Tuesday, March 25, 2008

The Bankers' Ball

Time for the JP Morgan/Bear Stearns/Fed shenanigan. I've delayed writing about it this long for a reason: my knee-jerk reaction was on the vitriolic, almost fundamentalist side, so I thought it best to get some perspective. And, oh my, it paid off in the defining clarity bought by yesterday's events.

This is going to be a long post, so I'll follow the consecrated rule of starting by saying what I'm going to say, then saying it, then..:

What has happened here is a bailout, pure and simple, 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; 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.

What happened on that Friday, ten days ago, was that a combination of recent events (Carlyle Capital et al) led Bear Stearns to suffer something akin to a bank run in the sense that its creditors wouldn't rollover its short term financing (despite rosy statements earlier that week).

The Fed took action by giving BS access to collateralised borrowing from its primary discount window. According to the rules at the time, BS was not entitled to it because it wasn't a deposit-taking institution, which is short hand for saying that investment banks were not considered of systemic importance to the retail and wholesale payment cycle. They were on the other side of the protection/regulation trade-off from commercial banks such as JP Morgan. And they had been happy for it so far.

The Fed circumvented this restriction by giving JP Morgan a $30bn non-recourse loan through the discount window, one that JP would use to give a loan on similar terms to BS. JP would be, in effect, nothing but a financial channel running a loop around regulation; the collateral would flow through JP, from BS to the Fed, at no risk to JP and all risk to the Fed.

Was it a bailout? BS was so leveraged and in need of short term finance, so insolvent, that it would have gone bankrupt. Of course, the BS side will argue in the 100 years of lawsuits about to be unleashed that it was a liquidity issue born out of illiquid markets, not a solvency issue. Although I would do the same if I was them (this is business, not a morality play), that is so wrong, it gives me a headache: saying you would be fine under circumstances ideal to your investment strategies is meaningless, really. Under the market as it was, as it is, and as it will be for quite a while, BS was insolvent, period. Bankruptcy awaited.

But liquidity, solvency, whatever: the Fed was bending the rules as they existed at that point to rescue a particular company through a mechanism intended for a different set of businesses.

Even then, some important questions remained: What collateral would the Fed take from BS (the best or worst rated papers)? What was the haircut on the collateral? What was the rate JP was going to charge BS (JP is not a charity, it was in for the money)? These would define the risk being assumed by the taxpayer and the level of suffering for BS shareholders, which was needed in considerable amounts to avoid moral hazard.

But in my view, the real issue among them all was: Was it even necessary?

BS was the fifth largest investment bank. Still, it was puny compared to the market. And of course, it was not a traditionally systemic part of the payment cycle.

The problem was arose from how highly leveraged BS's assets were and, because of this, the contagion that would result if BS dropped them in a fire-sale in such illiquid markets in a last-ditch, doomed attempt to save the business.

Ben Bernanke must have been waking up from nightmares of financial meltdowns just to see them coming true.

(Aside: on Sunday 16th, the Fed extended the discount window to investment banks. While this seems to complicate the story, it's almost completely irrelevant to it. Having said that, it is probably the most important event of financial-sector regulation in ages as it might mark the beginning of a seismic change in which investment banks and private capital in general come to be recognized as systemic to the payment cycle. In other words: more support, but more regulation. But, heck, we knew they were systemic since LTCM, right? Anyway, that's a whole different issue and one likely to trigger the battle of all lobbying battles if it ever gets seriously discussed.)

So back to the core of it all: was this necessary? I'm a sucker for first-best solutions when these are available. You lose efficiency when you don't attack the problem itself, but some iteration of the problem, some incarnation down the road. The problem here was the potential contagion because of BS selling assets in illiquid markets to reduce its private damage while it rushed all the way to the bankruptcy window. It was not that BS was going bankrupt.

So what the Fed needed to do was to prevent the sale of these assets in illiquid markets, not to shore up BS.

Instead, what the Fed did was to buy credit risk into the tax payer's portfolio and to shore up a company that had played unsustainable cards (at the very least in the sense that it wouldn't have survived given the current situation).

When a private firm is insolvent, it declares bankruptcy. But if there is a public interest in preventing a desperate, chaotic sale of assets which, in the process, triggers a contagion, the business is taken into receivership. That is, it is seized and wound down in an orderly fashion like the Fed would do with a commercial bank under similar circumstance.

Yep, I said it: "seized" as in "nationalized" No: I'm not saying the the gov should run an investment bank. Instead, the business is closed and the well-valued assets sold back into private hands, while those assets that would have triggered a contagion are held temporarily to be sold at a time in which the markets have returned to fundamentals. Debtors are paid with the proceeds, guarantees for the public purse are taken. And once all assets are finally sold, if something is left then, and only then, this is given back to the original shareholders.

It's contagion-less bankruptcy. Pure and simple.

Instead, what the Fed did do was to absorb the risk with nothing in return and generating in the process moral hazard by signaling its willingness to bend the rules to save a particular investment bank. And someone was going to pay JP for its troubles, whether BS or the Fed or both.

A lot has happened since then, and yet so little has. To be frank, beyond the expanding of discount-window loans to investment banks, as mentioned above, things since then have amounted to nothing more than a cat-fight between JP and BS shareholders on how to split the spoils.

On Friday, we went to sleep with BS shares hanging there at $30. On Sunday, JP announced that it was buying BS at $2 per share through a deal brokered by the Fed. And best of all, the Fed was still lending those $30bn, but at least we now knew which assets it would get as collateral: the riskiest, most radioactive of them all. And it seems save to assume that this deal wouldn't have happened without the Fed's loan. I say this to give the benefit of the doubt to the Fed: it the deal had gone through otherwise, then the Fed had no business in what should have been a transfer of wealth (and risk) between private parties. So those $30bn must have been key. (In fact, JP's valuation went up by a little over $32bn between the 14th and the 20th.)

(Aside: BS's board agreed to issue stocks for 39.5% of the company's worth at $2 per share and that these would be sold to JP; together with the 5% the board controlled directly, JP would almost be able to impose a stock swap and absorb BS for good. Why 39.5%? A rule-of-thumb says that Delaware courts, were both companies are incorporated, will not stop the board of a company from issuing and selling stock up to this amount without consulting stockholders under an emergency for the business' survival (see here).)

In other words, the Fed was in the same situation as before, which was now revealed to be the riskiest of all possible ones. JP was getting the sweetest of all deals: to keep all the juicy assets, including the super-blogged-about BS's headquarter building (valued at >$1bn), for about 1/4 of a billion thanks to the taxpayer absorbing the worst risk. If ever there was a windfall, here it was. The open question was how much punishment did $2 per share mean for BS shareholders.

That last question became the main distracting issue in this whole affair. BS's shareholders were getting $2, which, after all, is infinitely more than $0. So was this a bailout or enough punishment to wipe out moral hazard? Although some shareholders would still take millions home, it'd be hard to deny it was a harsh drop from the $30 per share of the 14th: how much less could they have gotten from bankruptcy or from receivership? Not a lot less than $2 less for sure! (Although apparently someone thought that more; see below.) In fact, I'd like to think that the Fed's estimates for the return per share through bankruptcy were $2; I really hope that was the case.

While that could have been the end of the story, instead we saw BS shares trading at >$5 and even >$6 in the subsequent days. This highlights yet another failure of the Fed's approach: it gave agents much more leeway to try to game the system when compared to a definitive seizing of assets.

(Aside: What was going on? Two hypothesis: (1) The current shareholders refused to sell because they thought they would get more through bankruptcy. (2) The current debtholders wanted to buy stock to make sure the deal would pass since they would get more from having JP take over their otherwise almost worthless BS debt.)

But who cared for those valuations, right? The deal was signed, JP only needed about 5% more of the stock; the bottom line: the Fed had intervened to transfer BS's assets to JP and the taxpayer. The best ones went to JP at no cost; the worse, the riskiest, went to the taxpayer. I sincerely fail to see the public interest in that.

(Aside: In the following days, the markets went up, the dollar went up, etc. Some analysts have argued that this shows the Fed did the right thing. What? Why would a transfer of wealth such as this encourage the markets? Because it signaled more bailouts to come? Moral hazard, here we come! But even at my most cynical, I cannot buy that as the main explanation: it must have had a lot more to do with the expansion of the discount window's lending, and the positive (less negative than expected) results from Lehman Brothers and Goldman Sachs.)

So this should have been the end of the story, except... Except that the lawyers for JP really screwed up. Massively. Someone must have been banished from private practice for six hundred and sixty six years. A clause in the signed contract meant that JP had agreed to back all BS trades for a year, even if the deal didn't go through. Now BS shareholders had some real bargaining power here and they knew it. JP had to get the old contract thrown out and a new one brought in. That's how we got the $10 per share yesterday.

But what does this change? Nothing from the public's perspective. Not fair: to be exact, there is a token change. The Fed now guarantees "only" $29bn and JP assumes the first $1bn in losses. Same-difference for the tax payer, but not quite: it's worse as there is greater scope for moral hazard in the future. The rest is just a redistribution of the windfall from JP back to BS shareholders. JP is, of course, still making a killing. And now, BS shareholders are getting five times more than before and a third of what the company was worth when we all found out how worthless it was.

Because of this latter, the discussion of whether this is a bailout for BS shareholders has again intensified. But this is still as misguided as before, it's still the wrong question: it was and remains a bailout plus a redistribution between private actors. The tax payer footed the risk, the juicy assets were distributed among the private parties in some bargaining game.

Moral hazard: Here we come.


Background reading, just in case you've been living in a cave: the FT offers a summary of the current state of affairs here (just ignore the first comments on the home data and the "rally") and a longer term perspective here; the NYT has the juicy tidbits of what happened Monday here.


Gabriel said...

Longest freaking post EVER!

If you expect us to read all of this at least spice it up with charts, equations or pictures of Bernanke's beard.

ram said...

I know; it took me forever to write, too.

But see, now you cannot say I don't pay attention to reader requests!

Although, no, I did not post a pic of Bernanke's beard, I did the next best thing:

I've spiced up the blog to have expandable summaries. So you don't have to read the whole thing unless you are *really* interested in the topic.

(Or rather, in my take on the topic, which might be judged completely different.)