Bear Stearns: Not Your Average Bailout
Third in a series of web-only articles on the subprime/securitization crisis.
This article is from the March/April 2008 issue of Dollars & Sense: The Magazine of Economic Justice available at http://www.dollarsandsense.org
This is a web-only article.
at a 30% discount.
Of all the events that have occurred since early March, when the last installment in this series came out, the Federal Reserve-orchestrated takeover of Bear Stearns by JP Morgan Chase was by far the most important, both in terms of its immediate significance, as well as its likely lasting impact. That impact will involve the forging of an altered relationship between central banks and the financial sector, one which will, no doubt, result in the promulgation of new rules on the one hand, but which may, ironically, make possible a still greater danger of what is known as "moral hazard"—or the expected likelihood that the authorities will come to rescue in the case of failure, which can encourage the development a correspondingly relaxed attitude toward risk as a result on the part of investors and financiers—on the other. And then there's the wider economy: does the Bear rescue increase the likelihood that the recession (or downturn) will be short-lived and shallow, or will it simply slough off the economic burden onto the backs of workers and taxpayers, perhaps thereby, eventually, prolonging it? Finally, there's the bailout question: does Bear qualify as a good, old-fashioned bailout? Or is it something new that, for better or worse, we'll all have to learn to accommodate ourselves to (assuming it turns out to be, in fact, a bailout)?
First, then, the details: at the weekend of March 15th/16th, Bear Stearns had endured a withdrawal of $17 billion during two days of the previous week, due to rumors that other banks were refusing to serve as counterparties—and Bear is a counterparty to $10 trillion in over-the-counter swaps, and this despite the fact that brokers operate with far smaller capital requirements than commercial banks—to its trade in complex securities called derivatives, a crucial segment of Bear's business. And since Bear was also a major participant in the so-called "tri-party repo (or repurchase) market," in which banks and brokers lend overnight to each other for cash (banks have to keep a mandated level of cash or liquid securities in reserve, and often borrow overnight to maintain the required reserve levels, paying a fee corresponding to the interest when the securities are bought back by the brokers, often the next day), suspicions grew that Bear might not be able to play its role in this sort of essential funding. This, in turn, could jeopardize the flow of funds to other institutions, in addition to increasing the likelihood that Bear itself could default on its own deals (as the Financial Times noted, transactions in repo markets tend to be "highly intertwined"). It didn't help, of course, that Bear, though not a large Wall Street investment bank, had the most subprime loans on its books, and had indeed suffered the collapse of two associated hedge funds (which also had portfolios crammed full of subprime mortgages, some of which Bear had to take back on its balance sheet) last summer. As regulators were already concerned that Bear had not done much to shore up its capital base in the wake of these potential disasters, it did not take much to send investors heading towards the exits. Bear's share price, accordingly, tanked, falling by about 60% in those two dark days alone. Unless a buyer could be found, fast, it seemed that Bear would have to give in to the inevitable and declare bankruptcy.
But it was not the possibility that Bear alone would collapse that motivated the Fed to move in, under the auspices of JP Morgan Chase (Bear's clearing bank, which, as the largest derivatives trader on Wall Street, stood to lose a lot if Bear defaulted and the derivatives market seized up). Instead, the Fed, JP Morgan Chase, and other big players were afraid that, in the words of the Financial Times, Bear's "problems funding itself through repurchase transactions...would cause the broker to default on its related contracts, sparking a daisy chain of defaults across the banking sector (emphasis mine)." So it was questions over Bear's reach into the finances of others, more than its own sorry state, that caused the Fed to act; and it was in this sense, that Bear was not considered too big to fail (as mentioned before, Bear is actually not one of the larger Wall Street firms), but, rather, enabled by the exceptionally vigorous sort of financial deregulation that has characterized the last few decades, that it was too interconnected to fail, that forced the Fed's not so invisible hand. Again in the words of the Financial Times, "regulated, lightly regulated and unregulated institutions [are] increasingly exposed to each other's risks."
And the Fed didn't stop there. In an historic shift, it extended lending to all bond dealers from its discount window (the venue for distressed borrowers, who pay a—in these days very slight—penalty for appealing to it as a last resort), making such lifelines available to investment banks and even brokers as well as commercial banks. Now all these players (though not hedge funds) have a have lender of last resort, unlike hitherto, when only institutions offering deposit insurance, observing reserve requirements, or subjected to stricter regulatory oversight, did. On top of that, the Fed dropped interest rates another 75 basis points, to 2.25%, at its scheduled meeting on March the 18th. The significance of the former action cannot be underestimated: the Fed is, according to The Economist, "taking the unprecedented (and disturbing) step of financing up to $30 billion of Bear's weakest assets. This could cost the central bank several billion dollars if those assets fall in value." That offer, needless to say, was what clinched the deal from the point of view of JP Morgan Chase.
JP Morgan Chase, for its part, again according to The Economist, "has pledged to honour all of Bear's commitments, despite having had only two days for due diligence. Bear's gross mortgage exposure is still likely to be well over $10 billion after the Fed guarantees the least liquid stuff." Still, the wider danger to the financial system increased when similar suspicions fell upon Lehman Brothers and Merrill Lynch regarding the durability of their capital cushions, and with them the likelihood that they will continue to serve as desirable counterparties to crucial deals. Though these firms muddled through, cutting repo exposure and raising cash on the markets, the fear persists that "the new Fed window is untested and the very act of drawing on it could rattle markets (The Economist)."
And what did JP Morgan Chase pay for Bear? It was supposed to pay $2 a share originally, but the offer was raised to $10 (shareholders were aghast at the $2 offer, and threats of lawsuits were legion) a share a few days later. Though way, way down from the $170 the shares traded at a year ago (and over $200 a share in 2006; they had fallen to about $3.70 a share when the agreement was announced), it is clear that JP Morgan Chase is getting something out of this: JP Morgan Chase has coveted Bear's prime brokerage division for a long time, and its New York headquarters alone is valued at over a billion dollars. In addition, as mentioned before, Bear was one of JP Morgan Chase's big customers in its clearing business, and the latter certainly had an interest in making sure Bear's obligations are ultimately honored, so that other contracts cleared through it (generating fee income along the way) continue to be recycled without delay or hindrance. However, JP Morgan Chase also agreed to take on the first $1 billion dollars worth of obligations from the Fed (should it come to that) when it made its $10 offer, a job the Fed was only to happy to relinquish, even though the raised bid made the deal look a tad more like something akin to a bailout for shareholders.
So: let's put all this in larger perspective. Prior Fed actions (in which the Fed tried to restore confidence in the markets by separating risky from quality assets, by guaranteeing the best assets once they had been presumably stripped of the dross) had attempted to get banks to lend again. Because banks with subprime exposure—or simply reacting to asset loses triggered by the more general market downturns that have taken place since the subprime crisis began—needed to ramp up their capital bases quickly (both to cover losses on their own balance sheets from dud investments, and to re-accumulate reserves on loans they had taken off balance sheet, but have been forced to take back on, due to so-called "covenant lite" agreements they signed with hedge funds and the like when times were good, as well as to prepare for the loss of loan-based and other income expected during a period of serious economic downturn), they did not begin lending in spite of the Fed's historic spree of huge interest rate cuts. This was particularly the case where real estate lending was concerned, of course (commercial and industrial loans have held up, more or less, providing some measure of comfort for those banking on recovery), but also characterized lending for things like mergers and acquisitions, which require syndicated (involving a number of banks) loans big enough to lubricate such mega-deals, not to mention the late lamented "commercial paper" market (which was largely made up of asset-backed securities like, you guessed it, subprime mortgages), not to mention for more mundane—from a financial, but not necessarily economic point of view—purposes like student loans and credit cards.
To address this problem, the Fed also did things like expand the types of assets it would accept as collateral from distressed banks seeking emergency loans (previously it had accepted only the best quality bonds), and encourage banks to queue up at its discount window by reducing the penalty rates that had to be paid to tap it down to almost nothing. It increased the period of time it would accept these easier conditions considerably, and speeded up auctions of quality bonds, which banks could take on their books in place of more questionable ones they could now dump on the Fed. But these moves didn't help much, either: as long as no one knew how much whole classes of important assets were currently worth (since markets had dried up, all too many had no selling price at all), and other indications of recovery in glutted markets pointing to the future—hence a more indirect clue about asset prices—were not forthcoming (like a recovery in the housing market), even the Fed's vigorous actions to fire up the monetary transmission mechanism didn't do much except, perhaps, prevent complete collapse.
That was up until Bear's meltdown. How was it that Bear on the one hand seemed to represent both that point of no return corresponding to systemic collapse, and the impetus behind the remarkable recent upswing in asset values and market sentiment (if not economic indicators) on the other?
The Fed-led rescue of Bear gave investors an unmistakable signal that the central bank would not allow what had long ceased to be perceived as a "mere" liquidity (involving availability of funds to carry out current business) crunch to finally, however belatedly, tip over into a full-blown solvency (involving conditions pertaining to whether or not business could be carried on or not at all) crisis. The unique thing about this shift was that any prior distinction between systemic solvency and the solvency of one particular institution was reduced to precious little, precisely because the types of investments Bear and innumerable other financial institutions loaded up on (enabled by a perfect storm of unprecedented financial deregulation in an atmosphere of extra-low interest rates and correspondingly subdued underlying economic strength, legal laziness, desperation for quick profits to make up for past losses or expected future shortfalls, and technical wizardry, amongst other things) sliced risk up not only so unimaginably broadly, but also in such opaque—and even legally contestable or even contradictory—ways, that it has become impossible for essential financial institutions to carry on business without relying heavily on them, whether or not they can even be priced in a timely or accurate way in an emergency. Indeed, the model relied on the assumption of the ever-appreciating asset values precisely because appreciating assets mean less collateral has to be put down to generate further fee-generating deals when markets are rising, thus ensuring increasing volumes: this sort of logic had a major impact in the so-called collateralized debt obligation (CDO) market during the bubble, for lower collateral demands meant securities consisting of assets with different ratings could be packaged together with less collateral. Needless to say, when the downturn hit, this process went into reverse.
The Fed must be hoping that its ur-action involving Bear can finally put a floor under markets and kick start an upswing that will make any similar action unnecessary, and even unimaginable. The logic seems to go like this: by making its guarantee of securities as broad as is feasible, and barring any further disasters, any increase in confidence is bound to spread across the financial spectrum, and give rise to greater investment activity (and remember, Bear seems to be the institution most exposed to subprime loans, and so a repeat rescue would be in this sense impossible); such a rebound would then increase the likelihood that the Fed would be repaid any monies it had to spend taking on assets of firms that do go under, thereby reducing the taxpayers' bill to something acceptable, if not zero. And, as financial recovery becomes reinforced by economic recovery, the Fed and regulators will perhaps then fill in a new regulatory framework, one that will possibly amount to the cutting of the Bear lifeline over the moat of traditional insolvency once again (though it remains very unclear how large that moat itself will remain, after its unprecedented erosion of the last few decades). This seems to be the contour of the new kind of thinking on "bailouts." And it represents something of an advance on the old way of looking at things: whereas the Fed previously would not even attempt to diagnose, let alone prick, financial bubbles before their bloated outlines were clear to almost everybody (and especially to shady dealers and short sellers—not that the two necessarily overlap), and waiting for bubbles to burst before pumping cheap money into the system, or hitting taxpayers up to pay off the debts of entire subsectors of the financial system (Savings and Loan Banks in the early 1990s), the Fed is now talking about dispatching "SWAT" teams of regulators to preempt abuses and limiting bailouts to the guaranteeing of payment of essential debts (so related firms—not just payees—can carry on with business), with the expectation of full repayment by the offending institutions, and little net taxpayer involvement.
Still, it seems that there is something inherently contradictory about an idea that involves preemption or timely, painless remediation of losses, unless securities are somehow severely limited regarding their potential division and distribution (in a process known as "securitization," or "slicing and dicing," in the jargon). These days, proposed regulation regarding such operations tends to be referred to in terms of potential limitations on financial innovation, which is vehemently opposed by the financial industry. And, in an election year in which the financial sector is the highest net contributor to presidential campaigns (despite its huge losses), it is hard to say where any significant steps toward reregulation would begin. This is all the more the case given all the talk of Wall Street losing business to the City of London (though the City is hardly a great example given its own sorry performance during the crisis) and other financial centers because of Sarbanes-Oxley and other, existing "intrusive" forms of regulation. Still, the essential problem regulators must face, according to The Economist, is this: "...gambling has been fed by knowledge that, if disaster struck, someone else—borrowers, investors, taxpayers—would end up bearing at least some of the risk."
But it goes beyond this. The real problem is not so much that investors were prone to believe that someone else would bear some of the risk, but that the regulatory authorities did not even bother to concern themselves with the notion that the system of payments itself could not remain intact if too many investors, encouraged by perverse incentives on every level, which resulted in fatter fees being thrown off at every stop on the securitization gravy train even as any accurate sense of risk proceeded to evaporate away, assumed they could probably elude liability (often via the employment of completely legitimate means, like the taking out of default insurance via the so-called "monoline" bond insurers, who, engaging in the same sort of securitization on top of perilously thin capital bases, found themselves struggling frantically to raise funds to meet obligations) for payment—especially as the idea of falling markets itself was considered an "extraordinary event," or about as likely to occur as some sort of weird, undiscovered configuration of astronomical objects. And as long as the financial sector—with its unique lobbying power—resists reform regarding of the potential distribution and division of securities, or of acceptable levels of leverage—i.e. investing with borrowed funds (which it must do, given the centrality of the these latter not only to its remunerative scheme, but to its very operations)—it's difficult to see what will reduce the danger of the formation of repeat bubbles—and meltdowns—Fed SWAT teams or no.
This is not to say that there will be no reregulation of the financial industry in the wake of the wider financial crisis. A tacit provision of the Bear Stearns deal seemed to be that the financial industry would accept some regulation in return for a lifeline as comprehensive as the Bear one was understood to be. But, again, in the post Glass-Steagall world (and it's impossible to believe that off-balance sheet conduits or special investment vehicles, which played such a pivotal role in the subprime fiasco, would have been employed on such a humungous scale if Glass-Steagall hadn't been so thoroughly dismantled), the interconnections are so great that it's fiendishly difficult to decide on where to begin to carry out fundamental reform before some, already delicate part of the financial system began to get hit with unacceptable losses (from the point of view of the interconnected whole). That being the case, it's all too likely that easy targets will be agreed upon to bear the brunt of the pain (including, most likely, subprime mortgage holders who, unfortunately, have received precious little public sympathy for their plight), especially if there is some sort of nascent recovery. But this creates all the more danger that, in the absence of fundamental reform, market players will operate in the expectation that central banks may have to bail them out of any future, and probably greater, systemic difficulties, which, after all, will be all the more likely if, assuming no limits are placed on it, "financial innovation' is allowed to flourish again.
What about shareholders? Are they not feeling the pain? Well, the shareholders of Bear (30% of which is held by its employees, many of whom are ex-employees by now, to boot) certainly are. However, as mentioned earlier, shares, even those of loss-making companies in the financial sector, have been enjoying a firm recovery since the Bear deal was announced. And if it were not for the deal, shareholders across the board would probably be facing considerable losses by now. So in this sense, shareholders are, at least for now, and with the exception of certain firms, being bailed out. The effects of the bailout, however, will be almost certainly be reversed if economic recovery fails to take root.
But the medicine may be working, at least temporarily. An important indicator of this is the sinking cost of credit default insurance. Before the deal, this type of insurance, which allows investors to insure any losses on bonds they buy for a fee, reached historic levels, even as other interest rates were being pushed way, way down (LIBOR, an important set of interest rates, also remained stubbornly high, but this may be due to technical—if partially shady— reasons). In addition, the market for leveraged loans mentioned above reacted very favorably to the move. More importantly, banks are beginning to find buyers for the delicate, to put it politely, loan portfolios (they often sweeten the offer for buyers by providing huge loans at highly favorable rates to seal the deals) they need to sell to ramp up their capital and begin lending again. Between these two developments, an unmistakable note of confidence took hold on financial markets in the last two weeks of April, buttressed by the idea that the monetary transmission mechanism (especially in interbank—or between banks, in order to maintain mandated reserve requirements in the face of gyrating day-to-day business conditions—markets) was finally beginning to become unstuck. US employment figures showing much less-than expected job losses in April (though for the 4th straight month), coupled with the Fed's decision to cut rates an additional 25 basis points to 2 per cent on April 30th, led to a rally on Wall Street on Friday, May the 2d, which, however, petered out as Sun Microsystems disappointed with a depressed earnings forecast.
All the celebration may, however, be a tad premature, to put it mildly; important weaknesses still afflict the interbank market, not to mention the wider economy. And that raises the question of whether or not the Fed action will lead to a brief financial recovery which will, in turn, merely increase the burden for the rest of us. In other words, the Fed, by inflating asset values across the board in the face of dodgy, if not deteriorating economic fundamentals, could foster a note of confidence that will cause politicians and the wider public to lose sight of the real weak spots in the economy, like the housing sector, which simply must continue to decline if house prices, and, by extension, a completely outsized part of the American economy in the last few years, are to become truly affordable again. In addition, some of the indicators market players are cheering turn out to be, on closer analysis, more worrying than comforting. As Nouriel Roubini made very clear in his characteristically sober web post, the official uptick in first-quarter growth, another factor that had been pushing markets higher, contains more to worry about than to put money on. For instance, the bulk of growth was dedicated to inventory buildup (probably in the resurgent expert sector, which will perhaps lead to overshoot, given the relentless rise in inflation in so many other economies); without that, growth would have been negative again. Add to this the fact that employee compensation was stagnant. Moreover, consumption is being directed toward only the most essential purchases.
Even on the financial front, things are hardly encouraging. Ambac, one of the "monoline" bond insurers that managed to hold on to its pristine bond rating (bond insurers can pass that rating onto their clients, who are often simple municipalities and the like, allowing them to avoid excessive costs in normal municipal financing), announced horrific losses less than two months after having its top-notch rating restored by one of the major ratings agencies (which leads one to wonder how this could have happened in the first place). Add to this the at times perplexing upsurges in inflation being reported across the globe, including in the US, and the recovery model looks less and less compelling. So: it's clear that we have a ways to go before this mess is cleared up. One thing, however, needs to be said: in Europe, workers used the (alas, not in the US) traditional May Day holiday to protest against the rises in inflation which are afflicting their countries. In Europe, it seems, inflation is threatening living standards to such an extent that many younger Europeans, especially given the demographic bulge (many more baby boomers than offspring of baby boomers), fear that they will not attain the levels of living standards that their parents achieved. It's time for workers in the US to become much, much more sensitive to such swings, and adjust their wage (not to mention benefits) demands accordingly.