March 17, 2008
How the Fed avoided the Northern Rock trap
Go back a few weeks and the idea that JP Morgan Chase would have been able to snap up Bear Stearns for $230m - a big discount to the value of its Manhattan headquarters, never mind the remainder of its business, would have been laughable. But that is what has just happened.
The reason that JP Morgan could get such a bargain deal is, of course, that Bear would have collapsed last week without the intervention of the US Federal Reserve, which gave Bear an emergency funding guarantee.
The Fed followed up on Sunday by guaranteeing funding for about $30bn of Bear’s less liquid balance sheet assets, which gave JP Morgan comfort that it can de-leverage Bear’s balance sheet without too much pain. More pain, that is, than it is pricing in with its low-ball offer.
Any time that a central bank steps in to rescue a financial institution, it had better have a good defence to those who argue that it is interfering wrongly in markets and promoting moral hazard.
The case against the Fed doing so was put by Gretchen Morgenson in the Sunday New York Times:
Regulators must do whatever they can to keep the markets open and operating, and much of that relies upon the confidence of investors. But by offering to backstop firms like Bear, who were the very architects of their own — and the market’s — current problems, overseers like the Fed undermine a little bit more of that confidence.
Meanwhile, my fellow FT blogger Willem Buiter put it thus:
While the bail-out of Bear Stearns is still a very young, thus far at any rate I have heard not a single convincing argument for why this financial business should be assisted by the Fed, rather than the ball bearings company in Cleveland, Ohio.
The economists, including Prof Buiter and Nouriel Roubini, generally favour the view that the Fed ought not to have intervened to prop up a non-bank institution and, if it was not able to hold back, should have proceeded straight to nationalisation. Prof Roubini argued this last month and restated it on Friday:
First fully wipe out those shareholders, then fire all the senior management and have the government take over such a bankrupt institution before a penny of public money is wasted in bailing it out.
But I think the different outcomes in the cases of Northern Rock and Bear Stearns at least help to justify the Fed action. They perhaps explain it too, since Ben Bernanke, chairman of the Fed and Tim Geithner, head of the New York Fed, no doubt wanted to avoid getting caught out like Mervyn King, the Bank of England’s governor.
In the Northern Rock case, the Bank of England and the Treasury were asked to provide temporary liquidity guarantees last August to give Lloyds TSB the confidence to acquire Northern Rock and its fragile balance sheet. The UK authorities refused to do so, and wound up having to nationalise the bank instead several months later.
In other words, the Bank failed to act in a decisive but contained fashion at the start, then had to guarantee Northern Rock’s deposits and finally had to buy it outright with public money because the alternative on offer from the private sector was (in the Treasury’s view) inadequate.
In contrast, the Fed committed emergency funding on Friday in order to give breathing space for a private sector deal to be engineered over the weekend. It then helped push Bear into selling for a knock-down price to JP Morgan and assisted the sale with a $30bn funding guarantee.
That is not a perfect outcome and it is possible to argue that the Fed should simply have let Bear go down, along with its mortgage book. But that would have risked turmoil in the mortgage and other credit markets and would not have made Bear’s shareholders much worse off than they are now.
Nor do I think it is inferior to nationalising Bear in the manner advocated by Prof Roubini and others and placing it in the same position as Northern Rock.
This way, the shareholders have been nearly wiped out, the bondholders remain at risk until the takeover is approved, JP Morgan is assuming all operational risk, and the Fed simply has to guarantee funding for $30bn of assets. The last part is unfortunate but I can think of worse results.
In late 1973 when a UK secondary bank; London and County Securities became insolvent in much the same way as Northern Rock, the Bank of England responded with what was known as the ‘lifeboat’. This approach was remarkably similar to the Fed’s handling of Bear Stearns. Natwest was invited to take control and de-merge L & C. Other secondary banks with similar problems were parcelled out to Barclays and Lloyds. They were all then wound up quietly and efficiently while disappearing from the headlines.
Bear Stearns as opposed to Northern Rock however is a sharp reminder as to how the Bank of England has now lost its authority to deal with a crisis in its own financial back yard. Here it seems that perceived political advantage and disadvantage had to be the first consideration before action to rememdy a banking crisis can be decided on. As a result the problem has not been resolved, rather it has been transferred to the taxpayer. That is why our own banking crisis will continue crop up in the headlines here for years to come.
Posted by: figurewizard | March 17th, 2008 at 6:03 am | Report this commentSir,
I agree with much of what you are writing here, but disagree with your basic conclusion: this “bail-out” of Bear Stearns comes down to nothing else but “nationalising” its problems whilst leaving the upside entirely to JP Morgan. The secret lies in the 2 seemingly unguilty words “non-recourse” that accompany the FED’s back-to-back financing of Bearns’ illiquid assets. JP Morgan therefore quity bluntly put into their presentation to analysts & shareholders last night that “20bn of exposure are covered through non-recourse, and only 13bn remained as net exposure to JP Morgan”.
I call this ridiculous, and not too far away from Goldman’s pathetic original proposal for Northern Rock.
Besides, the move has - as one can see from the markets’ turmoil in Asia last night - not avoided further loss of confidence, but instead added some more. Had Bearns fallen apart, we would have seen a few derivative positions collapse and their underlyings shaken by volatile price movements, but not much more than that.
What we get instead is a prolonged process of “Zombiefication”((c) Mish Sedlock) of the financial system. And I fail to see that this would be any better, than a straightforward purge of problems off the markets.
Posted by: weissgarnix.de | March 17th, 2008 at 8:53 am | Report this commentNon-recourse financing? On what unencumbered assets? One would have to imagine any assets that have any discernable value would have been levered to the hilt; non-recourse in this case would imply a deeply subordinated lien, which I guess the Fed is guaranteeing anyway.
Posted by: Will | March 17th, 2008 at 9:33 am | Report this commentI suspect Jamie Dimon will be “Time Magazine’s Person of the Year” as a result of this deal. He’s picked up a real bargain and JPMC will be all the stronger in 12 months time.
As for solving this crisis - it will come down to the brutal realisation that, when there are no willing buyers, long term assets (particularly property) are only worth the present discounted value of their current and future earnings [rent], actual or imputed, that derive from ownership.
When that sinks in to the minds of property owners, mortgage lenders and the holders of CDOs then we might get a real idea of the “price” of these assets (even in the absence of a market to which to mark).
So here’s a scary thought - take a long hard look at your assets (that house, that car, that painting) and ask - “if I had to hold these for the rest of my life, what would they really be worth to me ?”
Posted by: Huw Sayer | March 17th, 2008 at 10:12 am | Report this commentI totally agree with weissgarnix.de. The only people to lose out under the nationalisation of Northern Rock are the share holders - the actual burden on tax-payers is over-played- almost all the assets are recoverable in terms of property, although that would be a last resort - Northern Rock’s problems came about not by it’s own customers defaulting payments. The alternative - nationalise the losses and privatise the profits is neither fair on the tax-payer, nor any more an effective anodyne against a turbulent economy. If one really wants to talk about preventative measures, then one needs to get to the start of the trouble and turn to politics: better regulation of the housing market, preventing such occurrences as the practices by a number of property developers for the last decade, artificially inflating the prices of their properties for the land registry, inflating the housing market bubble.
Posted by: MoreTeaVicar | March 17th, 2008 at 10:28 am | Report this commentMoreTeaVicar suggests “turning to politics”. Lord save us if that means getting Darling involved.
Posted by: Peter K | March 17th, 2008 at 11:09 am | Report this comment“Run, run, fast as you can…
can’t catch me, I’m the gingerbread man”
Jamie Dimon may indeed end up with a medal as the come-back kid of American banking. Citi probably regrets the way they treated him not so long ago.
As for the JPMorgan Chase “lifeboat” to Bear, well, from my view in Copenhagen it looks more like the fox offering to swim the obnoxious gingerbread man to the opposite side of the river (and that story didn’t end well at all).
The only banking companies with a viable model for 2008 are those with a depositor base. So expect the ghosts of commercial banking to reappear on the scene with a vengeance.
The next victims in this pseudo-tragedy look like Lehman and perhaps even the untouchable Goldman. While they apparently shorted sub-prime, the “long-term investments” still on their balance sheets ($614b and $822b, respectively as of 1st December) are huge relative to their equity ($22b and $43b). JP Morgan, in contrast, had only $688 of investment assets with $123b of equity.
Lehman and Goldman might have avoided the sub-primes, but what about Alt-A, agency bonds or even municipals? They’ll be in deep water indeed when they mark-to-market this inventory.
Posted by: todd w. johnson | March 17th, 2008 at 11:20 am | Report this commentInstead of pumping public resources into the private sector in small concetrated doses, which assumes the federal government is actually able to properly direct capital to its most needed source (also promoting an idea that regulators should be stock traders instead of governors), why does the ever concerned meddling congressional body not simply offer an across the board reduction in taxes. This will give the entire market more cash flow, capitilization, and offer these much needed funds in an organic way, which would allow the market to direct resources to where they are most needed.
Posted by: Eric Kovalak | March 17th, 2008 at 12:37 pm | Report this commentThis most approperate measure was missed in the recent tax ‘rebate.’ This was basically disguised welfare, and should be both insulting as well as infuriorating to the American people.
@Will
Sorry if I made myself not clear in my first poste (I am not a native speaker as you may have guessed): the “deeply subordinated financing” is not just “guaranteed” by the FED, it actually stems from the FED. And it has no strings attached whatsoever, it is expressis verbis “non-recourse”, read: “Pay back, JPM, if and when you can, but if you don’t, never mind …”.
Posted by: weissgarnix.de | March 17th, 2008 at 12:42 pm | Report this commentPlease listen to the taped conference call of JPM of last night or study the investor/analyst presentation available on their website, to see for yourself where JPM’s chiefs have their minds … “the bulk (i.e. 20bn) is picked up by the FED, only 13bn net exposure to us” …
[…] Financial market confidence is a fragile thing. And it is often beyond the kind of abstract academic analysis so beloved of commissars like Brown and Balls (again, see Greenspan for his reflections on that notorious irrational exuberance remark). Smoke-filled rooms might be dark and stinky, but in the real world we abolish them at our peril (also see here for good John Gapper blog). […]
Posted by: Lessons From The Bear at Henricus | March 17th, 2008 at 1:54 pm | Report this commentI’ve seen this theme posted elsewhere. Basically, the Fed’s response to this crisis has been to socialize the downside risk and privatize the upside potential. That doesn’t sound like capitalism to me. Plus, if Bear was worth more to its shareholders in bankruptcy than $236 million (and surely it would have been, in an orderly wind-down of affairs), then it should have been allowed to fail. This is a major gift for JP Morgan, care of the Fed and the taxpayers.
Posted by: KPO'M | March 17th, 2008 at 2:19 pm | Report this commentWhat we are witnessing, in handling this ongoing crisis, is the contrast between Scottish caution and American decisiveness.
Whilst Brown and Darling have allowed the Northern Rock problem to fester, the Federal authorities have opted to lance the boil.
Posted by: David Burdon | March 17th, 2008 at 3:49 pm | Report this comment@Lessons From The Bear at Henricus: Bear would have been worth more than $236m “in an orderly wind-down of affairs”. True, but chances of that happening in current slow-motion crisis environment? Pretty low.
Posted by: Rd232 | March 17th, 2008 at 5:22 pm | Report this comment[…] How the Fed avoided the Northern Rock trap […]
Posted by: Bear Stearns, Bearer markets: who’s next? « de(e)pre(ce)ssion | March 19th, 2008 at 4:42 am | Report this comment[…] point 8, we have certain beneficiaries of these exercises to wipe out those shareholders as the evil Professor Roubini puts it. Let’s try to work out who these […]
Posted by: How to play dominoes « Uncharted Territory | March 19th, 2008 at 5:22 pm | Report this comment