Since the bank runs of the 1930s, federal protection of retail depositor institutions has been a hallmark of American capitalism. The Federal Reserve, in a sweeping extension, has now extended the privilege to gilt-edged investment firms.
Its flurry of interventions has prompted a double dose of unease. The central bank offered a lifeline to Wall Street investors who, seemingly, deserved a worse fate. And it arguably interrupted the cycle of boom, bust and renewal that leads to a durable recovery.
What is the true value of Bear Stearns? If the government-orchestrated takeover of Bear goes through as planned, we will never know. As with Bear, so with the billions of dollars of mortgage securities for which the central bank has suddenly become an eager customer. So, too, perhaps, with the nation’s stock of residential homes — the prices of which, instead of reverting to more realistic values, will get a boost from the Fed’s repeated rounds of interest rate-cutting.
Government interventions always bring disruptions, but when Washington meddles in financial markets, the potential for the sort of distortion that obscures proper incentives is especially large, due to our markets’ complexities. Even Robert Rubin, the Citigroup executive and former Treasury secretary, has admitted he had never heard of a type of contract responsible for major problems at Citi.
Bear is a far smaller company, and, it would seem, far simpler. But consider that as recently as three weeks ago, it was valued at $65 a share. Then, as it became clear that Bear faced the modern equivalent of a bank run,
JPMorgan Chase negotiated a merger with the figure of $10 a share in mind. Alas, at the 11th hour, Morgan’s bankers realized they couldn’t get a handle on what Bear owned — or owed — and got cold feet. Under heavy pressure from the Fed and the Treasury, a deal was struck at the price of a subway ride — $2 a share.
It is safe to say that neither Jamie Dimon, Morgan’s chief executive, nor Ben Bernanke, the Fed chairman who pushed for the deal, know what Bear is really worth. For the record, Bear’s book value per share is $84. As Meredith Whitney, who follows Wall Street for Oppenheimer, remarked, “It’s hard to get a linear progression from 84 to 2.”
Capitalism isn’t supposed to work like this, and before the advent of modern finance, it usually didn’t. Market values fluctuate, but — in the absence of fraud — billion-dollar companies do not evaporate. Yet it’s worth noting that Lehman Brothers’ stock also fell by half and then recovered within a 24-hour span. Once, investors could get a read on financial firms’ assets and risks from their balance sheets; those days are history.
Firms now do much of their business off the balance sheet. The swashbuckling Bear Stearns was a party to $2.5 trillion — no typo — of a derivative instrument known as a credit default swap. Such swaps are off-the-books agreements with third parties to exchange sums of cash according to a motley assortment of other credit indicators. In truth, no outsider could understand what Bear (or Citi, or Lehman) was committed to. The thought that Bear’s counterparties (the firms on the other side of that $2.5 trillion) would call in their chits — and then cancel their trades with Lehman, perhaps with Merrill Lynch and so forth — sent Wall Street into panic mode. Had Bear collapsed, or so asserted a veteran employee, “it would have been the end: pandemonium and global meltdown.”
Perhaps. Or perhaps, after some bad weeks or months, Wall Street would have recovered. What is scary is the degree to which the Fed assimilated the alarmism on the Street: “These guys are so afraid of an economic cycle,” a hedge-fund manager remarked. And without public airing or debate, it stretched the implicit federal safety net under Wall Street.
To question intervention is not to dispute that markets need rules. But for nearly two decades, Washington has trimmed its regulatory sails. The repeal of Glass-Steagall, which once separated banks from securities firms, and the evolution of new instruments that circumvent disclosure rules have loosened the market’s moorings. Huge pools of capital have been permitted to operate virtually unregulated. Mortgages have been written to the flimsiest of credits. Swelling derivative books have made a mockery of disclosure.
The relaxation of oversight has implied an unholy bargain: let markets operate unfettered in good times, confident that the feds will come to the rescue in bad. In 1998, the Fed intervened to cushion the collapsing hedge fund Long-Term Capital Management; dot-com stocks immediately began their dubious ascent. Then, when the tech meltdown led to a recession and the Fed cut rates to 1 percent, adjustable-rate mortgages became as hot as the iPod. One rescue begets the next excess.
It is true that Bear’s shareholders have suffered steep losses. But the Fed went much further than in previous episodes to calm the waters. Notably, it announced it would accept mortgage securities as collateral for loans — enlarging its role as lender of last resort. (Wall Street jesters had it that the Fed would also be accepting “cereal box-tops.”) Then the Fed extended a backstop line of credit to JPMorgan to tide Bear over; finally, it agreed to absorb the ugliest $30 billion of Bear’s assets.
Government rescues are as old as private enterprise itself, but we are well beyond the days of guaranteeing loans to stodgy manufacturers à la Chrysler and Lockheed. Those cases were contained; the borders of finance are more nebulous. However pure of motive, Bernanke & Co. are underwriting overleveraged markets whose linkages, even today, are dimly understood. The formula of laissez faire in advance and intervention in the aftermath has it exactly wrong. Better that the Fed, with Congress’s help if need be, ensures that regulators and markets have the tools to know what companies are worth before the trouble hits.
Roger Lowenstein, NYTimes, 30.03.08
