No one knows where this ends: James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own.)

By James Saft

LONDON (Reuters) - All bets are off.

No one knows where the financial crisis is going, no one knows who might be next to fail, and no one knows what the Federal Reserve can do about it.

The bank run on Bear Stearns BSC.N, ending as it did with an almost unprecedented Federal Reserve bailout and a sale to J.P. Morgan Chase (JPM.N) at an ominously low price, has undermined the confidence needed for banking and markets to function.

Bear Stearns fell because others lost faith in it, and in the absence of better information, refused to extend it credit or do business with it.

That it was forced to sell itself to Morgan for about 2.5 percent of its recent stock market value would tend to back up those concerns.

And though Bear Stearns was undoubtedly among the most aggressive players in mortgages, how fundamentally different is it from its peers? It is impossible to know, and that very impossibility breeds doubt which feeds upon itself.

Though the Federal Reserve has taken heroic measures to avert the chaos that a Bear Stearns bankruptcy would have brought, as it is in medicine, the outcome for patients on whom heroic measures are taken is usually not so good.

It is hard to overstate just how radical the Fed's actions have been.

Besides slashing interest rates by 2.25 percentage points, including at emergency meetings, the central bank has hosed hundreds of billions of dollars of liquidity and loans to the financial system, has lent against collateral that is much riskier, and most recently has extended its largesse to a group -- investment bank primary dealers -- whom it does not regulate in the same way it does commercial banks and about whom it may know less.

Make no mistake, the Fed's actions are risky, which is much different than saying they are foolish.

So will the Fed succeed?

"I don't know and I don't think anybody knows," said Ross Walker, an economist at Royal Bank of Scotland in London. "The policy medicine might work, it might take some time to work but there is a feeling that it is all beyond our control."

Few can doubt the Fed's resolve, but if another large investment bank or bank sinks, justifiably or not, there is also concern about who can be found to buy them, even at fire sale prices.

"As the market focuses on the next shoe to drop, (it) needs to consider if there is another JP Morgan Chase out there to step into the breach," analyst Marc Chandler of Brown Brothers Harriman wrote in a note to clients.

"Many financial firms, as the earnings reports this week are expected to show, are experiencing their own stresses."

MONEY MARKETS LOSE FAITH

It's also important to remember that this is fundamentally a crisis of solvency, of banks and borrowers without enough money, rather than simply liquidity, or their access to ready cash. That means that liquidity and interest rate measures can only buy time, hopefully giving financial companies room to raise capital, or find a buyer.

But it also critically leaves the whole operation hostage to economic developments.

The problems, and the risks, won't end until house prices in the United States stop falling. With a long recession on tap, that won't happen soon unless we get a massive bailout of housing and banking from the government, something that is a lot less unthinkable than it was only a month ago.

If we needed more evidence that the problems will not end with Bear Stearns, money markets, which banks use to fund themselves, were in a state of near collapse. Overnight dollar London interbank offered rates jumped by more than 80 basis points on Monday, the biggest such move since September 11, 2001, as some banks scrambled for cash and other simply declined to do business with many counterparties.

Simply put, this can't go on and if it does it will bring down more banks.

"Banks, unlike non-financial corporates, have a binary business model," Morgan Stanley interest rate strategist Laurence Mutkin wrote in a note published on Friday.

"Non-financial corporations can continue in business - economic cycle permitting - even when their creditworthiness becomes stretched ... But banks are either creditworthy, and have a business; or are not worth lending to, and do not."

Credit, the business of banking, is ultimately about trust. The word credit has its roots in a Latin word meaning believe or entrust, which is why bank offices are usually so impressive.

Until we can see hard reasons to believe that banks are sound, and that will be a while, we will be in dangerous times.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. e-mail: saft@reuters.com --

(Editing by Ruth Pitchford)