Namely, why must it be bailed out or, in other words, what would happen to the economy if it wasn’t? I know that many of these institutions operate in a very high risk environment, but how exactly did the rest of the economy become so exposed to that risk?
That’s easy.
Bear Stearns is an investment bank with a considerable capital markets exposure. Broadly put, it was the risk counterparty to a lot of other entities in the capital markets. This can take about a million different forms, including repo financing, derivatives, lender, borrower, etc. In Bear’s case, counterparties had decided not to take any more repo risk with them, which is why the firm ended up so close to bankruptcy. If Bear were to file BK, obviously their ability to function as a counterparty to existing agreements becomes essentially null and void. If you’re the other side of that, then you now have to mark down your books as well because you no longer have the value that you think you have - in laymen terms, if your balance sheet includes a deposit at Citibank, and Citibank goes under (ignoring FDIC, etc.), then guess what, you’re not as rich as you thought, and as importantly, anybody else relying on your ability to repay them now has to rethink their own situation. Since Bear was counterparty to basically everybody, you would have had a vast remarking on the street, which would have included other banks, hedge funds, institutional investors, etc. That would have created a situation where a lot of people would very quickly no longer trust the other side of the trade because you don’t know their damage level, loans would be called in, and margin calls issued, making the situation worse and creating a very rapid vicious circle. Then everybody being pushed down would have to sell whatever they could quickly, pushing down prices for well-known assets and creating depressed prices for not well understood assets like mortgage bonds, and basically cycling this until some base level is reached. Basically, a run on the bank would quickly become a run on the entire market. This is what the Fed was trying to avoid.
Basically, the US and world markets would have shut down very quickly on Monday morning, which would have been the only way that you could avoid a completely catastrophic market day. Nevertheless, the damage would have been done and some sort of extraordinary measure would be required to reliquefy the markets.
There are still other ways this can happen - a catastrophic failure of a big bond insurer could create a similar effect. In fact, on days of high volatility where the market drops over 400 points, you do see significant rollover into other unrelated markets, because when investors are put into margin calls, they sell other assets, often in other markets.
If its not obvious, this has considerable impact on the larger economy, including inability to get credit, dramatic wealth effects, failure of corporations, etc. Market liquidity is always presumed to exist, until it doesn’t, in which case you are up against the meltdown scenario.
Okay. I get it. Thanks for the thorough reply. I’m trying to get a handle of the conditions under which pure free markets fail. Well, fail may be the wrong word, but probably close enough. Is there anything to suggest that government interference/regulation contributed to this crisis? In that absence of that, it would seem this is an example of the need for our market economy with some form of government involvement.
If the gov’t (i.e. you an I) is responsible for bailing out companies like this, who’s health can significantly effect the national economy, should they have some rights/obligations in overseeing and monitoring certain companies like this? If we the people have to foot the bill to keep them solvent, then don’t we have some interest that they are being managed conservatively and don’t overreach their portfolio risk? I don’t know all the ins and outs of the situation, just makes me wonder what the management’s risk adversion is, when they know the government will always step in to keep them solvent.
Do companies like Bear Sterns have certain liquidity and debt targets that must be maintained…similar to what we require banks to do? Anything?
.
Pure free markets fail when there is a lack of confidence in the other parties in the market.
One of the conditions for pure free markets to function, purely academically, is for there to be perfect information. Only the purely ideological would argue that this justifies little to no regulation, because obviously perfect information doesn’t exist. Parties are opaque, their holdings are opaque, and value is often difficult to ascertain for a number of reasons.
I think that’s the trillion dollar question.
The question has arisen as to what level of regulation should banks and investment banks be beholden to if they are going to get the benefits of government intervention, but few of the burdens? This fits into the question of moral hazard as well. It appears that Treasury and Fed are going to concede that you can’t not regulate banks and then be expected to cover their ass when their risks go catastrophically wrong. As a result, I think further regulation is coming and warranted.
As a matter of course, I’m not of the opinion that Bear was bailed out, per se. That is, Bear’s stock price was deliberately set to $2 by Paulson so that optically it wouldn’t look like a bailout. When your stock price was $170 and now its $2, that certainly doesn’t look like a bailout. However, my contention is that the true beneficiaries of the undue risk taken was a relatively small group of managing directors and senior managing directors who pulled in millions for years before it all went bad. And they’re not giving it back. The shareholders saw relatively little of that, so to say that a bailout properly disincents moral hazard I think is inaccurate. The same Bear employees took a large portion of their compensation in Bear stock so they were hurt as well, but its not clear to me that they still didn’t benefit in an outsized way from the risks that ultimately took Bear down.
Investment banks are generally not strongly regulated. The other issue is that investment banks and other entities in the “shadow banking” system are responsible for a lot of financial innovation such as derivatives, securitization, etc., often as a means to avoid regulation. The problem is that these innovations are often very complex and not well understood both because of their complexity and their youth. That is, you can model any sort of behavior you want on a computer, but in the real world, with real people making decisions, its essentially impossible to predict what actually will happen. We also don’t know how many of these instruments will behave in interaction with other existing and new instruments. So every time a new instrument is introduced, the system actually grows more complex by a larger amount. It has been suggested that we end up in an epistemological dead end - at some point systems grow so complex that it is theoretically impossible to predict all the ways it can go bad, like the space shuttle.
The question is whether regulation can help, or is it always going to be behind the curve. My feeling is that there are ways to force disclosure of shadow liabilities and regulate effective leverage and other means to create more transparency, which is the ultimate issue. You are still going to have the problem of complexity and chaos, but hopefully this will reduce the frequency of these meltdown scenarios, which is the real issue here - deregulation and innovation certainly hasn’t reduced the frequency of these events, which happen way way way more frequently than would be statistically suggested. In the presence of this knowledge, we have to consider that perhaps the way we’ve been looking at this is wrong, and that we need to either slow down or create better standards of transparency so that we can better see and understand the kinds of risks we are actually taking. Will this solve the problem. Absolutely not, but it may better prepare us in the future.
Allowing BSC to collapse would have been extremely painful but it would have ended the cycle of Moral Hazard that started in Greenspan’s tenure. With each crisis – Mexico meltdown, Russia meltdown, Asian Contagion, LTCM – the Moral Hazard ante has been upped, setting the stage for an even greater future crisis.
Sure, the BSC collapse would have been painful – maybe 3 years of deep recession; 2 or 3 major banks failing; 5000 point drop in the DJIA. But no one - NO ONE - would ever f**k around with overleveraging again. If someone overleverages, no one will trade with them because they’ll remember what happened to BSCs counterparties. So no one will do it.
It would be the end of the absurd $30 trillion Default Credit Swaps market. The end of leveraging Agency bonds 30 to 1 (like the Carlyle idiots). The end of “rogue” traders, who somehow magically get past all the internal audits. Maybe even the end of hedge funds. That would be good. Very good. And the markets and the economy would emerge healthier and stronger for it.
– jens
I agree that it’s a slippery slope of government intervention and the subsequent mentality in the market that the government will bail you out. That may actually increase risky behaviour. OTOH, I don’t see how you can guarantee that a BSC failure would teach the market to behave in the long run. In the short, maybe, but just like any kind of speculation, there will always be those willing to shoulder risk for reward and if they make money while they can and get out, then why should they worry about the larger economic aftermath?
I think that’s untrue.
The problems aren’t simple enough to be cured by a particularly bad single event. If you consider the '29 crash, the '87 crash (which was worse), the LTCM meltdown, the Asian Contagion, etc., these are not necessarily issues of moral hazard - they are dramatic events which occur way more likely than one would expect. Just because somebody big goes out on a limb and screws up, that doesn’t necessarily make it a case of moral hazard. For instance, in the case of LTCM, they had highly leveraged trades which were based in fundamentally economically reasonable logic. The problem, in their eyes, was that the statistically extremely unlikely event occurred - spreads on the trade widened and continued to widen despite all reasonable logic that they shouldn’t. Obviously, their leverage exacerbated, but not as much as their underestimation of the risks of collapse. And given the brainpower behind the fund, I don’t think its a matter of whether or not they were smart or took great risk expecting a bailout. I’m quite certain they did not trade expecting there to be an implicit put to the government.
I think the problem is as I said before. The instruments are so complex and rely on a lot of market liquidity assumptions that tend to fail just when you need them not to. They then contribute complexity to the overall system to the point where its not only impossible to model probabilities, but impossible to imagine all of the different ways that it can fail.
I don’t think its a matter of leverage. You can never take leverage out of the system, and its fundamentally inefficient and impossible to do so. Nobody would be able to buy a home, start a company, etc. - the economy would shrink catastrophically. The problem is not necessarily leverage - its that we don’t know how all of the pieces work together, and when things zig when they should zag, leverage makes that more painful. You also have a problem as to how to define leverage and overleverage, which is not a straightforward notion. You may think 30:1 is overleverage. Do you know what your average money center bank is leveraged at?
I think the answer is transparency and to some extent regulation. If you consider Bear, much of the problem was that there was no transparency as to the value of their assets. Unfortunately, in a lot of the cases, even transparency of the assets would have been of limited value as the markets they trade in are extremely illiquid. This is part of the failure pure laissez-faire economics, which presumes that every market will put a reasonably efficient price on an asset. This is clearly untrue.
The nature of the process is that we invent new devices, and figure out if they work. We try and invent concurrent risk controls as well, but the reality is that like any complex system like, as I said, the Space Shuttle, it works until it doesn’t, and like any inherently chaotic model, its impossible to predict how it will fail until it actually fails.
I think the real answer, which is probably impractical, is a combination of regulation, further transparency, and to some extent, a moratorium on further gee-whiz financial “innovations” until some time has passed until we better understand the ones we have. Otherwise we will always be behind the curve and these calamities, which statistically should only happen every few dozen lifetimes or so will continue to happen every decade or so.
Wow, I was going to attempt to answer this, but anything I post now would just look silly in comparison to trio’s excellent explanation. To explain it in one sentance.
A large bank can not go bankrupt because every bank is tied to every other bank and losing one bank through bankruptcy would cause other banks to fail (through margin calls and such) resulting in a temporary collapse of the system.
That would be VERY bad.
"Just because somebody big goes out on a limb and screws up, that doesn’t necessarily make it a case of moral hazard. "
No, moral hazard is when the govt. establishes a pattern of bailing such people and their counterparties out — as is currently the case.
"And given the brainpower behind the fund, I don’t think its a matter of whether or not they were smart or took great risk expecting a bailout. "
I took a class or two from that “brainpower.” However smart, they were completely ignorant of kurtosis risk and their own hubris.
"I’m quite certain they did not trade expecting there to be an implicit put to the government. "
Did you know that Meriwether is out there doing exactly the same thing all over again? Do you think he would be able to if not for the bailout? Do you think investors would invest with him, banks would lend to him, or counterparties trade with him?
http://www.reuters.com/...eedName=businessNews
And that’s the key point here: there will always be individuals and hedge funds willing to go out on a limb. But they can’t get very far out there without the willing participation of investors, lenders, and counterparties. If those other players get badly burned enough, they won’t participate in the next crazy overleveraged scheme. If the government establishes a pattern of rescuing them, they will do it over and over again. And we’ll launch from one crises to the next.
Yes, there will always be sparks to start a fire. But without the govt. putting fires out all the time, the fuel will never accumulate enough to have a catastrophic fire.
– jens
Agreed, jeepy’s explanation is excellent, but Jens brings up an interesting point too. Namely, that this kind of catastrophic market failure would future-proof the economy from the kind of over-leveraged speculation that led to these problems in the first place. Is that really likely though? I can see it delaying the cycle somewhat but not completely eliminate it, so there would always be a need for some government involvement/regulation.
“However smart, they were completely ignorant of kurtosis risk and their own hubris.”
Exactly. They were completely confident in their application of Black-Scholes. No lack of moral hazard would have stopped LTCM from placing the bets they did.
“But they can’t get very far out there without the willing participation of investors, lenders, and counterparties.”
I think you underestimate human nature. The fact that JM has been able to raise a new fund of any sort after LTCM seems to support the idea that human nature often defies logic…especially where money is concerned.
Haim
"Exactly. They were completely confident in their application of Black-Scholes. No lack of moral hazard would have stopped LTCM from placing the bets they did. "
Yes LTCM would have made the same bets, but the bets would have been very small and inconsequential as far as broader markets were concerned. You can’t have leverage unless a lender or a counterparty allows you to. Without moral hazard, lenders and counterparties wouldn’t allow such risky leverage — or they would demand premiums so high that they would curtail the growth of such hedge funds. That’s actually happening right now. It would happen a lot more without the govt’s hand in things.
"I think you underestimate human nature. The fact that JM has been able to raise a new fund of any sort after LTCM seems to support the idea that human nature often defies logic…especially where money is concerned. "
No, the behavior is completely rational and logical. Financial markets have always traded off risk against return. When the government puts a floor under risk, it completely skews the trade-off and investors and banks favor risk much more than they otherwise would. Without a floor under their risks, the banking system would never permit the likes of Merriwether to get off the ground with any leverage.
Do you think people would build houses on the Mississippi flood plain or the Outer Banks after they get destroyed every 2 years if the government didn’t continue to bail them out? The same priniciples apply to government involvement in finance and banking. That was the real lesson of the S&L crisis – which was lost on our Congress.
-jens
Agreed, jeepy’s explanation is excellent, but Jens brings up an interesting point too. Namely, that this kind of catastrophic market failure would future-proof the economy from the kind of over-leveraged speculation that led to these problems in the first place. Is that really likely though? I can see it delaying the cycle somewhat but not completely eliminate it, so there would always be a need for some government involvement/regulation.
Yeah. I overstated my case. We would still have crises, but they would be every 30 or 40 years instead of every 6 or 7.
Again, I liken it to forestry practices. You can allow a few little healthy fires that remove the underbrush and dry fuels every few years. Or – you can keep putting the little fires out and accumulate decades worth of fuel. Eventually you’ll get a conflagration that’s too big to control.
“No, the behavior is completely rational and logical.”
If you said human behavior is completely “rationalized” and logical, I would agree with you. Scams have been with us since the beginning of time, yet people never fail to fall for the latest version of some get rich quick scheme. Investors and Investment banks are not much different. Tell a good story and promise outsized returns, and they will throw money at you. It doesn’t matter how many times the same scenario has failed in the past. There is always a rationalization that this time will be different. If by putting a floor under their risk you mean not allowing our financial system to collapse as a whole, I agree with you. It does skew risk, but, in the face of imperfect information, I think the lack of confidence associated with the alternative would be vastly more destructive to economic growth as risk is skewed toward the other extreme.
Haim
Thanks for the thorough explanation, I haven’t been following this in much detail. Was part of this related to any off-balance sheet financing (aka Special Purpose Vehicles) similar to Enron by chance?
One issue I have with some of the more recent corporate scandals and meltdowns (and this situation with BSC may very well not apply) is the lack of backbone by auditors who acquiesce to the client more often than not. Frankly, off-balance sheet financing seems like a great idea if your goal is to pull something sneaky. The general holds that if investors would find information helpful, it should be disclosed, and by disclosed, I’m not referring to some benign footnote. If there is a overhaul of government oversight, I’m wondering if some of the criteria for financial reporting and auditing should be addressed, it appears that Sarbanes Oxley, while running up the costs, might not be the be all end all.
Not trying to hijack the discussion, just wondering if any of this applied here.
I think your proposal is unrealistic on a couple of levels.
You argue that letting Bear fail would teach “the market” a lesson and be worthwhile on that basis alone. The problem with that is that once you unleash that kind of chaos, you’re presuming that you know how its going to end and how its going to get there. I don’t think that’s true. The whole point of the Fed doing what it did was to prevent not only the predictable chaos, but the unpredictable part as well - you would have a whole shitload of unintended consequences, most of them bad. And the chaos unleashed would hurt a lot of people who had little to do with the initial crisis in the first place. That’s probably an unreasonable cost to bear and nobody wants that kind of uncertainty. To use your metaphor, if the forest fire starts burning down the city and maybe sets the atmosphere on fire, then perhaps the initial decision wasn’t such a smart one, and the fact that you open the door makes that situation statistically possible.
Your assertion of moral hazard suggests that people knew they were taking undue risk in the first place. I’m not sure that’s the case. For example, a couple of years ago I actually participated in a small conference call with the hedge fund managers at Bear who ultimately blew up. They were running a structured fund where the basic premise was that they were trying to get BBB type spreads for their money by taking AAA assets, namely the top-rated tranches of MBS and levering it up 10:1, which should theoretically get you those yields with considerably less credit risk. Not to toot my own horn, but I suspect I was in the minority of investors who understood that this was the nature of their arbitrage. I asked one of the managers how long he thought this arb would last, and he said he didn’t know, which told me that I was correct in my analysis. Its easy in hindsight to fault their analysis, which probably suggested something on the order of a 1% or less chance of default risk, but this was backed by the agencies, modeling, etc. Obviously, the leverage made things worse, but the core problem was that the underlying assets were poorly understood, linked to a much larger problem with systemic flaws, and ended up deteriorating in credit quality, exacerbated by a significant liquidity discount. The problem is that I don’t think there was any way for them to avoid this outcome given relatively orthodox analysis techniques, VAR, etc. I think the rot was both more systemic, and epistemological in nature, meaning that we can say that kurtosis is a problem and fat tails, etc., but we don’t really know what we can do about it other than to generally say not to be short volatility. We may not currently possess the financial technology to make the “right” decision as it is. But that doesn’t do much for general market liquidity.
So I’m not sure what “lesson” people would learn from a catastrophic market failure. We’ve had them before, and clearly we haven’t learned anything or at the very least learned not to make the same mistake again. But to paraphrase Jeff Goldblum from Jurassic Park, we make all new mistakes instead. I think that my earlier point was that because we constantly invent new devices which should theoretically ameliorate risk, we’re constantly at risk of having these new devices create unforeseeable situations, so we end up making all new and interesting mistakes. For example, the problem is not that derivatives are used as speculative tools and therefore dangerous - the problem is that they are used as risk mitigation tools, but their presence creates all new systemic risks which end up dwarfing the risks they’re fixing.
I recommend Richard Bookstaber’s book “Demon of Our Own Design” which came out earlier this year. He basically predicts this current crisis because on a philosophical level, we are unable to comprehend our own creations and end up in this situation.<b
Thanks for the thorough explanation, I haven’t been following this in much detail. Was part of this related to any off-balance sheet financing (aka Special Purpose Vehicles) similar to Enron by chance?
One issue I have with some of the more recent corporate scandals and meltdowns (and this situation with BSC may very well not apply) is the lack of backbone by auditors who acquiesce to the client more often than not. Frankly, off-balance sheet financing seems like a great idea if your goal is to pull something sneaky. The general holds that if investors would find information helpful, it should be disclosed, and by disclosed, I’m not referring to some benign footnote. If there is a overhaul of government oversight, I’m wondering if some of the criteria for financial reporting and auditing should be addressed, it appears that Sarbanes Oxley, while running up the costs, might not be the be all end all.
Not trying to hijack the discussion, just wondering if any of this applied here.
To answer your question, no.
The problem with Bear in broad terms, and the same problem owned by all of the investment banks and many of the commercial banks, is that they have assets on their books which are both going bad and unsellable. Think about it like owning a truckload of rare tropical fruit. In a perfect world, the tropical fruit would ripen and last as long as you think it will, and can be sold at an open auction with hundreds of buyers and sellers, so that you know the price you get is the best you could have gotten. But imagine this - the fruit ends up spoiling pretty fast, and on top of that, you have no place to sell it because nobody really wants to buy it and to sell it you have to call up a bunch of people individually and sell it by appointment, which gives you a price for the fruit, but probably not the best price because there isn’t an active market for it.
This is the situation a lot of institutions and investors are in. The underlying mortgage bonds are backed by residential mortgages. And given that there is clearly going to be credit deterioration in the mortgages, with foreclosures and defaults only going up, with housing values going down as well, then your guess is as good as anybody’s as to the “intrinsic” value of the mortgage bonds. Add to this that these were never particularly liquid in the first place (most were bought to be held for yield), then you can get a sense for their situation.
The problem, as I understand it, is that the banks have been able to hide this issue to some extent because they can declare a lot of these assets are considered Level 3 assets, meaning that since there is no market for them, management is going to guess what they are worth, based on some assumptions which may or may not be reasonable or accurate. Hence, you have the potential for some fairly nasty writedowns if things don’t turn out well.
Another problem is that in the event of some market dislocation and a bank is absolutely forced to sell some of these assets, this is bad for everybody else because now you’ve put a number on assets which were heretofore unpriceable, forcing everybody else to mark down their price and book a loss. So you can see how precarious the whole situation is and why everybody is holding their breath with respect to the banks. Some of the banks’ Level 3 assets are considerable, and if they were to take decent sized haircuts to value, the hits to book equity would be huge and require further recapitalization.