Wednesday, April 2, 2008 0 comments ++[ CLICK TO COMMENT ]++

Ben Bernanke Comments About Saving Bear Stearns

(Illustration by Christoph Niemann for The New Yorker)

It’s a good thing that Bear Stearns was saved. But it’s also a good thing that it nearly died.
-- James Surowiecki, Too Dumb To Fail, The New Yorker

The collapse of Bear Stearns will be remembered for centuries. It is not often that a top 5 Wall Street bank not only collapses, but ends up doing so under mysterious circumstances. It wasn't even 5 days before the collapse that the CEO of Bear Stearns was reiterating that Bear Stearns had ample liquidity. Investors who bought shares after the CEO's comments may disagree but I don't suspect that the CEO purposely lied. What is shady, however, is how Bear Stearns was taken over by JP Morgan Chase & Co under quite dubiuos of circumstances. There wasn't a coalition of the willing, using George's Bush's lingo, that was involved; instead, it looks like JPM was favoured and given the keys to Bear Stearns. In any case, all that is past and I am not a shareholder of BSC so I don't pay much attention to it. What is more important is why the Federal Reserve did what it did (i.e. provide a (initially) $30 billion loan to bail out BSC bondholders but not shareholders).

Ben Bernanke commented today on why the Federal Reserve did what it did with respect to Bear Stearns:

On March 13, Bear Stearns advised the Federal Reserve and other government agencies that its liquidity position had significantly deteriorated and that it would have to file for Chapter 11 bankruptcy the next day unless alternative sources of funds became available. This news raised difficult questions of public policy. Normally, the market sorts out which companies survive and which fail, and that is as it should be. However, the issues raised here extended well beyond the fate of one company. Our financial system is extremely complex and interconnected, and Bear Stearns participated extensively in a range of critical markets. With financial conditions fragile, the sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence. The company’s failure could also have cast doubt on the financial positions of some of Bear Stearns’ thousands of counterparties and perhaps of companies with similar businesses. Given the current exceptional pressures on the global economy and financial system, the damage caused by a default by Bear Stearns could have been severe and extremely difficult to contain. Moreover, the adverse effects would not have been confined to the financial system but would have been felt broadly in the real economy through its effects on asset values and credit availability. To prevent a disorderly failure of Bear Stearns and the unpredictable but likely severe consequences of such a failure for market functioning and the broader economy, the Federal Reserve, in close consultation with the Treasury Department, agreed to provide funding to Bear Stearns through JPMorgan Chase.

Nothing surprising here, but you can get a sense of the thinking at the Federal Reserve. I think the Federal Reserve did the right thing. Having said that, the execution could have been much better. First of all, instead of favouring JPM over others, a broader coalition should have been used. Doing so would have removed the favouritism exhibited by the FedRes. It also would have been preferable to get 'the Street' to calm things down. As it stands, if a similar issue pops up soon then what?

My opinion is quite similar to what James Surowiecki of The New Yorker said in a recent article titled Too Dumb To Fail. In essence, we have a situation where standing aside and doing nothing could have resulted in a domino effect. Because of that possibility, preventing a run on the bank--and that's what Bear Stearns was facing: a run on the bank--outweighs the alternative tactics.

More to the point, the threat of moral hazard in this case was simply less dire than the threat of financial contagion. The Fed could have done what it did in February, 1933, when it stood quietly by while Detroit Bankers Corp. and the Guardian Detroit Union Group, Detroit’s two largest banks, foundered after a series of bad loans. But the failure of those two banks quickly led to bank runs in neighboring states—Cleveland’s two biggest banks failed soon after—and eventually to a national banking panic. Bear Stearns’s collapse, similarly, could easily have provoked market chaos. Bear wasn’t among the largest Wall Street banks, but it was a major clearinghouse for stock trades and played a central role in hundreds of billions of dollars of credit deals. If not too big, it was too important to fail.

What we need to avoid is the 'too dumb to fail' mentality. Companies taking too much--and this goes for my holding, Ambac, as well--should be penalized by the market. I think this is what will happen when it is all said and done. I have a feeling that the market won't look at investment banks the same way ever again. It wouldn't surprise me if investment banks lose their prestige and awe that was common in the past. There will always be room for high risk banks but they will be valued for what they are.

Because investment banks’ trades and investments are typically very highly leveraged—Bear Stearns, for instance, had borrowed thirty dollars for every dollar of its own—the banks need to be exceptionally good at managing risk, and they need to insure that people trust them enough to lend them huge sums of money against very little collateral. You’d expect, then, that Wall Street firms would be especially rigorous about balancing risk against reward, and about earning and keeping the trust of customers, clients, and lenders. Instead, most of these firms have taken on spectacular amounts of risk without acknowledging the scale of their bets to the outside world, or even, it now seems, to themselves.

Until Bear Stearns blew up, I never quite realized how much leverage investment banks typically used. Bear Stearns was leveraged 30x and other investment banks are in the same ballpark figure. The fact these companies use that much leverage means that they are not as great as they seem. Just like how a hedge fund posting 30% return with 15x leverage is, in some sense, no better than an unleveraged mutual fund posting 5% return, the investment banks' leverage clouds many of their operations.

The hope by me--and many others--is that Wall Street will learn some hard lessons from all this... but it's really up to investors to keep the Street in check. After all, if investors didn't invest in these companies or support the exorbitant compensation for large profits (often resulting from taking large risks), things wouldn't get so bad.

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