March 19, 2008
Why Bear Stearns’ shareholders do not deserve more
Time lends perspective and having a couple of days to absorb about how the Federal Reserve acted over Bear Stearns has helped to clarify its intervention policy, which was devised on the hoof over the weekend.
Although there was a lot of worry about moral hazard - the US government protecting those who should not be protected from their financial errors - the Fed clearly tried to avoid it. It wanted to prop up Bear to avoid a fire-sale of its mortgage securities but did not want to give too much comfort to others.
The cornerstone of the Bear intervention was that the equity holders in Bear got largely wiped out while bondholders and other creditors were rescued from having to take their chances in insolvency. As John Jansen puts it: “The Fed will follow a blueprint which throws equity holders under the bus and saves bondholders.”
Furthermore, the Fed and the Treasury clearly have little interest in having to nationalise a bank or a broker, running it for a bit and then having to re-float it. That is what the Swedish government did in the early 1990s, what the UK government has now embarked on with Northern Rock, and what a lot of economists would have liked.
So the Fed outsourced the restructuring of an insolvent Bear Stearns to JP Morgan Chase. Jamie Dimon took advantage of having the Fed telling Bear to sign or else, and struck what increasingly looks like a great deal. Presumably, the Fed would find another private sector agent next time or people would really start to talk.
There are those who think Bear has been unfairly treated. Larry Kudlow, the CNBC commenter who used to work at Bear, expresses the Wall Street argument here. He thinks the Fed ought to have opened the discount window to brokers and given Bear the same treatment as commercial banks sooner, which might have avoided its collapse. By the way, Mr Kudlow also believes in free enterprise, the government getting off people’s backs etc.
That is a stretch. Even if you believe that it is logical for the Fed to lend directly to brokers, Bear knew the world in which it operated. The discount window change may have come too late for Bear’s shareholders but so be it.
Still, this is a long way from what the Fed would have preferred, which would have been not to have provided any funding itself. Compare it, for example, with the Fed response to the Long-Term Capital Management collapse in 1998, when the New York Fed organised a meeting on Wall Street banks but did not go further.
If I were the Fed, I would want to rein back expectations that it will always act this way in future. Even if shareholders of investment banks know they will be at risk, there are still unhealthy incentives for other market participants to deal with weak and badly-managed institutions.
But it has made clear that it is unwilling to be taken for a ride by investment banks’ executives, who are all shareholders of their institutions. The price of being rescued is likely to be most of their personal wealth.
The run-up in Bear’s share price yesterday to close at $5.91 indicates that a lot of shareholders take Mr Kudlow’s view and think they can force JP Morgan to pay more or the Fed to relax its weekend stance. I doubt whether the Fed will be very keen to comply.
Why though, should the creditors be bailed out? It’s reckless lending that got everyone into the mess in the first place, not reckless investing in the stock market, and at least the stockholders are punished when the risk is realised. What difference if the lending is to a sub prime homeowner, or to a sub prime bank? They are both unable to pay, and the lenders should have either known better or be more careful with their money.
There should be seriously tough regulation regarding what banks who take consumer deposits can do, then there wouldn’t be the pressure to bail out the ones, like bear stearns, who reject that option in favour of riskier strategies.
The trouble is the risk is allowed to be too interconnected at the moment. Banks always rely on the taxpayer bailing them out. Free market capitalists indeed.
Posted by: Ian | March 19th, 2008 at 10:06 am | Report this commentIn a perfect capitalist world we would have fair competition, honest participants and a meritocracy. Mistakes daing back to the 1990’s and the Greenspan put set the stage for the mess we are dealing with today. The idea that the street and the banking sector should be largely self regulating allowed financial alchemy to get far ahead of the control mechanisms to prevent catastrophy. A cheerleeding Fed Chairman proclaiming the virtues of derivates and ARMs did a tremendous disservice to the economy in a sad attempt to preserve a doomed legacy.It is difficult to return to the pure capitalim of Adam Smith and the concepts of Schumpeter and Kondratieff regarding the benefits of creative destruction. The financial web of extreme leverage,derivatives and undercapitalized lenders and countyparties removes the option of sink or swim hardball for now. To sensibly protect the fragile debt markets, upon which all else hinges, the Fed compromised. It punished the reckless firm,its shareholders and to a large degree executives. Rightly so. It spared debt holders out of necessity and responsibility to the general population/economy. JPM got a free ride, but its better than the two alternatives of outright failure and all that entails for the economy, and federal ownership of a brokerage company.The long term solution is to delever the finance based economy built on the false wealth of debt and derivatives. Then pull the Fed Put from the minds and lexicon of modern finance and capitalism once and for all.Delevering will mean a smaller economy built on real productivity, leverage that reflects a % of equity not a multiple and real risk analysis not the backward looking models that project the recent past into forever.What we know is that bell curves have much fatter tails and therefore less impressive predictive powers.America may have to learn to build things as well as provide services.We may need to learn to save rather than borrow, employ rather than outsource. The fed is filling a leadership void at the moment and certainly blazing dangerous new trails. When this storm passes we must not revert to the same old game. Globalization and the falling dollar tell us that we may not have another shot at getting this right without truly dire consequences for more than a few hundred wealthy bankers and brokers.The Fed Put is poison to capitalism and must be purged.We cant kill the patient to cure the ills.We will need order, a bit of luck and leadership to prevail.
Posted by: gym-bob | March 19th, 2008 at 3:34 pm | Report this commentThe vultures are circling.. picking up the pieces from the explosion.
Posted by: Marie-Athena ,lawyer | March 20th, 2008 at 1:45 am | Report this commentMore financial “toxic waste” is coming up to surface to be purged.
Apocalypsis now!
I think the question should be re-phrased: why do Goldman Sachs, Morgan Stanley, Merrill Lynch and Lehman Brothers shareholders deserve more than Bear Stearns’?
We live in regulated, rather than perfect markets. In some extreme cases, state intervention may be useful to calm down markets and avoid the realisation of self-fulfilling prophecies.
However, why punish Bear Stearns only? The securitisation boom of the last 10 years has been going on all over Wall Street, with issuance of cash and derivative instruments which made substantial profits for investment banks. Commercial banks were enabled to lend more money, as they could outsource the loans & bonds on their books. Consumers and corporates could borrow more at cheaper rates. Finally, rating agencies made billions from rating structured products.
The situation is not new and economists have been blaming the overabundance of credit and liquidity for a while. So who is to blame? It is too easy to point the finger to a bank, like Bear, whose management has often taken an arrogant attitude.
A bank that is smaller than the others and therefore represents a relatively smaller social cost.
The Fed forced Bear to be acquired by JPM in one weekend, prioritising market stability over shareholders’ and employee’s interests.
It is the same Fed who has, in the last decades, responded to any crisis by injecting more and more liquidity in the system and ignoring the various asset bubbles that were the consequence.
It is obvious to remember that among Bear employees are not only Jimmy Cayne and Warren Spector, who will probably continue playing bridge and golf somewhere in the countryside, but also thousands of common people who will lose their jobs and their life savings.
The treatment for Bear and its shareholders and employees is top-down, arbitrary justice, and will not change the incentives of market players and regulators. On the other hand, the fact that shareholders’ interests can be ran over by govermnent decisions, even in the US, will definitely harm long-term trust in free markets.
Posted by: Fred, investment banker | March 22nd, 2008 at 10:03 am | Report this commentI find it amusing that Bear Stearns may be down, but the value of its headquarters 383 Madison buildling seems to be skyrocketing. The 45-floor skyscraper’s worth was $800 million the weekend of the Fed bailout, then I read $1 billion in the WSJ, and the FT used $1.2 billion. Now Larry Kudlow, linked above, has it at $1.5 billion.
Posted by: edward allen | March 23rd, 2008 at 12:30 am | Report this comment