Monday, March 17, 2008

Is Bernanke's Job on the Line?

Over the weekend, the Federal Reserve orchestrated the takeover of Bear Stearns by J.P. Morgan for $2 per share. This is an almost unbelievable development. Bear Stearns, which started 2007 with a $22 billion market capitalization, is now valued at only $250 million! Some observers argue that this is better than the alternative--bankruptcy; but some Bear Stearns shareholders are wondering if that is really true.

There are two big problems leading to this latest crisis in financial markets. The first is falling housing prices. This is something that was easily foreseen. Many well known and respected economists, including Robert Shiller, Gary Shilling, and Nouriel Rubin, have been warning for years that housing prices could not possibly keep appreciating. Simple reversion to the mean dictated that prices had to fall considerably just to get back to long-term trends. Excessively easy access to mortgages created the housing bubble. Now that banks are tightening their lending standards, the air is coming out of the balloon.

The second problem is the Fed. It no longer has the confidence of investors. Instead of providing targeted liquidity to frozen credit markets, the Fed has destroyed the value of the dollar and created a tremendous amount of inflation in dollar-denominated commodities by aggressively cutting interest rates. Foreign tourists are having a ball vacationing and shopping in the U.S., and foreign investors are gobbling up our decimated assets, which are even cheaper than they appear when priced in euros and yens. Americans, however, are paying a steep price.

Treasury Secretary Henry Paulson (jokingly known as Mr. Strong Dollar) is trying to assure investors that we're just going through a blip. He wants us to believe that there is light at the end of the tunnel. Mr. Paulson, along with President Bush, will be out of work in 10 months. How much longer will Ben Bernanke have his job? To be fair, he can't be fully blamed for all of the ills in the economy. Some of the seeds of the current crisis were sown before he took office. Nonetheless, it is starting to look as if Mr. Bernanke's tenure at the Fed will not be setting any records.