Moral hazard, here we come!

And there was naive me believing that in the entire Bearn Stearns/JP Morgan debacle at least one tiny blow against moral hazard had been struck: the Bear Stearns shareholders would get next to nothing under the $2 per share offer from JPMorgan. But no, Easter brought resurrection from the dead also for Bear Stearns shareholders. JPMorgan is now offering them $10 per share. Bear Stearns management and board are still in situ, of course.

All this had to be signed off on by the Fed. So what did the tax payer get in exchange? Well, the $30bn de facto first-loss guarantee for Bear Stearns’ cruddiest assets has been changed to JPMorgan taking the first $1bn loss and the Fed the next $29bn. A billion here, a billion there, but you are still not talking real money. Under the new deal, JPMorgan no longer guarantees Bear Stearns’ liabilities for a year even if its offer were voted down. That ought to be worth a few billion to JPMorgan.

So what the tax payer gets out of this is the first $1bn of its old guarantee in exchange for a warm embrace of moral hazard. There is also the nice touch that the New York Fed $29 bn loan and the JPMorgan Chase subordinated $1 bn note will be made to a Delaware limited liability company established for the purpose of holding the Bear Stearns assets. Special purpose vehicles and other off-balance sheet entities were part of the syndrome that brought us the current mess. It’s therefore charming to see the New York Fed bestow the tax payers’ largesse through such a construct.

Just to round off a great start to a new day, checking this morning on the NY Fed web site, I found that it remains the case that the collateral offered at the Term Securities Lending Facility (lending Treasury securities against collateral to Primary Dealers) will be valued daily by the clearing bank acting as the agent for the Primary Dealer. This is the same cockamamie approach to valuation as was agreed for the Primary Dealer Credit Facility (PDCF), the new arrangement under which Primary Dealers can borrow overnight from the Fed’s discount window. If ever an arrangement was designed for Primary Dealers and their clearers to collude to pass off pig’s ear assets as silk purse collateral to the Fed, this is it.

Time for a tax payer class action suit?

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website