Tuesday, March 18, 2008

If This Meltdown Were a Movie

Ben Bernanke would be played by Harvey Keitel, reprising his role as Winston Wolf if we're lucky or Victor the Cleaner if we're not.

The responsibility for this financial meltdown does not rest with him. It was his predecessor, Alan Greenspan, whose stewardship of monetary policy set the stage for the debt-laced consumption rampage of the American consumer and the leverage-soaked financial carnival of mortgage lenders and investment bankers. (If you're keeping score at home, Greenspan still doesn't get it.) Based on his performance so far, I'm nominating Ben Bernanke to the All-Madden team of central bankers.

Bernanke has two broad categories of options:

1) Damned if He Doesn't

Bear Stearns just collapsed--it cannot pay its creditors. What was a liability to Bear Stearns was an asset to some other investor. That asset now has no value. If the other investor was also a financial institution, then it has fewer assets relative to its liabilities and is now less solvent. It may not be able to pay all of its creditors. And so on, all through the leveraged financial sector.

The Fed can act to prevent or mitigate this cascade. Looking at the prospect of contagion, the Fed has acted on two fronts. It has lowered short-term interest rates to prop of asset values across the economy. As discounting for risk has increased, discounting for time has decreased. The Fed has also intervened in specific episodes, directly backstopping private actors like JP Morgan who have stepped in to assume the liabilities of the likes of Bear Stearns.

Bernanke can't sit idly while large financial institutions crumble. There is a perception, if not the reality, of too much collateral damage in the process.

2) Damned if He Does

The Fed is supposed to be the economy's lender of last resort. If a solvent but illiquid bank needs short-term cash and cannot find it on the private market, the Fed should make credit available. Without this backstop, financial institutions would be less willing to take leveraged positions in support of beneficial economic activity.

But sometimes financial institutions take these leveraged positions in support of exceedingly risky activities. This is particularly true when they hold a put option to sell the activity to someone else if its value falls. Any intervention by the Fed extends that put option to would-be speculators, if not today, then certainly in the future.

You can call this Samwick's Law if you like:

If an institution is deemed too big to fail, then it is only a matter of time before it finds a way to get big and fail.

When you provide insurance against outcomes that a financial institution cannot control, you distort incentives on the activities it can control. Specifically, they take on more risk. To address the immediate problem, Bernanke invites the next one. Snotty bloggers two or five or ten years from now may be hanging the next crisis--runaway inflation, a persistent liquidity trap, even more spectacular bubbles in financial markets--around Ben's neck.

The task of finding the least worst way to do the wrong thing is a thankless one, but Bernanke is persevering admirably. Let's see what he does at 2:15 today.


Anonymous said...

I am wondering/hoping that "Too big to fail" accurately describes the Fed right now.

Re this:

What was a liability to Bear Stearns was an asset to some other investor. That asset now has no value.

Hmm. An illiquid but potentially valuable asset gets shuffled, as when the AAA structured securities of the Carlyle Group hedge fund where claimed by the creditors.

Which is fine as long as those claimants do not themselves have a liquidity issue.

My Bold Prediction - since what is missing is long term capital willing and able to wait and see if these assets actually perform, we may end up with Resolution Funding Corp II which will accumulate this illiquid mystery paper at discounts calculated by wizards such as A Samwick; We the People will then wait twenty years to see how we have done.

Tom Maguire

Anonymous said...


subject to review and confirmation:

for recently completed fiscal year, merrill had $51 billion in interest expense. think about this: if merrill paid 5% interest, this means merrill has around $1 trillion in debt. $1 trillion dollars. and merrill at this point is probably paying more than 5% - it is riskier debt than 5% debt.

Anonymous said...

Check out latest annual statements for Lehman and Goldman Sachs. Lehman had 40 Billion in interest expense, and GS had 41 Billion in interest payments.

Perhaps more stunning is the rate of growth in those interest payments (and debt) from 2005 to 2007. For Merrill interest expense grew from 22 billion to 51 billion in 2 years. Revenue and profit did not grow at the same rate, not even close.

These guys are on margin.

Anonymous said...

you are correct - it is an industry thing. many are potentially underwater in a deflationary environment with a weak labor market. it depends on hedging and asset mix - those with a disproportionate number of assets that are declining in value, coupled with deteriorating operations, are in serious trouble.

Anonymous said...

Did Greenspan have bad monetary policy?

Or was it a failure to adequately regulate?

IOW, was the problem low interest rates? or failure to put adequate restrictions on who could borrow at the lower rates?

jonny b

Anonymous said...

Here's one piece of it:


Anonymous said...

Failure to adequately regulate, yes -- removal of the uptick rule (shorting could only happen on an uptick) was a huge mistake. I wrote to my senators/congress critters about it but they ignored me (I don't think they even know what it is).

Jim Cramer just came out ranting about it. Well sure. As soon as they take down his buddies at Bear Stearns, damage Merrill and Lehman -- all of a sudden it matters. What a bunch of dupes. Didn't anyone ask why SEC board members resigned after removal of the rule? It was put in after the 1929 crash to prevent what is now happening . . . they removed it six months ago, and oh, lookie markets are crashing.

And don't get me started on naked shorting . . . or repeal of glass-steagall


Anonymous said...

The Fed is not the problem. Fair Value accounting and the repeal of Glass Steagall are the culprits here. No major bank in the world could have survived the 1980s under the current accounting system, which warps values so much that it leads to sheer panic among the misinformed investors. Commercial banks running equity derivative books with depositors money isn't exactly comforting either. Steve Ceurvorst '78

Anonymous said...

The Fed and in particular Bernanke simply didn't get it last fall... As the credit crisis began to unfold there were sitting there like a bunch of Ph.D economists (which some of them indeed are) waiting for actual visible impact in the economic number, instead of getting up from there comfortable chair and actually doing: A lower target rate, reduction of discount window spread, TAF, TSLF, PDCF, all this should have come much much earlier. That they did come of with this finally is great. And we have to thank Bernanke for it because a lesser central banker would perhaps not have even understood the necessessity of these action (although there are precedents see Sweden in 90 etc.) However, in typical academic fashion there were sitting on their hand for much much too long not wanting to risk anything, and wanting to leave things as they were in order to not run the risk of breaking something. Breaking what exactly one must ask. Inflation expectations? Bizarrly that they Bernanke was much concerned with inflation in the summer and fall last year when it was misguied, and now, despite the sharp drop in the target rate that concern has been abandoned - rightfully so. But this goes to show that the Fed/Berannke did learn, but it took him a long time and THAT is the principal fault that you can find in him.

Anonymous said...

i disagree with anonymous posted at 3/21. bernanke has been very responsive. plenty of companies and people can easily repay the money they have borrowed - even at a high fed funds rates. inflation is still very much a problem. speculation may have been a problem.

i give ben a strong A- so far, with the possibility of still getting an A or A+ in the future. he has been extremely responsive. compare how much the US rates have gone down vs. UK - Europeans think we are hypersensitive and prone to micromanagement. The B, C, and D performances are more likely to be found outside monetary policy - fiscal, etc - or before Ben's time (lowering rates too far during previous slowdown).

i don't like "snotty" to describe bloggers

Anonymous said...

Yes, thank God for Bernanke. Yes, he's a PhD economist from an academic background but what does that matter? The point is he GETS it. The guy is an expert on Great Depression (wrote books on it), so he, better than anyone else, understands WHAT TO DO during a credit crunch.

I'm impressed at how he's been able to take the mess Greenspan made and work up creative (unprecedented but what is needed) solutions.

Thanks to Bernanke's leadership and his courageous acts we might be saved from severe recession. When you think of all the egos he had to get to "play together" it's an amazing feat. Thanks Ben.

Anonymous said...

the financial times weekend addition has an article on govt purchase of mortgage-backed securities. i tend to be against this. this would indeed be a bail out. the bear stearns situation is more appropriate: let equity holders in orgz that bought mortgage backed securities feel some pain. otherwise orgz and investors have no incentive to make good decisions or have good governance going forward.

many people who perpetrated this situation continue to run the financial svc orgz and those who abstained are waiting with dry powder, ready to fire when the whites of the eyes of irresponsible mgrs are visible. You will not see the dry powder be used until the govt lets terrorist managers be eliminated by the market. some regulation and intervention is needed but not a bail out.

does anyone know what happens to the bear stearns debt? does JP morgan chase have to assume all the debt of Bear Stearns? Plus, it looks like JP Morgan Chase is going to shell out big cash $s to keep key Bear employees. Chase may be buying an empty bag full of debt. This situation may require even more patience and take years for hte bargains to appear.

Anonymous said...

The problem with Bear Stearns is that a lot of innocent people felt the pain -- 14,000 employees, most of whom had nothing to do with risky investment decisions at the company. And shareholders -- widows and orphans and people just trying to save for a humble retirement and such.

If you subscribe to the domino theory of financial collapse (and face it, banking institutions are all interdependent -- the best and most conservative of banks can fall when there is a confidence crisis), allowing the entire sector to fail would hurt all of us (and already has -- in reduced home equity, market downturn, job loss, etc).

Bernanke is doing the right thing. Yes, it is welfare for the rich but it is the lesser of evils right now.

Anonymous said...

I understand this is a meritocracy, and talented and hard working and risk-taking people should get paid lots more for their efforts. But lets face it: bear stearns was a clustermuck. The system that brought about this industry-wide problem should not be nurtured or upheld by govt.

We need the big brains in america to look at the terms of the Chase-Bear transaction. I looked at a text of a conference call (over at Seeking Alpha blog - hopefully that blog sent me to the correct text). It looks to me that Chase says they will get about $1 billion in additional earnings from the transaction. Chase also gets Bear's capital structure (which means Bear's long + short term debt of $288 billion at end of Nov 2007 and long + short term investments of $297 billion at end of Nov 2007 - #s from yahoo). So for a billion in recurring earnings, Chase has to hope the assets wind up to be more than the liabilties. Chase has to hope they can hold on to the assets (not sell under distress) until the assets are clearly more than the liabilities. Would you take this deal with your own personal finances?

Also, Chase says they are going to deleverage the balance sheet, and the cost of deleveraging is included in a cost of $5-$6 billion of transaction costs. Does $5 billion deleverage a company with hundreds of billions of debt?

Schwab (discount brokerage) is probably not excessively leveraged - public info.

So to summarize: I do not see how the Chase-Bear transaction solves the problem of excessive leverage and risk-taking in large fin svc companies, or deals with changing times due to dereg and tech. It postpones the day of reckoning. The cash Chase is paying to keep key Bear employees may effectively be borrowed money - does not seem conservative to me.

Mankiw has interesting text. He says one problem in deflationary environment (real estate anyways - not food) is that debtors may have a higher propensity to spend that creditors. Thus, when deflation happens, the creditors who benefit do not spend enough to offset debtors who spend less. If this is the case, then the govt needs to find creditors and give them incentives to spend - I am guessing that older people may have a disproportionate number of creditors due to age and nature. Young people have to borrow to buy houses, go to school, and start or buy a business. So govt programs that get old people to spend some cash might be an interesting idea.

It would also be interesting to address labor markets as much as possible - get people working.

It would also be interesting to fast-track or facilitate things that increase supply of commodities (lower price) or things that encourage more efficent use of commodities.

Anonymous said...

One way to alleviate the outrageous bubble in commodities is to regulate margin in those commodities markets. Speculation has been irrational, and that hurts everybody.

Not sure how to get old people to spend, but a few are doing it out of patriotic duty (that happens out here, believe it or not) to help prop the economy.

Get people to work -- good idea. Let's fix the St. Cloud bridge that just closed down, and a few others while we're at it.

"Also, Chase says they are going to deleverage the balance sheet, and the cost of deleveraging is included in a cost of $5-$6 billion of transaction costs. Does $5 billion deleverage a company with hundreds of billions of debt?"

Now this is scary. Chase is taking a huge risk. But did they have any other choice? Or is it corporate memory/culture in action (Morgan also acted to avert panic in 1907) ?

Anonymous said...

At its worst, the deal was reflected a desire to be big (empire building) for ego reasons and not shareholder and client value

at its best, it puts Bear assets and operations under better management, which will mitigate the chances of insolvency, improve the value of Bear and save taxpayers or debtholders a bailout or bankruptcy

You might look at JP Morgan dividend policy during previous years. You can see dividends paid in total $s by looking at annual cash flow statements. Chase was conserving cash (not paying big dividend increases) from year 2005-2006. JP Morgan's historical dividend policy looks kind of smart compared to some other banks that were hiking cash dividends paid. This would seem be be evidence of better management and board governance at JP Morgan vs. other banks (the banks that were raising dividends, which in retrospect they could not afford to do).

Anonymous said...

The US fed govt might get a % of the equity if the govt is going to use the govt balance sheet and put itself in a position to incur a loss in a transaction. This is what a private bondholder would demand or require (see previous workouts, bankruptcy, restructuring where bondholders become equity holders and previous equity holders are diluted).

Govt ownership of big business is like a "state owned enterprise" or communism.