With Bear Stearns having to be rescued by the Fed (i.e. the government), the credit crisis is entering the seriously ugly phase. And I say this now because we Street types exhibit sangfroid when a sub-prime family gets thrown out of its home ("they should have been more responsible in managing their debt"), but when the sheriff comes calling to our neighborhood "it's the market's fault". Come to think of it, I have never seen a mirror at a bank/broker/investment bank office - I wonder why..?
Anyway, prior to rescuing Bear Stearns yesterday, there were only two prior occasions when the Fed used the obscure provision about funding non-bank institutions through the Discount Window. As The Economist points out, the last time was in the 1960s - and before that in the 1930s. References and parallels to the Great Depression are getting all too frequent lately, it seems.
While the failure of one major-bracket investment bank to get funding on its own is bad enough, worse is yet to come. Broker/dealers are entirely dependent on ample short term loans and trading lines to carry their securities' inventory and to clear transactions. Any hint of trouble and counterparties pull their lines and customers pull their accounts. The end comes instantly, usually no more than a few hours: Sudden Debt, to coin a phrase*..
The trouble at Bear will now cause every firm to become even more cautious with counterparty risk, clamping down on credit lines to trading partners and customers. The immediate reaction is "Bear is history, who's next?". Unlike the isolated 1998 LTCM snafu - one bad apple threatening to contaminate many otherwise healthy apples - the current crisis is fundamentally more serious and widespread. We know that many healthy-looking apples are already wormy inside, but we don't know which ones. The result is less trust in "apples" overall, a major problem in an industry where trust is the cornerstone of daily business.
Bottom line: short-term market credit (aka margin) is going to get squeezed much harder in days and weeks to come, forcing the Fed into even more "gifts" of TAFs, TSLFs, etc. That's too bad: to use mythological parallels, Pandora has opened the box... or the Trojans have wheeled a certain horse into their city.
* Yes, hours. To provide an example, during the 1987 crash my then firm (a major bracket, too) asked that customer margin calls be satisfied immediately - as in "wire or bring a check to the cashier by 2 pm or you will be sold out". Fun, eh? When survival is at stake in the Street, noblesse never oblige.