A modern day equivalent of a run on the bank?

Granted, the Fed's intervention to avoid the total collapse of Bear Stearns is not exactly analogous to saving an institution from the threat of a bank run if we consider the precise definition of a run on the bank, i.e. a situation in which panicked customers simultaneously withdraw their savings as a result of fear that by not doing so they may lose what they have. As the bank only keeps a fraction of deposits in cash, without some type of external help, it will implode.
Bear Stearns is not a commercial bank and therefore technically does not have any deposits to raid. In Bear's case the crisis began when their ability to borrow was suddenly cut off. It ensued the collapse of Carlyle Group's flagship Carlyle Capital fund when rumors began to circulate that Bear had a large stake in the fund. So why, you may ask, would this be considered the modern day equivalent of a run on the bank, warranting Fed intervention? The answer has to do with the bigger picture. The Fed figured that the risk of triggering systemic risk by allowing Bear to go bankrupt was higher than the risk and repercussions of moral hazard. It would have led to further casualties in the financial sector as lenders became more reluctant. In addition to coming to the rescue of Bear Stearns, the Federal Reserve announced that it would extend its lending facilities to a wider segment of the financial sector. This should help substantially to mitigate the risk of another blowup.
As for market conditions, the rough ride is likely to persist as the root housing crisis will drag on for a while to come irrespective of what the Fed and/or government do.

A record breaking month...

March has turned out to be a month in which several records were broken. In the commodities front both gold and oil were notable for surging past their all time highs whilst in currencies, the ever so weak U.S. dollar reached new lows most notably against the Euro and the Swiss Franc. It also turned out to be a month in which wealth got wiped out in record breaking speed with the dramatic implosions of Carlyle Capital (a highly leveraged flagship fund of the Carlyle Group) and Bear Stearns (formerly the 5th largest U.S. bank) which saw it's 85 year history evaporate into thin air in just a couple of days.
The Fed has attempted to counter the hemorrhage from several angles by boosting the term auction facility to 200 billion dollars and raising the lending period to 28 days, cutting the discount window by 25 basis points and cutting the target rate by 75 basis points. It is clear from these actions that the Fed perceives a growing threat on the orderly functioning of the financial system. These moves have also brought the morale hazard debate back into center stage as a growing chorus of pundits are arguing that bailing out the likes of Bear Stearns is sending the wrong message.
In an environment in which fear has overtaken greed and where emotions are running high, irrational behavior seems to be the order of the day. The sharp drop in commodities following the 75 basis point cut in the target rate is a prime example of this. It seems that the sell off occurred because the market was anticipating a 1% cut and was therefore disappointed with a cut that was a quarter point less. If we take this train of thought a step further, what the market seems to be suggesting is that a difference of 25 basis points will be enough to determine whether we will experience an economic expansion or a recession or whether there will be inflation or price stability. If this is not insane, I don't know what is!

Want a tip?

Treasury Inflation Protected Securities, better known as TIPS are all the rage these days and should be, given their stellar returns (more than 6% since the start of the year versus roughly 4% on plain treasuries). In effect, these instruments are the equivalent to plain vanilla treasuries but carry even lower risk given that they protect the holder from the corrosive effect of a surge in inflation which is accomplished by adjusting the nominal value at maturity by changes in the broad measure of the CPI index. The inflation hedge explains why yields are below those of standard treasuries.
TIPS which were introduced in 1997 are also an important measuring tool for inflation expectations. One looks at the spread and the change in spread between the treasury yield curve and that of TIPS to get a feel of inflation expectations. Like with an ordinary bond, if the yield (or real yield in parlance terms) remains the same, the bond price doesn't budge. But if there is a shift in inflation perception, price movements occur (like we have seen over this year and last).
With a steepening yield curve and the performance in TIPS and commodities in general, the market is telling us that the risk of inflation on the horizon is rising. It is no wonder given the aggressive cut in rates over the past weeks and months. But then we have a lag factor of between 6 and 8 months from the moment a change in rates takes place and it's effects begin to appear in economic releases. This means that the Fed is playing a very delicate balancing act whereby as soon as it feels confident enough that the conundrum has subsided for good, they will have to aggressively tighten to avert inflation from getting out of hand. In the mean time, having some form of hedge against inflation in one's portfolio should be considered as a sound proposition.

In the age of turbulence...

It is challenging enough to keep a cool head in an environment of negativism when a growing chorus of industry pundits are suggesting the end of the world is near. Now I am not suggesting that a major correction is not in the cards, what I am trying to point out here is how difficult it becomes for a portfolio manager to stay the course when turbulence hits with full force. An environment of elevated psychosis in which emotions are running high frequently leads to a situation in which managers lose focus of long term objectives (a key feature of modern portfolio theory), and instead concentrate on playing cat and mouse so to speak. In the current environment where uncertainty reins, one may be tempted to switch into cash and just stack it under a mattress. But what happens when things return back to normal? More specifically, without hindsight, how can we be sure that normalcy has returned?
To illustrate these important points let's take the October '87 crash. On a single day the S&P 500 lost around 20% of its value. Emotions where running very high at the time and a lot of investors decided to take the plunge either by liquidating their positions and switching to cash or bonds. But who would have guessed that just a bit over 3 months later, 90% of that loss had been recouped. Those that had ceded to panic had not only lost 31% of the value of their investments (if we take the drop from it's peak), but failed to capture any of the upturn (bonds had already peaked before the stock market crash).
Again, I am not suggesting that staying the course in turbulent times is an easy task. On the contrary, it can be extremely challenging. If there are any lessons to be learnt, however, it is that ceding to emotions can prove to be an extremely costly endeavor in the long run as we have seen with the example and there are plenty of studies out there that support this view.