During the bloodiest part of the French Revolution in the summer of 1794, hundreds of people were led to that infamous execution device, the Guillotine.  There the condemned faced a nasty, public death in front of their enemies, their peers, and their friends.  Waiting your turn to face that dreaded Guillotine must have been utterly terrifying, hence the name for that brutal nadir of the time, the Reign of Terror.

The rank and file folks on Wall Street must feel the same way right now as they await the sound of the crowd screaming that the dollar and the Fed funds rate have both gotten the “off with their head” treatment today.  Bear Stearns was the first to get decapitated.  Nearly everyone is betting that it won’t happen again.  Specifically, everyone is roaming around Wall Street betting that it won’t happen to them next.  The same “nearly everyone” will be wrong about the first part.  And some unfortunate few will be very, very wrong about the second.
That rate cut is expected to be impressive, anywhere in the neighborhood of 100 basis points…or perhaps 125…or more.  So what happens now?  The Dow actually finished up 21 points yesterday and Asian and European stocks are up on Tuesday anticipating a strong day on Wall Street.

The key phrase there is “strong day“.  A rate cut may very well boost the market today or even tomorrow.  The Fed dumped $200 billion into the markets not more than a few days ago and Wall Street had its best day in 5 years.

Then Bear Stearns collapsed anyway.  Keep that in mind.  Odds are the employees of that company, all 14,000+ of them, felt pretty good when the markets went up over 400 points.  Now up to half of them could be out of a job a week later.

It will come as no surprise to some Bear Stearns employees if they lose their jobs as a result of the company being sold to stave off bankruptcy.

Financial markets had been rife with speculation for weeks that the fifth largest U.S. investment bank was in trouble because mortgage bond holdings went bad.

“Bear Stearns professionals have been sending out their resumes, and this flow will only increase as the week goes on,” said Michael Karp, chief executive officer of Options Group, a global executive search and strategic consulting firm based in New York. “The current market is not as bad as 1990-1991, but it’s getting there.”

On Monday, CNBC television news, citing unnamed sources, reported that JPMorgan Chase, which agreed on Sunday to buy Bear for $240 million, expected to cut about half of Bear’s 14,000 employees.

Like other Americans, some of them would face a parched jobscape as the U.S. economy weakens and the cost of living rises. The U.S. unemployment rate in February was 4.8 percent and payrolls fell by 63,000, the second straight month of payrolls decline.

In the first two months of 2008, U.S. financial companies cut more than 20,000 jobs, according to employment consulting firm Challenger, Gray & Christmas Inc, as they racked up losses triggered by the collapse the subprime mortgage market.

Once again folks are optimistically talking about yesterday’s failure to collapse as proof the Fed’s got the problem licked.

To them, I say this:  if the Fed could have solved the systemic problems in the economy right now, don’t you think they would have done so already instead of allowing all this to happen?

I’ve heard three basic things from the media over the last 24 hours regarding Bear Stearns, that 1) the Fed had no choice in order to prevent a meltdown at the time (this is true), 2) The Fed took bold and decisive action (this is true to a point) and that the worst of the crisis is now over (which is patently false).

People are talking about the collapse of Bear.  They aren’t really talking about what else the Fed did, mainly cut the discount window 25 basis points and then threw it open to non-commercial banks.  The Fed has now become the lender of last resort for a number of investment banks, not just commercial banks.  There’s a huge difference between bailing out one and bailing out the other.

That difference is risk.  Investment banks take riskier investment than commercial banks.  As a result, they have different rules applied to them.  There are strict rules to what a commercial bank can do with Fed last resort money.  But until Monday, those rules never applied to investment banks because they were far less regulated.  Now they have the benefit of a Fed bailout and can continue with the same risky investments that got them into that mess to begin with.

Nowhere have I seen any mention that the same rules now apply to investment banks.  They don’t.  This is an alarming moral hazard situation now; there is a distinct reason why this has never been done before.  The rules were there for a reason.  Now?  Anything goes.

If you’re an investment bank, and the Fed just opened its window for you to get super cheap cash, why not take them up on it and invest it in risky but high-paying gigs?  There’s no downside, really.  Fed will bail you out.  It’s like a rich teenager borrowing Dad’s new $200,000 car…what’s he going to do, ground you?

But let’s look at what that rate cut is really going to do.  The dollar is going to drop like a stone from its already low perch.  Anything less than 100 basis points and the market will drop like a stone too.

The Fed is now almost out of rate to cut.  And no rate cut can possibly solve the problem of those deadly derivatives floating around, trillions and trillions of them out there, with nobody knowing what they are worth.

Bear Stearns fell because people yanked their money out from the company when it became clear the company was worth far less than what it was trading at.  It was leveraged at 30 to 1, for every dollar it actually had, it had 30 bucks in IOUs from Wall Street.  When people wanted their money out, Bear didn’t have it.  The market panicked.  It was a classic bank run scenario…get your money out of the stock before it’s worth…well, $2 a share.

So now that company was really worth $2 a share all this time.  Bear’s Manhattan headquarters building is worth about five times more than the company itself!

So like everything else the Fed has done this year, the rate cut will juice the market for a day or so.  But in a few days, when it becomes clear that the rate cut (no matter how big) won’t save the rest of the financials, then the REAL bank runs begin on Wall Street.

And the runs on the bank branches near where you live may not be far behind.

Update [2008-3-18 12:46:33 by Zandar1]: An informative story from CNBC sums up the situation and the Fed’s intentions.

Look at Bear Stearns. It may be no coincidence that the biggest casualty on Wall Street thus far was suffocating under a blanket of mortgage-backed securities.

It may also be no coincidence that the Fed last week took the unusual step of creating its so-called Term Securities Lending Facility, allowing it to take up to $200 billion of non-Treasury securities, including federal agency backed mortgage securities and mortgages, as collateral for up to 28 days.

“It’s probably an admission that federal funds will not be enough,” David Resler, chief economist at Nomura International, said at the time. Reseler considers the lending facility, the “most significant policy initiative since the credit crisis began last August.”

Ahh, but here’s the rub…

But it may be as far as the Fed can go. Federal law prevents the central bank from buying mortgages outright. Congress, of course, could change that, or otherwise, empower another arm of the federal government to do that.

“The most effective way is to create some way so the federal government can force a markdown in some of these mortgages and take them on itself — say through some sort of bank — such that the government becomes the holder of mortgages,” says Irons.

Pay attention folks, the multi-trillion dollar bailout is coming. When the Fed runs out of rates to cut and money to inject, the outright purchase of trillions in mortgages and securitized junk will follow. How much money will the bailout cost you, on top of Iraq, on top of everything else we’re trillions in the hole on?

What’s a few more trillion among friends?

Update [2008-3-18 15:36:30 by Zandar1]:And it’s only a 75 basis point cut, three-quarters of a point. Stock market wasn’t happy and dropped some but it’s rebounded now. That was expected. Dollar’s actually up a fraction because that rate cut wasn’t as much as people expected.

So what’s next? The systemic problems in the market still remain. The next few days should tell the tale.