Arnold Kling  

Financial Commentary

Posner on What Teachers Want... ROTFL...

Russ Roberts said,

The Federal Reserve and the Treasury Department have orchestrated the survival of Bear Stearns. The defenders of that maneuver argue that if Bear Stearns had failed it would have created a lot of collateral damage, so much collateral damage, that you and I, normal folk who don't invest in hedge funds, normal everyday people who know nothing about high-falutin' financial instruments like "collateralized debt obligations" would have been engulfed as well... subsidizing the marriage of Bear Stearns and JP Morgan, the government has removed some of the loss from the profit and loss system...

...government bails out Bear Stearns and its creditors rather than letting those who have been reckless learn a lesson for the next time.

I disagree. Bear Stearns was liquidated in a hurry. The market was in the process of liquidating it and forcing it to sell its assets for less than what I believe they were worth. I believe that both J.P. Morgan and the taxpayers are going to make a profit at Bear Stearns' expense. I don't see this as creating moral hazard.

I believe that something different is going on with homeowners. The problem for homeowners is not that they are being forced to sell valuable homes at fire-sale prices. In general, the problem is that they overpaid for their homes to begin with. If the Fed wanted to supply funds to keep homeowners in their homes, the Fed would end up losing money.

My claim is that if Bear Stearns had access to capital or to large loans at reasonable rates for sufficient time, it would eventually turn out to have positive net worth. No amount of capital or loans will enable a borrower with a $400,000 mortgage on a $350,000 home to have positive home equity.

Meanwhile, Tyler Cowen writes

When the "shadow banking system" does not have capital requirements, normal financial activities, as regulated by the Fed, are inefficiently taxed and too much of an economy's leverage ends up in the unregulated shadow banking sector.

I agree that regulatory arbitrage is a big deal. Regulatory arbitrage exists when one institution can invest in a given asset more profitably than another institution solely because of its lower capital requirements. Fannie Mae and Freddie Mac took most of the risk in mortgage markets away from banks and savings and loans in a remarkably short span of time, thanks to regulatory arbitrage. The subprime mortgage market was largely the creation of an even less-regulated set of institutions. Many of them are now defunct and will not be missed.

What keeps less-regulated institutions from taking all risky assets away from banks? Government safety mechanisms, including regulation, allow banks to borrow more cheaply than other firms. To the extent that government safety mechanisms are being extend to investment banks, their cost of funds will be artificially low, because they do not face bank capital regulations.

However, I am not convinced that the government has effectively guaranteed investment banks. Again, I do not think that the government prevented the demise of Bear Stearns. Instead, it took a speculative position in Bear Stearns' assets.

I am also not convinced that government can get capital regulations right for investment banks. The capital regulations for commercial banks seem to be working well. The capital regulations for Freddie and Fannie were working well ten years ago, but that may not be the case today. Capital regulations for investment banks will be no better than the state of the art of risk measurement. And state-of-the-art risk measurement is what failed to prevent the current problems.

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COMMENTS (12 to date)
Matthew C. writes:

It seems likely to me that the value of Bear Stearns was in fact much less than zero. They had loaded up their balance sheet with low-quality mortgages that turned out to be worth far less than the money they had borrowed to purchase them. That is what the 30 billion dollars of loan guarantees from the Fed for JPM is all about. Versus the 1 billion or so that the shareholders are getting at $10 per share.

I think this also tells us something interesting, and truly frightening, about the actual capital position of a great many other banks right now.

Please tell me if I'm missing somthing here. . .

Ajay writes:

Arnold, I'm not sure why you keep focusing on whether Bear got bailed out or not, when the real issue is whether this government intervention will spur future risk-taking, as Russ so clearly explains (and as I also commented on at Econbrowser [second to last comment]). You keep framing the issue as though it is whether or not the Fed will make or lose money on its investment when that's the farthest thing from the mind of most of the Bear deal critics. If you really believe Bear was a steal, please tell me why JP Morgan needed inducement to purchase them. You seem to believe that Bear being bought at a fraction of its former price is sufficient punishment, echoing James Hamilton, whereas the Bear critics say "What makes you the judge of what is adequate punishment?" Why not let the market punish them? I would personally prefer if we just let all the highly levered investment vehicles fail and let the markets learn the dangers of leverage yet again. Of course, the Fed creates moral hazard by continually stepping in in this way.

Anthony writes:

"My claim is that if Bear Stearns had access to capital or to large loans at reasonable rates for sufficient time, it would eventually turn out to have positive net worth. No amount of capital or loans will enable a borrower with a $400,000 mortgage on a $350,000 home to have positive home equity."

For the right value of "reasonable rates" and "sufficient time", sure a borrower with a $400,000 mortgage on a $350,000 home can come out ahead. Even more easily if you remember that home ownership is consumption as well as investment.

Matt writes:

Gee Arnold, you argument about positive net value seems a bit contradictory.

Bear Sterns is in trouble because they bought mortgage securities at more than the (back dated) value.

So did homeowners with their homes.

Bear Sterns will have better net assets if the mortgage securities go up in value.

So will the homeowners.

Bear Sterns bought the securities at a time when they thought their value woold hold.

Ditto for homeowners.

I didn't quite get why homeowners can't go to the discount window but Bear Sterns investors can.

I mean, isn't this the problem to begin with? The fed can't serve everyone,simultaneously because they are a monopoly, so the fed has historically served the rich, wealthy clients, each in turn; and I do not remember a time when I could log into the discount window and increase my account levels. The fed never got around to extending the discount window to all citizens who meet reserve requirements, yet the fed serves at our pleasure as a monopoly.

8 writes:

Bear Stearns is basically wiped out, their shareholders and employees get next to nothing because the firm could not access capital during a crisis. How is that going to encourage more risk taking the next time? J.P. Morgan and others can take a little more risk, knowing the Fed will step in to prevent a total financial meltdown. But where's the incentive to be the firm that brings the system to the edge?

Floccina writes:

IMHO as long as we have fractional reserve banking we will have now and then have fairly big banking problems.

Dr. T writes:

I agree with ajay.

Even if it is economically sound for the Fed to step in and help JP Morgan buy Bear Stearns, it is not a sound decision governmentally: it is another bad precedent. The financial collapse of Bear Stearns would not have wrecked the economy. This decision was just as bad as the one to provide funds to Chrysler. In both cases, the collapse of the companies would have been followed by acquisition of remaining assets by other firms.

ram writes:

What happened there was a bailout-variant, obscured by the subsequent bargaining over the spoils between two private groups. As usual, the bill is footed by the taxpayer, directly in the form of a return-unadjusted loading of credit risk in the portfolio the Fed holds for all of us; and indirectly both in the form of increased moral hazard and as an efficiency loss. By this latter, I mean that what was achieved in terms of contagion-containment could have been achieved at a lower cost to the public purse and at lower risk of moral hazard. The windfall for the beneficiaries is the reduction in risk, leaving behind a portfolio with better risk-adjusted returns. What is perhaps different is that there is not one, but two groups of beneficiaries, two groups of bankers, bargaining over who gets to keep how much; and we have gotten to watch this process more or less live. Furthermore, all that has happened since that first salvo on Friday, March 14th, has been but distracting iterations of this bargaining process between private parties.

More efficient alternatives? The problem was a possible contagion from the fire sale of assets by an imploding BS (pushed into this position by its own overleveraged investment decisions, not by the illiquid markets). The problem was not the collapse of BS. So the Fed should have focused on the problem at hand in the least (risk adjusted) costly way to the public and with the least risk for moral hazard.

With shock at myself, I think taking over BS assets, all of them (yep, taking it into receivership by the public sector), and then winding them down in an orderly fashion, would have achieved this better. The risky assets which are suffering from illiquid markets could have been kept longer. At then end, BS shareholders get the net amount left over from the sale of their assets minus their losses.

For example, the public purse would have sold the much-talked about BS headquarters etc, compensating the possible loss from the bad investments. If the investments didn't turn out sour, there's simply was more to return to BS shareholders (with interest, of course).

Right now, if they DO turn sour, the Fed pockets all the loss with nothing to cushion the impact. JP (plus hard-bargaining BS shareholders) have taken all the upside.

Lord writes:

The moral hazard of short-term profits at the expense of long-term viability is a perpetually reoccurring one, one the government has little influence over or can do much about.

Dan Weber writes:

According to Tyler Cowen, there were very few buyers waiting in line to buy Bear.

But in the past week, we've seen all sorts of jokers on the Internet claim that, gee, we wish we could've been allowed to buy Bear!

So I guess the Fed's actions seem to have worked. Their plans acted like a bank holiday, letting the financial markets catch their breath and avoiding the panic.

Marcus writes:

Arnold, can you explain how taxpayers may make a profit? Articles in the media are not very forth coming with useful information. It would be great if you guys could explain what's going on.

Presumably, the Fed can profit because it'll be holding on to profitable bonds. Yet, the media presents it as the Fed is simply covering the JPMorgan's backside. Robert Reich is claiming the Fed will suffer all the losses while JPMorgan will collect all the upside.

Phil writes:

Letting Bear Stearns fail on Monday 3/17 would not have just punished its shareholders. Bank runs can also hurt a lot of innocent bystanders.
Anyone who thinks the government could have supervised an orderly winding down of Bear Stearns businesses needs to rethink that process. What would keep the employees on the job. The value of the brokerage business alone was probably worth far more than $2 or $10 per share.

Consider that 800 brokers generated an average of $1.2 million in fees and commissions per year. If only 25% profitable, and that's probably a low estimate from my experience in the brokerage business, that would represent $240 million per year. That's close to what JP Morgan offered for the whole business. And, the headquarters building is estimated to be worth more than $1 billion.

If the brokers who went home on 3/14 decided not to come back, but to transfer to the major competitors, all of which are likely to offer extemely competitive packages to attract them, then there would have been no orderly unwinding, but chaos.

As proof of the value of the brokers, it's been reported in the Wall St. Journal and in other industry sources, that JP Morgan is offering brokers total payments of approximately 1 year of revenues (fees and commissions generated) to anyone who generated 500,000 or more. These payments are being structured as loans foregivable over several years, along with shares in JP Morgan to be delivered after several years, along with bonuses after 3 years.

This only looks at the going concern value of the brokerage business and ignores all the other parts of the business.

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