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March 16, 2008
How tonight's Fed announcement paves the way for more emergency financing of investment banks
This post continues the discussion from here. The immediate question is, of course, whether the Fed's facilitation of JPMorgan's rescue of Bear Stearns was a good idea. Here is a "no" vote from Willem Buiter (via Felix Salmon)
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.
...
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.
Good points. And the first of those points (unusual and exigent circumstances) is what tonight's announcement by the Fed addresses--in a new and innovative way. From the press release,
First, the Federal Reserve Board voted unanimously to authorize the Federal Reserve Bank of New York to create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets. This facility will be available for business on Monday, March 17. It will be in place for at least six months and may be extended as conditions warrant. Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities. The interest rate charged on such credit will be the same as the primary credit rate, or discount rate, at the Federal Reserve Bank of New York.
So there it is. A new lending facility which appears to be inspired by the spirit of the "unusual and exigent circumstances" clause to which Buiter refers. But as path-breaking as this is, it is not quite as drastic as if the Fed had invoked that phrase and opened the door even wider. It is limited to primary dealers, which are listed here. These are the institutions that the New York Fed works with on a daily basis in the conduct of open market operations. One could argue that the Fed already uses them as a conduit for routine monetary policy, so they are the natural choice for facilitating these emergency actions.
If they are simply acting as a conduit for loans, that would be odd--sort of a regulatory quirk reflecting a holdover of the post-Depression wall that has now fallen between deposit institutions and investment institutions. It's a patch rather than a permanent fix while we try to figure out how to keep this from happening again and how to address it more effectively if it does. Not what I would suggest if I were designing the system de novo, but an understandable thing to do in the heat of battle.
But if it leads to the primary dealers swallowing up troubled institutions, then it does raise some issues of the sort that Buiter outlines in the second part of the quote. Why not take Bear Stearns (and whoever may be next in line) into public receivership directly?
Such questions are all the more relevant tonight as news comes of the sale of Bear Stearns to JPMorgan for $2 a share.
Reflecting Bear Stearns’s dire straits, JPMorgan agreed to pay just $236 million for the firm, a figure that includes the price of Bear’s soaring headquarters on Madison Avenue in Manhattan. At $2 a share, JPMorgan is buying Bear Stearns for a third of the price at which the troubled firm went public in 1985. Only a year ago, Bear’s shares fetched $170. The cut-rate price reflects deep misgivings about the firm’s prospects.
JPMorgan said it was guaranteeing the trading obligations of Bear Stearns and its subsidiaries, effective immediately. “JPMorgan Chase stands behind Bear Stearns,” Jamie Dimon, JPMorgan’s chief executive, said in a statement. “Bear Stearns’s clients and counterparties should feel secure that JPMorgan is guaranteeing Bear Stearns’s counterparty risk.”
The companies said that the Federal Reserve would provide special financing in connection with the transaction and that the Fed had agreed to fund up to $30 billion of Bear Stearns’s “less-liquid assets.”
If you're a fan of the movie It's a Wonderful Life, this is where George Bailey says "Potter's not selling. Potter's buying!" I mean, the Bear Stearns building alone must be worth....
But it's the last paragraph I quoted that leads to headlines like this, from a blog on the L.A. Times: "With Fed financing, JP Morgan buys Bear Stearns".
I suspect that's not how Mr. Bernanke wants this to be viewed.
But the cynic who has moral hazard on his mind can't help but ask... If they do it once like this, what if it happens again? What if another entity considered too big to fail gets special financing from one of the primary dealers through this new facility? As we saw tonight, it is but a small step from a loan guarantee to a fire sale.
This is a good time to link to Brad DeLong's excellent post in which he tells us what Bernanke, Paulson, et al. should have done this weekend. He would have the Treasury set a (discounted) price for mortgages that look a little shaky, buy them, push the market back to equilibrium, and make money for the taxpayer in the process.
If I were working for the Treasury right now, I would be saying: make this happen on Monday. There isn't time to set up a new bureaucrtacy--a HOLC, which is what Alan Blinder wanted to do as of three weeks ago. So use an existing bureaucracy: Fannie Mae. If I were Treasury Secretary Hank Paulson, I would spend the weekend building a legislative vehicle to introduce Monday morning on an emergency basis to give Fannie Mae the resources and the mission to undertake this mortgage rescue operation, and I think Fannie Mae is the right institution for the task: why does it have its government-sponsored status and guarantee if not to be used for purposes like these at times like these?
And if I were Ben Bernanke and Tim Geithner, I would be spending this weekend thinking about how to first thing Monday morning punish bear speculators on Bear Stearns, Lehman, and others by pushing their CDS spreads back to more normal levels. It seems to me that people on Wall Street need to be taught that betting that the Fed will not intervene to stabilize or that its interventions to stabilize will be unsuccessful is an unhealthy thing to do.
The Bear Stearns sale notwithstanding, it's not too late to do something approximating DeLong's (and Blinder's) suggestions to head off future episodes. (Who thinks that this is the end?)
Whether $2 a share is sufficient punishment for the speculators is left to the reader.
Some closing thoughts (at least for tonight) in the next post.
Posted by William Polley at March 16, 2008 09:33 PM
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