Minutes after news hit the tape on Friday that Bear Stearns Companies Inc. was getting emergency funding from the Federal Reserve, the Wall Street humour mill was busy at work. “Thank you for calling Buy-a-Bank,” said an email from a long-time reader. “Please listen carefully as our menu items have changed.
For Mandarin, press 1.
For Arabic, press 2.
For takeover of Bear Stearns, press 3.
For Lehman Brothers, press 4.
For any monoline insurer, press 5.
To purchase residual assets of defunct hedge funds, please stay on the line and an operator will assist you.”
We live in perilous times. Crises are cropping up faster than the Fed can propose solutions to stabilize them.
Fearful that Asian markets would open the week with Bear Stearns’ fate hanging in the balance (it wasn’t, but markets tanked anyway), the Fed took yet another emergency action on Sunday evening, lowering the discount rate by 25 basis points to 3.25% and opening its discount window—previously a bank-only privilege—to primary dealers, the 20 firms with which it deals directly.
Why lower the discount rate two days before a regular policy meeting?
“Unless the Fed cuts an interest rate, most equity managers don’t get it,” said Jim Bianco, president of Bianco Research in Chicago. “I doubt 25 basis points would make a difference to primary dealers in need of funding.”
Lending by acronym
The new lending facility came with a new acronym (PDCF, for primary dealer credit facility) and a broad range of investment-grade collateral eligible for overnight loans.
Less than a week ago, the Fed created a term securities lending facility (TSLF) for the same primary dealers (give me your tired, your poor, the wretched refuse of your AAA mortgage-backed securities, and we’ll lend you up to$200 billion (Rs8.1 trillion) of treasuries for 28 days).
To seal the deal on JPMorgan Chase and Co.’s purchase of Bear Stearns for the bargain-basement price of $2 a share (the stock closed at $30 on Friday), the Fed tossed in a $30 billion loan to fund Bear Stearns’ “less liquid assets,” or junk by any other name.
When the central bank said on Friday it would provide funding to Bear Stearns via JPMorgan (PDCF wasn’t in place yet; just TAF and TSLF), it had “moral hazard” written all over it. The Fed, in bailing out a major financial institution, was encouraging risky behaviour in the future.
Bear Stearns was too big to fail, too weak to continue operations, and too intertwined with counterparties to go down without causing serious collateral damage. It was the judgement of Fed policymakers that the risk to the national economy from a margin spiral was greater than the appearance of bailing out a bank.
In retrospect, it seems that the too-big-to-fail bank served as a sacrificial lamb, held out (hung-out?) as an example.
“The Fed let JPMorgan steal Bear Stearns because it needed cover for the putative moral hazard in keeping the system afloat,” said Paul DeRosa, a partner at Mt Lucas Management Co. “For macro reasons, the Fed had no alternative.”
The reception from the markets was not what the Fed hoped for. Asian and European stock markets took a dive, the US dollar crumbled, and US stock index futures were in deep negative territory before the opening bell. The Dow Jones Industrial Average managed a 21-point gain for the day while the other major US indexes posted losses.
That’s hardly a vote of confidence, especially at a time when the Fed is “running out of bullets,” said Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago.
Kasriel said the Fed should have done what it’s doing now back in August, instead of cutting its benchmark rate so aggressively. Fed chief Ben Bernanke is “buying time,” Kasriel says. “He’s saying, we’re going to extend you a lifeline, but you’re going to take a hit”—you being the shareholders. “But you’re going to have to raise capital.”
Banks have watched the value of the assets they hold, especially those that are mortgage related, decline. At the same time, their liabilities don’t change. That means an erosion in their capital, or assets minus liabilities. When bank capital falls below regulatory minimums relative to assets, financial institutions have to sell assets, which sets in motion the kind of downward spiral the Fed was looking to prevent.
Bear Stearns was the victim of a good old-fashioned bank run last week, with lenders and customers playing the role of traditional depositors.
Now that JPMorgan has guaranteed Bear Stearns’ counterparty risk, “the creditors are safe, and the stockholders vulnerable,” DeRosa said.
And that’s how it should be. The 85-year-old Bear Stearns is history; other banks may be ripe for the picking. “Please enter the first three letters of the bank you are interested in buying,” the Buy-a-Bank phone line might say. “Or try again later. Our menu items are changing on a daily basis.”
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