There is one thing about being a central banker in the UK or the US. Most of the time, it sounds like a pretty dull business of looking at economic statistics and deciding whether to move interest rates a quarter of a point in either direction. Every so often, however, there is an adrenalin-filled weekend in which you get to decide whether a financial institution survives or goes under.

Last night, I reckoned the Fed had done a good job of balancing moral hazard with financial uncertainty by manoeuvring Bear into the hands of JP Morgan for a knock-down (actually negative) price and only having to stand behind $30bn of assets. That looked like a better outcome than the Bank of England had managed with Northern Rock.

In the cold light on morning, with the US markets open and Armageddon apparently postponed, I think that observation stands. But, of course, the difference between Northern Rock and Bear Stearns is that the latter is not a deposit-taking institution and the only run on the bank was from hedge fund customers withdrawing from its prime broking business. Rescuing hedge funds and other counter-parties is not the ordinary business of the Fed.

So how did the Fed do in terms of avoiding moral hazard? Let us take the parties in turn.

1. Shareholders. Pretty well. There were worries on Friday that the shareholders were being protected by the intervention of the Fed, when they should have been wiped out by nationalisation, if anything. But getting $2 per share for the business amounts to little more than a tip for leaving. So they have hardly been rewarded.

2. Bondholders. Decently. The bondholders’ money is still at risk while JP Morgan deleverages Bear’s balance sheet. They will only get the backing of JP Morgan when and if the deal goes through in June.

3. Customers. Poorly. Arguably, those who allowed Bear to hold their securities as collateral or otherwise deal with it ought to have lost everything. That would encourage everyone to deal only with more solid institutions in future, which would be an incentive for investment banks to play safe. Instead, the customers now have JP Morgan as a counter-party.

Overall, from the perspective of moral hazard and the robustness of the financial system, the ideal outcome would have been for Bear to go bust. In fact, that could well still happen since a third of the shares are held by Bear employees and some are already talking about taking their chances with bankruptcy instead.

But the Fed still has a decent argument in favour of its action. It pushed Bear into essentially wiping out its shareholders in return for protecting the financial system from a forced liquidation of mortgage securities in a moment of panic. That is at least a defensible position.

March 17th, 2008 in Finance | Permalink