Arnold Kling  

Vincent Reinhart on Bear Stearns

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He writes,

the form of the Bear Stearns resolution actually invited another form of speculative attack. The official playbook appeared to protect creditors fully and to wipe out shareholders. This expectation made it profitable to identify the next financial firm to be resolved and then to sell its stock short and use the proceeds to purchase its unsecured debt. If the candidate firm was identified correctly, the debt would appreciate in value and its stock collapse. The basic message is that repaying unsecured creditors at par creates an opportunity for capital gain. When the government creates an expectation that it will intervene in this way, market participants bring forward the pressures officials fear in a classic speculative attack.

This is worse than moral hazard. This is bailout arbitrage. I had not thought of this possibility before. I wish that Reinhart would write an article that focuses on this. It is too important an idea to be buried as one paragraph in the middle of a longer article.

One point that he does not mention is that this sort of speculative attack will wipe out the firm's capital, which forces the regulator's hand.

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COMMENTS (6 to date)
Karl Smith writes:

Skimming quickly there was nothing in the description of events that seemed inaccurate to me, however, at least a few of the conclusions don't quite jive.

Reinhart argues that the governments playbook lead to a decline in equity values and a rise in credit values. That seems right to me, but why would this be construed as a speculative attack? It is speculative to be sure but not a meaningful attack.

Share prices can, in theory, fall to zero without a run. Now, in fact that is unlikely to happen unless without a wipeout large enough to affect creditors. However, if the government committed to saving creditors it would be possible.

Reinhart then goes on to explain that the government could not credibly insure all creditors. I am not sure that is in fact the case but lets stipulate. In this case the effect of the Bear action is simply muted. Creditors are reassured, but not perfectly so.

I also don't really get the implication that saving Bear and then letting Lehman fall was worse than just letting Bear fall. Especially if lending to someone else taking on Bear's position was the fall back.

There is of course some regime uncertainty, but it is dominated by uncertainty about the likelihood of letting a major broker-dealer fall. If you let that probability go to one, I don't see how you get a better short term result.

We can debate about the long term for sure.

e writes:

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Joe Marier writes:

I think bailout arbitrage was one of the justifications for the Chrysler bond wipeout. The idea was that Perella Weinberg and the rest were hoping for a federal bailout that'd give them a capital gain, so Obama had no choice but to make an example of them.

Various writes:

I think you're reading a bit much into Reinhart's description of events. First, it is not unusual for there to be a "line in the sand" so to speak, with the relatively more junior tranches of the capital structure getting wiped out completely and those more senior remaining completely intact. Second, part of Bear Stearns common equity was indeed preserved, at $10.00 per share if my memory serves correct. Third, some of the subsequent failures had ALL of the equity wiped out PLUS certain traunches of unsecured debt, if you consider the TRUPS preferred securities to be a junior type of unsecured debt. But Reinhart does have a good point that, at least as far as the unsecured debt senior to the TRUPS is concerned, The Fed/Treasury did bend over backwards to preserve that stuff at par.

Jon writes:
One point that he does not mention is that this sort of speculative attack will wipe out the firm's capital, which forces the regulator's hand.

I think you mean it will impair the firms ability to raise capital. Regulatory capital on the balance sheet does not disappear just because the market cap does.

mobile writes:

Remembering the controversy over short selling and the exchanges' decision to suspend short selling on banks and other firms back in 2008, I am a little bit chastened by this article. At the time I thought such a restriction was unjustified and counterproductive. But now I have to consider that it was a necessary second-best solution.

@Jon - the market capitalization of a firm is tied in a very real way to its real capital, especially for a financial firm. As a firm's stock price falls and its ability to raise capital decreases, more of the firm's real capital will be required to be tied up to satisfy its collateral obligations with its counterparties, until the firm must default on those obligations and leading to a more general default.

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