Monday, March 17, 2008

How the Fed avoided the Northern Rock trap

(John Gapper in the FT) Go back a few weeks and the idea that JP Morgan Chase would have been able to snap up Bear Stearns for $230m - a big discount to the value of its Manhattan headquarters, never mind the remainder of its business, would have been laughable. But that is what has just happened.

The reason that JP Morgan could get such a bargain deal is, of course, that Bear would have collapsed last week without the intervention of the US Federal Reserve, which gave Bear an emergency funding guarantee.

The Fed followed up on Sunday by guaranteeing funding for about $30bn of Bear’s less liquid balance sheet assets, which gave JP Morgan comfort that it can de-leverage Bear’s balance sheet without too much pain. More pain, that is, than it is pricing in with its low-ball offer.

Any time that a central bank steps in to rescue a financial institution, it had better have a good defence to those who argue that it is interfering wrongly in markets and promoting moral hazard.

The case against the Fed doing so was put by Gretchen Morgenson in the Sunday New York Times:

Regulators must do whatever they can to keep the markets open and operating, and much of that relies upon the confidence of investors. But by offering to backstop firms like Bear, who were the very architects of their own — and the market’s — current problems, overseers like the Fed undermine a little bit more of that confidence.

Meanwhile, my fellow FT blogger Willem Buiter put it thus:

While the bail-out of Bear Stearns is still a very young, thus far at any rate I have heard not a single convincing argument for why this financial business should be assisted by the Fed, rather than the ball bearings company in Cleveland, Ohio.

The economists, including Prof Buiter and Nouriel Roubini, generally favour the view that the Fed ought not to have intervened to prop up a non-bank institution and, if it was not able to hold back, should have proceeded straight to nationalisation. Prof Roubini argued this last month and restated it on Friday:

First fully wipe out those shareholders, then fire all the senior management and have the government take over such a bankrupt institution before a penny of public money is wasted in bailing it out.

But I think the different outcomes in the cases of Northern Rock and Bear Stearns at least help to justify the Fed action. They perhaps explain it too, since Ben Bernanke, chairman of the Fed and Tim Geithner, head of the New York Fed, no doubt wanted to avoid getting caught out like Mervyn King, the Bank of England’s governor.

In the Northern Rock case, the Bank of England and the Treasury were asked to provide temporary liquidity guarantees last August to give Lloyds TSB the confidence to acquire Northern Rock and its fragile balance sheet. The UK authorities refused to do so, and wound up having to nationalise the bank instead several months later.

In other words, the Bank failed to act in a decisive but contained fashion at the start, then had to guarantee Northern Rock’s deposits and finally had to buy it outright with public money because the alternative on offer from the private sector was (in the Treasury’s view) inadequate.

In contrast, the Fed committed emergency funding on Friday in order to give breathing space for a private sector deal to be engineered over the weekend. It then helped push Bear into selling for a knock-down price to JP Morgan and assisted the sale with a $30bn funding guarantee.

That is not a perfect outcome and it is possible to argue that the Fed should simply have let Bear go down, along with its mortgage book. But that would have risked turmoil in the mortgage and other credit markets and would not have made Bear’s shareholders much worse off than they are now.

Nor do I think it is inferior to nationalising Bear in the manner advocated by Prof Roubini and others and placing it in the same position as Northern Rock.

This way, the shareholders have been nearly wiped out, the bondholders remain at risk until the takeover is approved, JP Morgan is assuming all operational risk, and the Fed simply has to guarantee funding for $30bn of assets. The last part is unfortunate but I can think of worse results.

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