What Bear Necessitated

Congressional hearings this week brought out some interesting details on the takeover of Bear Stearns by JP Morgan Chase that was arranged by the Fed and Treasury a couple of weeks ago. The Times reports:

The testimony also disclosed that regulators were unaware of Bear’s precarious health and did not know until the afternoon of Thursday, March 13, that the firm was planning to file for bankruptcy protection the next morning.

Pummeled by market rumors of insolvency, the investment house lost more than $10 billion —or more than 80 percent — of its available cash in a single day...

The deal was worked out in haste, sealed at 5 am, and maybe not everyone was thinking clearly:

The firm’s chief executive, Alan D. Schwartz, said that he thought on the morning of Friday, March 14, that he had engineered a loan, backed by the Federal Reserve Bank of New York, that bought him 28 days to find a solution.

But he said he realized that he had misunderstood the terms of the loan when the Fed decided later that day that the loan would last only through the weekend and that he had only until Sunday afternoon to find a buyer for the 85-year-old firm.

As Homer Simpson would say, D'oh!

Mr. Schwartz said his misunderstanding of the agreement was “an honest disagreement as to the words” of the loan.

“Everything happened on a very, very short time frame,” he said.

Asked about the adequacy of the price paid to Bear Stearns, Mr. Schwartz said he had no alternative.

“All the leverage went out the window when we were told we had to have a deal done by the end of the weekend,” he said.

James Dimon, the chairman and chief executive of JPMorgan Chase, offered a slightly different view on the question.

“Buying a house,” he said, “is not the same as buying a house on fire.”

Or, to the regulators, not really on fire, but suffering from the erroneous perception of fire (people will sometimes jump to conclusions when they see a little smoke...). An unimpressed Floyd Norris explains:

Bear’s principal regulator was the Securities and Exchange Commission, which says it was watching closely. “At all times,” wrote Christopher Cox, the S.E.C. chairman, in the aftermath of the collapse, “the firm had a capital cushion well above what is required to meet supervisory standards.”

Even when the Federal Reserve concluded it had to subsidize a takeover of Bear by JPMorgan Chase to preserve the financial system, Mr. Cox wrote, Bear qualified under the Fed’s rules as “well capitalized.”

Could that indicate there is something wrong with the Fed’s rules? Does it sound a little like a doctor emerging from a funeral to proclaim that he did an excellent job of treating the late patient?

The S.E.C. does not see it that way. It its view, this was a case of an old-fashioned bank run, and no capital standards can stop such a run when confidence is lost.

The Treasury was concerned - rightly - about moral hazard (according to the Times story):

Robert Steel, a Treasury under secretary, said that his boss, Mr. Paulson, had said during the negotiations that the price should be low because the deal was being supported by a $30 billion taxpayer loan.

He said a lower price was desirable to make the broader point to the markets that by rescuing the bank, the government did not want to encourage risky behavior by other large institutions, a concept known as “moral hazard.”

But, as Dean Baker notes, the low price reduces the moral hazard for shareholders, but not for creditors:

The Fed assured all of Bear Stearns' creditors that it would insure Bear's obligations, even though Bear lacked the capital to meet its commitments. It also explicitly made the same guarantee to the customers of the other major investment banks.

This commitment creates an enormous moral hazard problem. Ordinarily, creditors would be very cautious dealing with investment banks of questionable solvency. However, if the loans come backed up by a Fed guarantee, then there is no reason to be concerned about the solvency of the bank.

In such circumstances, investment banks have an incentive to take large risks. Effectively, the Fed has created a "heads I win, tails you lose" situation for the banks and their customers. If they take a big risk and win, they gain make large gains. If they lose, then the Fed covers the losses for the customers, although not for the bank. Nonetheless the opportunity for the creditors to make large one-sided bets is very valuable, so creditors will be willing to share part of this windfall with the banks in the form of large fees.

The Washington Post's Dana Milbank had this take on the hearings:

Meet Alan Schwartz, welfare recipient.

As the chief executive of Bear Stearns, he's getting rather more public assistance than your typical welfare mom -- specifically, $30 billion in federal loan guarantees to help J.P. Morgan Chase take over his firm. But then, Schwartz has had rather more than his share of suffering of late.

As his firm collapsed, he was forced to forgo his entire 2007 bonus, leaving his compensation for the past five years at a paltry $141 million, according to Business Week....

Fortunately for Schwartz, he had a sympathetic audience in the banking committee, whose members have received more than $20 million in campaign contributions from the securities and investment industry, according to the Center for Responsive Politics. "I want the witnesses to know, and others, that as a bottom-line consideration, I happen to believe that this was the right decision," Chairman Chris Dodd (D-$5,796,000) said before hearing a single word of testimony.

"You made the right decision," Sen. Evan Bayh (D-$1,582,000) told the regulators who worked out the loan guarantee.

"The actions had to be done," agreed Sen. Chuck Schumer (D-$6,162,000).