Sunday, March 16, 2008

The New Committee to Save the World

(Felix Salmon) Ben Bernanke hasn't caught very many lucky breaks of late, but the fact that Bear Stearns hit its liquidity crunch and got downgraded by all three ratings agencies on a Friday is probably one of them. The downgrade wasn't welcome, of course, but it did inject a sense of urgency into proceedings: a clearing investment bank can't function with a BBB rating.

Over the course of the weekend, a new Committee to Save the World was convened. And so, before the markets reopen on Monday, Ben Bernanke, Tim Geithner, Hank Paulson, and Jamie Dimon can announce, with no little sense of relief, that Bear Stearns is being bought by JP Morgan.

That news will likely send stocks up - with the exception of BSC, of course, which is being acquired for the bargain-basement price of $2 a share, despite the protestations of Bear's management that the bank's book value is still over $80.

This is a much better outcome than Bear being bought by Chris Flowers: if that had happened, there would have been question marks over his ability to withstand major further write-downs. With JP Morgan, there's no such question: JP Morgan Chase is enormous enough, and was fortunate enough to avoid the worst of the mortgage meltdown, that no one's going to worry about it failing.

The mooted price for Bear Stearns - roughly zero, despite the fact that Bear's headquarters alone is worth over $1 billion - is low enough that it gives Dimon a lot of room for maneuver. He can keep Bear as a going concern, take what bits he likes, and then close or sell off the bits he doesn't want over time, as the chaos dissipates. So my feeling is that there won't be mass layoffs in the short term, although Bear's top earners might well walk out the door on their own if they feel that this year's bonuses are likely to be nugatory.

But the price is also so low that it implies a huge amount of risk in the deal. And so the next question arises: if there's that much risk in Bear Stearns, how much risk is there in Lehman Brothers? Lehman's shares fell by almost 15% on Friday, and are now within shouting distance of falling below book value. Merrill Lynch, Morgan Stanley, and Goldman Sachs, by contrast, seem safe for the time being.

Still, I can't remember a time when investment banking, as an industry, was in as perilous a position as it is now. The LTCM crisis of 1998 was bad, but this is worse. Brad DeLong, in an excellent blog post, explains that the crisis has blindsided the markets precisely because no one thought that the investment banks were as bad at risk management as they in fact turned out to be. Now, no one trusts those banks to be good at risk management any more. And the existence of trust is a necessary precondition for efficient markets.

The other must-read post of the weekend comes from Steve Waldman, who would like to see a return to the days when trust was a central part of the banking system: the days when JP Morgan himself told Congress that "a man I do not trust could not get money from me on all the bonds in Christendom". "We shouldn't go back to the world as it was at the turn of the century," says Waldman,

But I do think that it's an interesting technical question, going forward, whether we couldn't set things up so that the criteria by which investors decide where to put their money map more closely to what we would recognize as trustworthiness or character.

There are two levels of trust which matter here. One is trust in financial institutions individually: fear of Bear Stearns suffering from a liquidity crisis was self-fulfilling, and the same could happen to other banks too. But the other is trust in the financial system more generally, and that's where the Fed's bailout comes in. The TED spread is still unhealthily wide, indicating that there's a huge amount of nervousness surrounding the health of the banking system as a whole, and it's the Fed's job to reassure the markets that the system will survive. One way of doing that is to make sure that liquidity crises like the one which hit Bear Stearns are dealt with in some semblance of an orderly and effective manner.

So it was very weird to read this, from Gretchen Morgenson, on Sunday:

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.

I think this is exactly wrong. Morgenson is right that the confidence of investors is needed if the markets are to remain open and operating. But letting Bear fail and default would boost the confidence of absolutely no one. Settlement risk alone would be reason enough for the Fed to provide support, even if the general mood of the market weren't so nervous that a major bank failure would risk a broad-based panic.

What the Fed's doing here, with the help of Jamie Dimon, isn't rescuing Bear Stearns, so much as trying to provide some kind of safety net for the financial system more generally. It's an open question whether or not the Fed has the ability to do that. But it surely has to try.

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