One of the many consequences of the US Federal Reserve’s bailout of the subprime-mortgage market is the sudden urge felt by Fed chairman Ben Bernanke to let everyone know he won’t be making a habit of the practice.
“Once financial conditions become more normal,” he told a Fed conference on 13 May, “the extraordinary provision of liquidity by the Federal Reserve will no longer be needed. As (Walter) Bagehot would surely advise, under normal conditions financial institutions should look to private counterparties and not central banks as a source of ongoing funding.” I don’t know if Bernanke believes his words will make any difference, or if he’s just hoping out loud. But he might as well save his breath because his actions have spoken for him. The long-term effect of the Fed’s decision to extend cheap money to distressed firms, and to take on the risk of Bear Stearns and Cos. Inc.’s mortgage trades, is transparent: Investment banks now have even less pressure on them than they did before to control their risks. Potential lenders will be less likely to worry about extending them the credit they need to run these risks, or being counterparty to their trades. Potential investors will suspect that their shares come with a put option attached to them. Potential employees will spend even less time than they now do asking if the place is likely to survive.
There’s a new feeling in the Wall Street air: The big firms are now too big to fail. If the chaos that might ensue from Bear Stearns going bankrupt, and stiffing its counterparties on its billions of dollars of trades, is too much for the world to endure, the chaos that might be caused by Lehman Brothers Holdings Inc., or Goldman Sachs Group Inc., or Merrill Lynch and Co. Inc. or Morgan Stanley going bankrupt must also be too much to endure.
Already we may have seen one of the effects of this financial order: the continued survival of Lehman. What happened to Bear Stearns might well already have happened to Lehman. Any firm that uses each $1 (Rs42.9) of its capital to finance $31 of risky bets is at the mercy of public opinion. Throw its viability into doubt and the people who lent them the other $30 want their money back as soon as they can get it — unless they know that, if it comes to that, the Fed will make them whole. The viability of Lehman Brothers has been thrown into serious doubt, and yet Lehman Brothers lives, a tribute to the Fed’s new policy.
But if the Fed’s money is implicitly on the line every time Lehman Brothers, or Goldman Sachs or Morgan Stanley make a trade, one of two things must now happen: Either the Fed permits nature to take its course and allows investment banks to get themselves into trouble all over again. Or, the Fed regulates the risk-taking ability of the traders inside the investment banks.
Either Lehman Brothers, Goldman Sachs and Morgan Stanley will use the implicit government guarantee to underwrite their relentless pursuit of incredible sums of money for themselves—and thus create problems for the Fed and the financial system that will make the undoing of Bear Stearns seem trivial. Or, some government agency will explicitly prevent them from taking those risks.
And there’s no chance that Wall Street investment banks, operating with a government guarantee, can be controlled by anything short of new rules. Even without a government guarantee their risk-taking has proven all but impossible to monitor.
One of the unsettling traits of our financial markets is the inability of its putative authorities—a group that includes not just the Fed chairman and the US treasury secretary but also the CEOs of the big firms—to understand what the people inside them do for a living. Another related trait is the near total absence of stigma attached to risk takers who lose large sums of money.
There’s status to be had from huge trading losses: The guy who lost the fortune must know something or he would never been put into the position to lose it. Brian Hunter breaks a world record, blowing through $6.8 billion betting on the direction of natural-gas prices at Amaranth Group Inc., then turns up a few months later, inside his new hedge fund, running other people’s money. No, once the government guarantees the debts of a big Wall Street firm, it must inevitably also seek to control the risks that firm runs.
And so while the bailout of Bear Stearns may seem like a gift to the big Wall Street firms, it’s really not. Limit the risk that these firms run and you also limit the sums of money they can make.
For some time now, the action has been moving out of the big Wall Street firms and into hedge funds. The quality of financial information, and the ability to act on it, is better outside the big firms than inside of them, even, it now appears, when the information concerns one of the big firms. (The Security and Exchange Commission’s investigation into the run on Bear Stearns that preceded the crash has identified three alleged culprits and two of them are hedge funds: Citadel Investment Group and Paulson and Co.)
That trend is about to accelerate, as the golden age of the Wall Street investment bank draws to a close. The glorious 25-year run of these firms will have ended not with a bang, or a whimper, but with a government guarantee. And the investment banker himself will have taken the final step on the journey to becoming, in all but name, the worst thing he can imagine being: a commercial banker.
Michael Lewis is a columnist for Bloomberg and most recently the author of The Blind Side. The views expressed are his own.
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