First, I have to declare an interest. I am a part-time Adviser to Goldman Sachs International. The views and opinions expressed in this blog are my own. They do not represent the views of Goldman Sachs International.
With a little help from its friends, especially JP Morgan, Bear Stearns, one of the 20 Primary Dealers (in US government securities) and one of 30-odd prime brokers, is now borrowing at the Fed’s primary discount window. Bear Stearns cannot do so itself, because it is not a deposit-taking institution entitled to access the Fed’s discount window. JP Morgan has access to the Fed’s discount window, so Bear Stearns is, indirectly through the good (and no doubt adequately remunerated) offices of JP Morgan, engaged in collateralised borrowing from the Fed. The loan from the Fed to JP Morgan is non-recourse and the JP Morgan to Bearn Sterns leg is part of a back-to-back arrangement, that is, it is a loan from the Fed to Bearn Stearns via a bank, JP Morgan. The non-recourse bit means that if Bear Stearns defaults on its loan to JP Morgan, JP Morgan does not have to repay its loan to the Fed. It is, effectively, a collateralised loan on discount window terms, from the Fed to Bear Stearns.
This means that Bear Stearns can take advantage of two of the key relaxations in the terms of discount window access introduced by the Fed at the beginning of the current crisis on August 17, 2007: the extension in the duration of the loan to 28 days (from the original overnight maturity), and the reduction in the ‘penalty’ spread of the discount window borrowing rate over the target for the Federal Funds rate to 50 basis points (from the original 100 bps).
The Federal Reserve Act (1913) allows the Federal Reserve to lend, in a crisis, to just about any institution, organisation or individual, and against any collateral the Fed deems fit. Specifically, if the Board of Governors of the Federal Reserve System determines that there are “unusual and exigent circumstances” and at least five (out of seven) governors vote to authorize lending under Section 13(3) of the Federal Reserve Act, the Federal Reserve can discount for individuals, partnerships and corporations (IPCs) “notes, drafts and bills of exchange indorsed or otherwise secured to the satisfaction of the Federal Reserve bank…”.
The combination of the restriction of “unusual and exigent circumstances” and the further restriction that the Federal Reserve can discount only to IPCs “unable to secure adequate credit accommodations from other banking institutions”, fits the description of a credit crunch/liquidity crisis like a glove. So why hasn’t the Fed declared “unusual and exigent circumstances” yet, so non-deposit-taking financial and other institutions in need of liquidity and blessed with eligible collateral can go directly to the discount window? When in doubt, leave the middleman out.
Why bail out Bear Stearns?
Public institutions like the Fed should support the provision of public goods and services that would not be provided optimally by the market. Markets – arrangements for bringing together would-be buyers and sellers of a good or service to engage in voluntary exchange – have some of the features of a public good. The attractiveness to any potential participant to actually participate in a market by searching for the highest bid price for something he has to sell or the lowest offer price for something he wishes to buy is increasing in the number of participants already in the market. This network externality makes for ‘thick market’ effects but can also result in equilibria where few buyers and sellers are active because everyone expects few buyers and sellers to be active – illiquid markets.
When a key financial market is caught in such an illiquid markets equilibrium trap, the central bank can and should, by acting as Market Maker of Last Resort, break the deadlock by standing ready to buy the illiquid securities. There is a prima facie case for the Fed supporting systemically important financial markets or instruments. To minimize moral hazard it should do this at a punitive valuation of the security, and with an appropriate further liquidity haircut imposed on that punitive valuation.
While the Fed, like any public institution, should support institutions and arrangements with public goods properties, like markets, it should not as a rule support private businesses, even when these private businesses are misleadingly called financial institutions. The Fed should support individual businesses only if failing to do so threatens serious negative externalities. In the financial field these externalities often are through contagion effects, as in the case of the classical bank run by depositors exercising their right to withdraw their deposits on demand on a first-come-first served basis. In financial markets, contagion manifests itself as a withdrawal of willing buyers of securities from the market, motivated by escalating risk aversion, fear or panic, which may be partly rational and partly irrational.
The Fed does not normally offer rediscounting facilities, even indirectly, when a ball-bearings manufacturer in Cleveland, Ohio is about to go under. The reason it has special liquidity facilities for certain kinds of deposit-taking financial institutions is that these institutions are deemed systemically important. For the same systemic financial stability reasons, such institutions are often bailed out when they are not just illiquid but also insolvent.
Deposit-taking institutions are deemed to fall into this category because they are an important part of the retail payment mechanism. Other institutions are deemed too systemically important to fail because they play a key role in the wholesale payments, clearing and settlement system.
Finally, some institutions are provided with liquidity on non-market terms or bailed out when they are insolvent because it is feared that their failure would trigger a chain-reaction of contagion effects. Fear and panic would spread through the markets and first illiquidity and then insolvency would threaten institutions that would have remained both solvent and liquid but for the failure of this ‘focal institution’.
How does Bear Stearns line up according to these three criteria for special Fed attention? Bear is not a deposit-taking institution. It plays no role in the retail payment mechanism and is of no systemic significance to the proper functioning of the wholesale payments, clearing and settlement system. At least Northern Rock, which was a deposit-taking institution, had a role in the retail payment mechanism.
Supporting a market can mean supporting a private business, if the private business is the market. Bearn Stearns, however, isn’t a significant share of the market for any security it holds. It is too small to be of intrinsic systemic significance. Bear Stearns is a medium-sized investment bank – the fifth largest in the USA. At the end of 2006, its assets were US$350bn. Compare this with Northern Rock whose assets in July 2007 were about £120bn, that is US$240 bn.
Northern Rock was therefore rather larger, compared to the UK economy, than Bear Stearns is relative to the US economy (measured relative to GDP, say, or relative to the size of the banking sector). If decent deposit insurance, of the kind available in the US (up to $100,000) had been available in the UK, there would have been no reason to provide a purpose-built ‘liquidity support facility’ to lend to Northern Rock. Once the government had guaranteed not just all of Northern Rock’s retail deposits but also wholesal deposits and many other unsecured creditors, there was no reason to support Northern Rock any further. A fortiori, the case for official financial support for Bear Stearns looks weak to the point of terminal anaemia.
What about the contagion argument? I already noted that Bear Stearns is not a very large investment bank. Without depositors, it also cannot trigger a run on its deposits, a la Northern Rock, which could have inspired depositors in other deposit-taking institutions to make a run for their money.
Without official assistance, Bear Stearns would probably have had one final desperate go at survival, by selling as many of its assets as it could as fast as it could to raise liquidity. In thin, illiquid markets, this could have caused the prices of the assets they were selling to be come artificially depressed. This argument is correct, but it is an argument for intervening to support the markets for the securities that Bear Stearns would be dumping in its survival-oriented fire sale, not for an individual institution-specific dedicated lender-of-last resort facility.
On what terms should Bear Stearns have been bailed out?
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. But given that a rescue was decided, what should be the financial terms of the rescue? The exercise is dripping with moral hazard. How can moral hazard be minimized?
It is a good principle that the Fed should, when acting as lender of last resort, make sure that when it supports an individual private business, it gives no comfort to the shareholders of that business, other than whatever comfort is the unavoidable by-product of the achievement of the objectives of the rescue. I take it that the objectives of the Fed in undertaking this rescue were either to ensure the continued existence of Bearn Stearns as a going concern, or an orderly winding down of the firm and its activities, whether by sale to a third party or by its break-up and the sale of its assets.
Preserving any shareholder value for the existing equity holders is not necessary to meet either of these objectives. The fact that the Fed had to come in to rescue the investment bank suggests strongly that without the official financial assistance, Bear Stearns would not have been able to meet its financial obligation. Without the Fed intervention, Bearn Stearns would have defaulted on some of its obligations coming due. Defaulting enterprises go into insolvency administration. The presumption is that the shareholders are last in the line of claimants on the revenues obtained from the realisation of the firm’s assets.
Since Bear Stearns is not a deposit-taking institution, and appears to be of no other systemic significance, there is no need for a special resolution regime of the kind managed by the FDIC for troubled deposit-taking institutions. The firm could have been left to go into receivership.
If the Fed fears the risk of contagion effects and financial panic, it could have requested the nationalisation of the investment bank. This should have been done at a zero price. The existing shareholders could, if the US government were feeling generous, be granted the privilige of claim on whatever value is left after all other creditors have been paid off.
But the shareholders of Bear Stearns are eating their cake and having it. Shares may have dropped 43 percent in value, but what is left still beats nothing. And nothing seems the only possible fair value for what Bear Stearns would be worth without Fed assistance. Why was Bear Stearns not taken into public ownership, preferably at a zero price?
One would hope that, as soon as the rescue was announced, the existing management and board of Bear Stearns would have resigned en-masse, and without any golden handshakes of the CEO of Citigroup and Merrill Lynch -variety. This should have been a condition of the loan being made. The argument that only the existing management understands the business well enough to see it through the storm is unconvincing, as these are the very people that screwed it up in the first place. Why are the old top management and board members still in their jobs?
Another key issue concerns the terms on which Bear Stearns now borrows. I have always considered the Fed’s decision to lower the spread between the discount rate and the Federal Funds target rate to be a mistake – an inframarginal subsidy to those lucky enough to have access to the facility. Now we see why. If Bear Stearns can borrow at 50 bps over the 28-day OIS rate, or anything in that ballpark, it would be scandal.
Finally, there is the crucial question of the nature of the collateral the Fed accepts (indirectly, through JP Morgan) for its loan to Bear Stearns, the valuation of this collateral and the haircut applied to it. If the Fed is accepting RMBS as collateral, it should insist on the highest grade RMBS on the balance sheet of Bear Stearns. The Fed is effectively buying the securities offered as collateral by Bear Stearns outright, because without the Fed’s intervention, the probability of default by Bear Stearns would be effectively 100%.
The Fed should also value the mortgage-backed securities and other illiquid assets offered as collateral punitively, certainly at no more than 60% of face value. With a further 25% standard liquidity haircut on the valuation, the Fed might just be sufficiently over-collateralised not to guarantee the tax payer a capital loss on the venture.
I am left with a list of questions:
- Why hasn’t the Fed declared “unusual and exigent circumstances” yet, so non-deposit-taking financial and other institutions in need of liquidity (like Bear Stearns) and blessed with eligible collateral can go directly to the discount window?
- Why was Bear Stearns offered the Fed lifeline rather than being left to sink or swim on its own? What were the systemic stability concerns that prompted this intervention to assist a non-deposit-taking institution?
- If Bear Stearns was deemed too systemically important to fail, why was it not taken into public ownership, preferably at a zero price?
- What are the securities the Fed is, directly or indirectly, accepting as collateral from Bear Stearns?
- What is the interest rate charged on the loan?
- How are these securities valued?
- What is the haircut applied to this valuation?