« How tonight's Fed announcement paves the way for more emergency financing of investment banks | Main | Link roundup »
March 16, 2008
Whatever happens in the morning, we'll still be writing about this twenty years from now
This is part three in a series of posts relating to this weekend's sale of Bear Stearns to JPMorgan and the Fed's role in the matter. (First post, second post)
The previous post highlighted a few of the reasons that some will be cynical about what happened tonight. The cynics make some relevant points. Moral hazard is a concern. Some will say that the Fed's role in backing JPMorgan is troubling. Similar points were made during the LTCM debacle. And yes, there might be other episodes like this. All true, and yet....
When I take my students up to Chicago to tour places like the Chicago Fed and the Board of Trade, I make sure to give them a little history lesson. At the corner of Jackson and LaSalle stands a reminder of another financial crisis with particular relevance to today--the old Continental Illinois building. Bank of America now occupies the space, but the name remains carved in stone as a mute testimony to what once was. The name faces out over LaSalle St. directly across from the main entrance to the Chicago Fed building. I have often thought, as I enter the Fed building, that having that name as a constant presence across the street must give anyone who works at the bank a sense of purpose. The Fed's very existence (and that of other regulators) is meant to prevent such bank failures and when prevention fails, to cushion the greater economy from the effects.
To be sure, there are some similarities as well as many striking differences between the Bear Stearns situation and that of Continental Illinois over twenty years ago. Continental Illinois was a commercial bank. Deposits were at risk. In that way, it was quite different from the situation we see today.
Despite these differences, one similarity between Continental Illinois and Bear Stearns is that they will both go down in the history books as a milestone in the Fed's evolution as a lender of last resort. For a great recounting of the Continental Illinois collapse, check out this document on the FDIC website: "History of the Eighties--Lessons for the Future." In particular, look at chapter 7, which details how the events unfolded and what was learned. This passage from page 249 is the appropriate text for today.
As has been noted, however, [Too Big To Fail] was an inaccurate term: too big to liquidate would have been more appropriate. Large banks did fail during the period, with shareholders losing their investments and managements being removed. In significant ways, Continental failed. But as one regulator observed, the banking agencies were reluctant to tolerate the sudden and uncontrolled failure of large institutions and therefore generally opt[ed] for managed shrinkage, merger, or recapitalization. There were several reasons for adopting such an attitude, the most important of which was systemic risk. This rubric covered potential spillover effects leading to widespread depositor runs, impairment of public confidence in the broader financial system, or serious disruptions in domestic and international payment and settlement systems. In addition to systemic risk, the logistical difficulties and potential expense of liquidating a large bank also contributed to regulatory reluctance to close such a bank and pay off insured depositors. Moreover, liquidation would mean tying up uninsured depositors funds during the lengthy proceedings, a situation that could have a very disruptive effect on a banks community. For all these reasons combined, the larger the bank, the more likely it was that bank regulators would look for alternatives to closing the bank and paying off the insured depositors.
Except for the part about depositors, it could have been written about this weekend. Indeed, Bear Stearns failed. But it proved too big to liquidate without assistance. Continental Illinois essentially did go into receivership. The FDIC guaranteed everything, even beyond the $100,000/deposit limit. The Fed provided the backstop liquidity. It was not without controversy. And it took months to come to a head, and months to finally work out.
How things have changed. When this story first broke, the NY Times reported:
The developments may only postpone the eventual sale of all or part of Bear Stearns, which has had crippling losses on mortgage-linked investments. To keep the 85-year-old firm solvent, JPMorgan, backed by the New York Fed, extended a secured line of credit that gives Bear Stearns at least 28 days to shore up its finances or, more likely, to find a buyer.
One day, folks. One day and the deal was done. Would the markets have gone into a tailspin if it didn't get done that fast? Hard to say. What is not hard to say is that no one wanted to take that chance. You know that everyone involved at the Fed knows that they are doing something that will be scrutinized and criticized. They know about the moral hazard problem. They know that this could have negative consequences. They know that there is only one reason to do it--and that is that the consequences of not doing it are potentially much worse. Mr. Bernanke, scholar of the Great Depression, knows that better than most.
By pulling out all the stops the way that he has, Mr. Bernanke is probably already the most innovative Fed chair in history. I'm sure he would rather not have that distinction, but there are worse ways to distinguish oneself. And so in the final analysis (at least for tonight) I have to applaud Mr. Bernanke and the Fed for taking the steps to allow for an orderly liquidation of a failed institution--a very different thing from a bailout (Ritholtz agrees). JPMorgan can probably liquidate the assets more efficiently than the government could in a short amount of time. With the way that financial markets are connected and positions are so heavily leveraged they could not afford to shop Bear Stearns around the way that they did Continental Illinois. If we are to believe what we're hearing, the wheels were about to come off. The "repo" market moves too quickly and is less forgiving than a depositor in a commercial bank. Undoubtedly banks and other institutions had loaned Bear Stearns large amounts in the repo market and if they didn't get paid, well, that would indeed be the sort of thing that causes the whole market to seize up very suddenly, perhaps catastrophically. Not a slow motion deposit-driven meltdown.
Kind of makes Continental Illinois look like a minor hiccup in comparison. And yet here we are twenty-some years later talking about that event--its aftermath coloring our perception of today's events.
The Fed was presented with a tough choice and probably made a good call. And while some of the critics objections are reasoned (Buiter), some just don't get it. Today's public flogging of the MSM is outsourced to Brad DeLong.
As Buce of Underbelly puts it, Gretchen Morgenson fails to understand the distinction between preserving the lines of business that are the enterprise and rescuing the holders of the equity in the firm:
Rescue Me: A Fed Bailout Crosses a Line: WHAT are the consequences of a world in which regulators rescue even the financial institutions whose recklessness and greed helped create the titanic credit mess we are in? Will the consequences be an even weaker currency, rampant inflation, a continuation of the slow bleed that we have witnessed at banks and brokerage firms for the past year?
Or all of the above?
Stick around, because we'll soon find out. And it's not going to be pretty.
Agreeing to guarantee a 28-day credit line to Bear Stearns, by way of JPMorgan Chase, the Federal Reserve Bank of New York conceded last Friday that no sizable firm with a book of mortgage securities or loans out to mortgage issuers could be allowed to fail right now.... But why save Bear Stearns? The beneficiary of this bailout, remember, has often operated in the gray areas of Wall Street and with an aggressive, brass-knuckles approach.... Let's not forget that Bear Stearns lost billions for its clients last summer, when two hedge funds investing heavily in mortgage securities collapsed. And the firm tried to dump toxic mortgage securities it held in its own vaults onto the public last summer in an initial public offering of a financial company called Everquest Financial. Thankfully, that deal never got done.... And so, Bear Stearns, a firm that some say is this decade's version of Drexel Burnham Lambert, the anything-goes, 1980s junk-bond shop dominated by Michael Milken, is rescued. Almost two decades ago, Drexel was left to die...
It does not seem that she gets it.
I have to agree with DeLong. This is far a desirable outcome, but the consequences of inaction were worse. I admit to being uncomfortable with the Fed as a backstop and I worry about the precedent this sets. Tell me who is comfortable with it? It should make one very uncomfortable, and I'm sure that a lot of folks at the Fed are not sleeping well tonight. But sometimes you need to make the uncomfortable choice.
And so now we'll just have to wait and see how much the new lending facility gets used.
I didn't even get to talking about the discount rate. In light of everything else going on, it's a minor part of the story, and the fact that they lowered it is maybe a little bit of overkill. If someone can explain why an extra quarter point today as opposed to Tuesday is going to help the liquidity issues, I'm all ears.
Posted by William Polley at March 16, 2008 11:10 PM
Trackback Pings
TrackBack URL for this entry:
http://www.williampolley.com/cgi-bin/mt-tb.cgi/980