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Financial Crisis Grows as Investment Bank Bear Stearns Collapses

By Adam Price

Federal Reserve Uses Emergency Powers from the Great Depression of the 1930s

San José, CA – On Friday, March 14, the fifth largest investment bank in the United States, Bear Stearns, failed. Over the weekend the Federal Reserve took over the riskiest mortgage-related investments worth $30 billion and arranged for J.P. Morgan Chase, the third largest U.S. bank (after Citigroup and Bank of America), to buy the rest of Bear Stearns for $2 a share, or 4% of its price on Thursday. The failure of Bear Stearns brings the growing financial crisis full circle, as it was the failure of two Bear Stearns hedge funds that invested in home mortgages that marked the beginning of the crisis last August.

In addition to arranging the take-over of Bear Stearns, the Federal Reserve used its emergency powers to begin lending money to investment banks, which don’t take deposits. The Federal Reserve also widened the types of collateral it would accept on loans and lengthened the loan period from 30 to 90 days. The Federal Reserve cut the interest rates on its loans to banks over the weekend, and then on Tuesday, March 18, it cut interest rates another three-quarters of one percent. The benchmark Federal Funds Rate, which the Federal Reserve controls, has now been cut from 5.25% to 2.25% over the last seven months.

The Federal Reserve is furiously trying to prevent a repeat of the Great Depression in the 1930s, where three waves of bank failures pounded the economy for a four-year decline, from which there was no real recovery until World War II. The Federal Reserve was worried that the bankruptcy of Bear Stearns would cause the bank to dump their investments, forcing down asset prices and causing more losses at other banks, leading to more failures.

While each of the Federal Reserve actions since August have been met with cheers of relief from stock market investors, the nation’s central bank has not been able to overcome the ongoing crisis in the credit markets. Interest rates on mortgages and many other kinds of loans are rising as banks cut back on lending due to their losses. Many banks are canceling home-equity lines of credit and making it harder for households and businesses to borrow. The mortgage crisis is having ripple effects on other credit markets such as auto loans, credit cards, municipal bonds, student loans and even loans between banks.

The Federal Reserve actions and the financial crisis have led to a dramatic fall in the value of the U.S. dollar, as foreign investors lose interest in buying U.S. assets. The dollar’s fall has fueled inflation, as the dollar price of goods traded on international markets, such as food and oil, go up. In addition many speculators are buying up oil and other commodities as a hedge against inflation and an alternative to falling stock markets. Rising inflation has driven a wedge between the Federal Reserve and other central banks, such as the European Central Bank, and is also leading to differences within the Federal Reserve over whether interest rates should be cut so far and so fast.

Last but not least, the Federal Reserve’s actions have done little or nothing to slow the fall in housing prices and home sales. Foreclosures continue to grow, and more and more borrowers who are ‘underwater’ because their mortgage is larger than their home price are walking away from their loans. Losses on investments backed by mortgages continue to grow. The falling housing market is depriving working people of their main form of wealth, while job losses are accelerating month by month. This is causing them to cut back on their spending, which will slow the economy even more, even as they fall behind on their debt payments, adding to the financial crisis.

As the crisis goes from bad to worse, there are more and more criticisms of Federal Reserve chairman Ben Bernanke and the Federal Reserve itself. But the problem is not the actions (or inaction) of the Federal Reserve in dealing with the crisis. In the past there was the hands-off attitude of the Federal Reserve under former chairman Alan Greenspan and the Bush administration during the housing boom from 2002-2005. The Federal Reserve had the power to curb the excesses of the mortgage madness, but did not do so. Republicans in Congress and the White House also blocked efforts to regulate mortgage lenders. This left the mortgage industry under state regulation, which in many cases amounted to little. Here in California, mortgage lenders are examined only once every four years. The Republican governor did not even appoint a permanent regulator until 2006, and there was little oversight until 2007, when the crisis began.

The problem is that the Federal Reserve and the government follow the interests of the wealthy, who seek ever-greater profits no matter what the cost to society may be. So the Federal Reserve, the Bush administration and state governments turned a blind eye to the excess and fraud of Wall Street, to keep their billions of dollars of profits flowing. Fundamentally, the problem is the capitalist system itself, built on private property and motivated by greed, which leads to recession and financial crisis.

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