percent. Some believe the Fed will slash rates by a full point to 2 percent.
This week's economic data is expected to show more weakness in the economy but some easing in inflation pressures.
Economists surveyed by Thomson Financial/IFR anticipate the Commerce Department on Tuesday to report declines in February housing starts and building permits; the Labor Department on Tuesday to report a modest increase in February producer prices; and the Philadelphia Fed on Thursday to report another contraction in the region's business activity.
Meanwhile, credit card processor Visa Inc. is expected to launch what it anticipates to be the largest initial public offering in U.S. history.