The Worst Risks of the Credit Crisis Averted

As a result of what happened last week, I'm now convinced that the worst risks of the credit crisis have been averted. It's safe to dive in and buy risky assets and risky sectors again. And I'm convinced that my worst fears about inflation are now not going to materialize. It's time to bail on some of the inflation hedges I've been writing about here for years.

Let's see... where to being to try to catch up... It begins with the crash of Bear Stearns (BSC), and the way the Federal Reserve handled it.

Last Friday the Fed made it clear that it would do virtually anything to keep a major investment bank from failing, and dragging the world's markets down with it. In the morning it announced it would both put up the money for — and guarantee — J.P. Morgan Chase's (JPM) $30 billion loan to help Bear Stearns through its liquidity crisis. If the loan turned out OK, Morgan would get the profit. If it went bad, the Fed would take the loss. Surely the loan could have been made on no other terms, since all Bear could pledge as collateral was a portfolio of questionable mortgage-backed securities.

Over the weekend, things got worse. On Sunday night it was announced that Morgan was acquiring Bear for a mere $2 a share, a price far lower than the value of Bear's midtown Manhattan office building. The Fed's guarantee of the $30 billion in mortgage-backed securities would stay in place. Morgan was virtually stealing Bear Stearns — with the Fed's money. Which is to say: the taxpayer's money.

Monday before the opening I put out a memo for my institutional investor clients telling them that the world had suddenly changed. I said we were potentially looking at the worst possible thing that could happen to the market — the instantaneous vaporization of a major company that about a year ago had been worth $20 billion in market cap — and for no apparent reason. Somehow a panic had gotten started, and then in a matter of days... poof! If that could happen to Bear Stearns, it could happen to Lehman (LEH), to Merrill (MER), to Goldman Sachs (GS) — or why not IBM (IBM) or General Electric (GE)?

But at the same time I told my clients that something very good had happened. The Fed has stepped up and made sure that, at least, Bear Stearns's collapse would be orderly, and that all of its vast web of financial obligations with counterparties around the world would be honored by J.P. Morgan. I predicted there would be a brief spasm of horror, but that this event would mark the bottom for stocks and the beginning of the end of the credit crisis. I said: Try to find the courage to buy weakness here.

It's way too soon to know for sure, but it looks like that will turn out to be right. The panic in the aftermath of Bear's collapse caused a new low in stocks to be notched on Monday, but then on Tuesday stocks came roaring back with the best single-day performance in about 5 1/2 years, with the embattled financial sector leading the way upward.

But wait. It's nowhere near that simple. I also told clients that by opening up its checkbook to save Bear, the Fed was unleashing an even greater tsunami of inflation than the one it had already set in motion. By cutting rates so much since the credit crisis began last summer. I felt justified in saying that, in part, because when the Bear/Morgan deal was announced Sunday night, the price of gold soared to new highs above $1,030 per ounce. If that doesn't say "inflation," nothing does.

But then the world changed again. On Tuesday afternoon the Fed cut interest rates by 75 basis points, to 2.25%, at their scheduled FOMC meeting. That's a big cut, and rates were low already. But the significance of it is that markets had definitely expected the Fed to cut by a full percentage point.

By cutting only 75 basis points, the Fed disappointed the market's expectations. That was an act of courage, because ever since the credit crisis began last summer, the Fed has never dared to give the market anything less than it demanded, for fear of setting off another wave of volatility. And it worked! After the "disappointing" cut, stocks soared. Markets, it seemed, were applauding the Fed's courage and moderation.