The Fed: On the Cusp of Moral Hazard
The front page headline in this morning’s New York Times: JP Morgan in Negotiations to Raise Bear Stearns Bid. Un-freaking believable.
Dear readers, if my initial analysis of the JPM/BSC situation was wrong, mea culpa. But my analysis was predicated upon one key assumption: that the Fed is not populated by a bunch of morons. If they go back at this point and re-trade the deal, they will look like a bunch of wimpy, pencil-pushing bureaucrats stumbling right into the minefield of moral hazard. From Wikipedia:
Moral hazard is the prospect that a party insulated from risk
may behave differently from the way it would behave if it were fully
exposed to the risk. Moral hazard arises because an individual or
institution does not bear the full consequences of its actions, and
therefore has a tendency to act less carefully than it otherwise would,
leaving another party to bear some responsibility for the consequences
of those actions. For example, an individual with insurance against
automobile theft may be less vigilant about locking his car, because
the negative consequences of automobile theft are (partially) borne by
the insurance company.
Bottom line: BSC would be in Chapter 11 if not for the Fed’s intervention. One can argue whether this was a mistake or not, but they elected to take draconian and immediate action to stave off what they perceived to be a clear and present systemic risk. In light of this fact, the equity was worth precisely zero at that time. BSC was dead firm walking. Nobody would trade with it. Employees were gearing up to flee. Its asset value would have rapidly eroded as values predicated upon firm reputation and people would have vanished in thin air. And this process would have happened in real time, if not for the Fed’s intervention.
Fast forward to today. You’ve got a bunch of shell-shocked employees with lots of stock, Bill Miller, Joe Lewis and some other sad people and institutions who bought in at prices above $100. You’ve also got debt holders who’d rather buy deal insurance by accumulative votes to protect their claims. But you know what - sorry. To all of them. Because conveying the equity holders any value at this point is simply writing a check, courtesy of the U.S. taxpayer. This sets an awful precedent that the Fed won’t soon live down, to the detriment of both the U.S. taxpayer and the financial markets in general. Because if they cave and toss BSC shareholders a bone, they’ll be committing one of the most egregious kinds of moral hazard out there: the kind that didn’t need to be, if they’d just stiffen their resolve and push on through.
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COMMENT:
AUTHOR: Chris
EMAIL: chuff@ha80.net
DATE: 03/24/2008 09:44:18 AM
If JPM realized they couldn’t get the deal done at $2 and were facing shareholders who would vote down the deal, what’s the problem? Perhaps I don’t understand the details of this transaction too well, but wouldn’t the incremental $8/share come out of JPM’s pocket?
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COMMENT:
AUTHOR: alex morrow
EMAIL: texalope@gmail.com
URL:
DATE: 03/24/2008 12:48:05 PM
Interesting that there;s so much grumbling about moral hazard concerning our financial system and virtually no comment on the steady erosion of our personal liberties by the government i.e. extraordinary rendition, invasion of privacy in banking.
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COMMENT:
AUTHOR: Sam T
EMAIL: sam@korral.com
URL:
DATE: 03/24/2008 01:36:04 PM
Have you taken any time to understand the structure of this deal? - You seem merely to delight in the plight of shareholders. And really using Wikipedia as your source says everything that needs to be said; it reflects poorly on your blog which is frequently excellent.
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COMMENT:
AUTHOR: Paul Denlinger
EMAIL: paul.denlinger@gmail.com
URL: http://www.chinavortex.com
DATE: 03/24/2008 01:44:11 PM
I just don’t get this.
If the Fed decides that BS is too strategic to let it go bankrupt, why didn’t it just take it over directly, appoint a new board which would appoint new management, then after turning it around arrange a management buyout or sell it to another bank? This way, at least the American taxpayers would get something out of it… On second thought, maybe that’s why they didn’t do that…
In China, the four major banks are state-owned. I guess that in the US, the banks own the government so they can take any crazy risks they like.
Wow, what a deal!
Doesn’t this mean that the bubbles will progressively get bigger and bigger because the banks know that they will get bailed out no matter what they do? And doesn’t this make the average American taxpayer the biggest schmuck in the world?
I call this taxation without representation.
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COMMENT:
AUTHOR: Roger
EMAIL: roger@informationarbitrage.com
URL: http://www.informationarbitrage.com
DATE: 03/24/2008 02:00:39 PM
Sam, your comment doesn’t say anything so it is hard to respond. Please ask a question. And why you have a bug up you a** about Wikipedia is beyond me. It offered a very good layperson’s definition, which is precisely what I wanted. This blog is supposed to be accessible, not highfalutin and over-intellectualized.
Chris, the issue is that in the absence of Fed intervention Bear would be in bankruptcy right this second. Common stockholders would have been wiped out. By virtue of the Fed’s bailout/largesse/rational act, however you want to label it, equity holders are being given something that in any other circumstance they wouldn’t be receiving. So while the incremental consideration is being given by JP Morgan, their ability to do so is courtesy of the U.S. taxpayer. That is my point.
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COMMENT:
AUTHOR: Steve
EMAIL: charakter0@aol.com
URL:
DATE: 03/24/2008 02:48:47 PM
I agree with Chris. It seems the Moral Hazard would be on JPM, because of the Fed’s willingness to take on the $30bn (now $29bn) in debt. How is paying $8 more coming out of the tax payers pockets?
It seems as if the new strucuture will take less from tax payers and more from JPM. Thoughts?
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COMMENT:
AUTHOR: Yaser Anwar
EMAIL: yaser@yaseranwar.com
URL: http://www.linkedin.com/in/yaseranwar
DATE: 03/24/2008 05:47:19 PM
I’m surprised to see JPM raise the bid to 10 bucks. JPM was after their Prime Brokerage but that witnessed an exodus of hedge funds, ditto with their Private Banking side, so a lot of franchise value has dropped.
With regards to book value of 84/share as Barrons says, I think on average people don’t know the actual PB of BSC because it can’t be that high anymore if they have a 395 bn$+ balance sheet filled with toxic waste.
Most importantly though, JPM has (had?) such a nice option to buy their building/common stock for cheap if there was no deal, so if I were a shareholder I’d root for no deal.
Though a lot of things are unclear. Maybe BSC has some investments from their Principal Investments side which we all don’t know about nor is indicated in the news? Or maybe the rumors that Fed will buy mortgage bonds to other more toxic stuff, so JPM paying up for those positions?
Paul- nationalizing BSC would have been too cumbersome for the govt. and would further drain their reserves and exacerbate the deficit (as if it doesn’t have enough pressure on itself ATM). Just look across the pond- the UK govt. is facing lawsuits from HFs and creditors for nationalizing Northern Rock.
Not to mention the headache of turning it around and cleaning it up (balance sheet wise), which in itself would take billions (on top of the 25 or so billion pounds NR owes the Central Bank).
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COMMENT:
AUTHOR: Iqbal Latif
EMAIL: iqbal.latif@gmail.com
URL: http://iqballatif.newsvine.com/l
DATE: 03/25/2008 07:59:08 AM
Fed Bernanke and the HKMA Donald Tsang- A study into the similarities of strategies in seeing off vandals and herd mentality of hedge funds..
The Fed has simply borrowed a page from the HKMA and Donald Tsang (then the Financial Secretary), who declared war on speculators. The Government ended up buying approximately HK$120 billion (US$15 billion) worth of shares in various companies[20]. They became the largest shareholder in some of those companies (e.g. the government owned 10% of HSBC) by the end of August, when hostilities ended with the closing of the August Hang Seng Index futures contract. The Government started selling those shares in 2001. They made a profit of about HK$30 billion (US$4 billion). The Fed will make similar kind of returns very soon once the vandals are staved off; economies donít go into recession when consumers are around. The speculators will learn that.
Bernanke’s interventionism is currently being frownded upon. However, financial historians will, in the near future, sing praises for this very internventionism. The last 7 days of Fed assertion has not compromised moral hazard. Rather, it has has strengthened public trust in the institution of state. Donald Sang was critized when he staved of speculators.
Today, Benanke will face the same criticism from the advocates of lassez faire. However, there is a time when any debt instrument can fail as a result of insolvency. There are times when even the best of instruments are discounted. The value of any debt instrument is the ability of people to service the instrument over its life. The ability of service has not been compromised, but the rumours could have taken the values out and brought the entire economy to a standstill. Usually debt instruments fail as a result of macro-economic failure. The speculators had hedged an inadvertant scheme through which they would have failed the economy though the failure of the instruments.
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2 years ago
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