(Originally published on March 24, 2008)
The Federal Reserve’s decision last week to put up $30 billion in the form of a loan to facilitate JP Morgan’s purchase of beleaguered investment bank Bear Stearns expectedly has come under a lot of criticism. Although the criticism was probably justified, it was argued by some that this was not really a bailout, because at $2 a share Bear was essentially worth nothing. Bear had lost over 90% of its value in just a week and was down almost 99% from its $170 high marked in early 2007. Bear’s shareholders were practically wiped out and the Fed was not doing anybody any favors. But the equation now changes a bit with JP Morgan quadrupling its bid for Bear Stearns to $10 a share.
Firstly, the argument that there was no bailout of Bear Stearns is incorrect, even if its share-holders were indeed practically wiped out. Insolvency necessitates 100% wiping out of a firm’s equity. A residual value of share-holder equity – even if only $200M – essentially implies that these share-holders still fully own the firm and that they stand to benefit from any possible increases in the market value of the firm due to the significant $30 billion liquidity support provided by the Fed.
Securities firms – except the very few that could be deemed to be systemically important – should succeed or fail of their own accord, without any guarantee – explicit or otherwise – that they would receive liquidity support in the event that they end up bungling up. As a thumb rule, non-bank financial institutions that are illiquid should be allowed to fail in case they mismanage their liquidity risk and are unable to find private sources of emergency liquidity. If they are insolvent, like Bear most certainly was, they should certainly be allowed to fail.
The Fed probably contended that Bear was ‘too big to fail’ – given its size and its interconnectedness with the system, Bear’s failing posed a major systemic threat to the financial system. But any such institution that is indeed systemically too important to be allowed to fail should be brought under the Fed’s ‘lender of last resort’ umbrella only if the said institution were regulated and supervised in the same manner as banks are. Currently, US securities firms are supervised by the SEC and have much lower capital standards than banks. Bear and others are only paying for their years of excess… reckless lending practices with practically non-existent risk management practices.
Prudence suggests that securities firms should properly manage their liquidity and credit risks, with the creditors to such firms providing additional market discipline by having their claims at risk if the firm becomes insolvent. A necessary corollary to such market discipline would imply that creditors to such firms should lend funds at rates that would fully incorporate all the relevant risks – credit, market, liquidity and others – that they face.
The appropriate resolution of the Bear Stearns insolvency – that would have minimized the moral hazard argument given the Fed’s liquidity support – would have been a complete wipe out of its share-holders, an en masse firing of its entire senior management (minus the golden parachute and rich severance packages) and an eventual nationalization of the firm. Public money was used to bail out the creditors of the firm in order to prevent a systemic collapse. Instead, it should have been used to ensure an orderly disposal of its assets or operations, including inflicting appropriate losses on its creditors. It is only appropriate that creditors of insolvent – as opposed to illiquid – securities firms not be bailed out when such firms get in trouble, even if they are dubbed systemically too important to fail.
Instead the manner in which the Bear collapse was handled, the Fed and the Treasury have only ended up creating the mother of all moral hazards. Bear share-holders are far from being wiped out, the senior management has stayed in place (and probably also played a role in the offer price being quadrupled) and the firm’s creditors, who lent without considering the significant risk they were undertaking, have not experienced the losses that they would have incurred had Bear been forced to close down.
This is a bailout irrespective of what the Fed or the Treasury prefer to call it. It may help to avert a systemic crisis in the short term. But it does nothing to provide a long term solution to what is being dubbed as the biggest financial crisis since the Great Depression.
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