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Mar 20, 2008 | 19:50 GMT

9 mins read

Global Market Brief: The Bear Stearns Bailout and Calls for Oversight

Bear Stearns Cos was the first major Wall Street player to fall under pressure from the housing and credit market crises. The Federal Reserve's historic rescue — in which the central bank extended credit to investment banks and guaranteed up to $30 billion of the failed investment bank and securities trading brokerage so it could be purchased by JP Morgan Chase & Co. — marked a new level of U.S. government intervention in the financial markets. The U.S. financial community will have new expectations and requirements. This is underscored by a March 20 announcement from Rep. Barney Frank (D-Mass.), chairman of the U.S. Congress House Financial Services Committee, that he favors the creation of a new regulatory body (or new duties within the Fed) to monitor credit institutions' risks. However, what is taking place now is large-scale tinkering, not a fundamental shift away from the underlying philosophy of American financial markets — a philosophy designed to punish mismanagement and promote economic efficiency and returns on investments.

When to Bail

The Fed has heretofore reserved the use of the discount window (a monetary mechanism in which the central bank makes short-term loans to banks facing liquidity shortages) for commercial banks. But the Fed created a similar system for the much more complex world of investment banking when it announced March 14 that it would extend unlimited credit to investment banks and brokerage houses for six months. This move, which secured $30 billion in funds from the Fed to back up some of Bear Sterns’ assets as part of the JP Morgan Chase deal, prevented what could have been a domino effect across financial markets. If individuals and institutions could not make transactions from their Bear Stearns accounts because of the firm's lack of cash, those individuals and institutions would have lacked the money to pay up on other liabilities, potentially triggering a wave of bankruptcies. JP Morgan Chase's Fed-insured buyout guarantees that Bear Stearns' trading obligations are met and prevents the start of a cascade of bank failures. FREE PODCAST FREE PODCAST Whenever the government of a predominantly free-market economy makes such interventions, critics often say the government is "undermining capitalism." Such interventions can bring about the so-called "moral hazard" condition in which investors make unsound and overly-risky decisions because they know someone or something will eliminate or soften the blow of unwise business decisions. In this case, laissez-faire advocates fear that banks will be less inhibited with reckless lending in anticipation of state assistance if there is a massive run on their funds. Some say that if negative consequences are softened or removed, investors eventually will only see the possible rewards of such behavior, resulting in a bubble that must eventually burst. The United Kingdom recently experienced a dilemma directly related to the subprime meltdown. When Northern Rock bank was faltering, London decided to nationalize it rather than risk a cascade of failures throughout its financial houses. The government has pledged to sell the bank's assets to the private market when the global credit crisis diminishes, but British taxpayers will ultimately bear any risks associated with any of the bank's failings. This decision led to accusations that the Labor government was backing away from its decade-long commitment to more pro-market economic principles. While the U.S. government did not nationalize a major private financial institution, it did intervene to back up the assets of a failing institution, insuring that investors whose money was managed by Bear Sterns were allowed to continue market transactions. However, this was not — and will not be — without considerable costs to Bear Stearns' management and shareholders. Institutions and individuals who put their savings into or worked at Bear Stearns are not being "bailed out." Half of the firm's 1,400 employees could be laid off during restructuring. Bear Stearns shareholders are being offered $2 per share in the JPMorgan Chase acquisition; shares were priced at $50 each at closing the previous night. Had the government supported the management and shareholders of Bear Stearns throughout this turbulent period, a fundamental change in American capitalism may have been abreast. However, those directly involved with Bear Sterns are profoundly hurt by the week's events, and such harsh realities promote the efficiency of U.S. markets and high returns for investors. Had the Fed bailed out a smaller firm whose failing would not have seriously affected global markets, as is often done in Asian economies, then fears that the Fed is not properly guarding against moral hazard would be well-founded. However, in the Bear Stearns case, the stakes were too high.

Why the United States Will Not Be Japan

In the United States, the financial system's efficiency and robustness are maintained largely through self-regulation that often entails severe legal ramifications and little mercy for failing companies. This fear keeps managers in check. While the safety net exists for depositors rather than the failing businesses and shareholders, U.S. financial institutions will remain competitive. Were the United States headed in the direction of Asian financial markets — in which non-performing loans (NPLs) are a way of life and government bailouts are commonplace and not viewed negatively — then there would be cause for concern. In contrast, the Japanese government often lavishly protects firms suffering from sudden bouts of illiquidity or insolvency, as well as the firms' shareholders and management (such protection is often greatest for the worst-performing institutions). During the 1990s, Japan experienced a wave of bank failures, but the country's banking regulator — the Financial Reconstruction Commission — was protecting the banks. As the banks were cleaned up, few managers faced charges of wrongdoing or corruption leaving the system open to further mismanagement. Japan's financial system is dominated by "relationship banking," broadly defined as the nurturing of personal relationships that often trump sound financial decisions. The system also emphasizes maintaining social and political stability, a characteristic found in most East Asian financial practices. Ultimately, this prevents the markets from exerting discipline on bank managers and eliminating NPLs. In Japan, the expectation of bailouts means that policies and personnel do not change and problems are allowed to fester. Japan can only continuously fund and bail out its financial sector by maintaining a stranglehold on the ultimate source of money: Japanese depositors. In order to fund the financial system, Japanese and many Chinese consumers are forced to deposit their money into government-influenced institutions. This does not occur in the United States, which does not prop up banks.

New Needs and Regulations

A fundamentally new development is unfolding, however. Until this crisis, the Fed had not opened up its credit window to investment and brokerage firms which are less tightly regulated and typically more speculative than normal banks. Now, however, the Fed is offering to be a lender of last resort to 20 major Wall Street firms. It is allowing investment banks to borrow money in return for collateral; thus, these firms' assets could be put on the line. With the entrance of the Fed into their affairs, investment banks and brokerages could look back at this period as the point when they lost their full independence. Most firms take pride in their independence. Outside assistance can indicate that their houses are not in order. However, the opportunity the Fed is offering could encourage more risk-taking and leveraging, ultimately leading to more bad loans. Now that the Fed has established itself as a safety net, its key challenge lies in determining how much collateral it will require to prevent firms from undertaking too much risk under the assumption that they now have access to easier money. The House Financial Service Committee's Frank addressed these concerns head on by calling for a reassessment of capital, margin and leverage requirements for the financial sector. Frank's call for a "risk regulator" is vague at this point, but if it catches on, it could move significant oversight away from the U.S. Securities and Exchange Commission to the Fed or lead to the creation of a new regulatory body. The Fed's new role as a source of money for investment banks would never come without new restrictions and new government powers — and they are coming. In the short term, new regulations could exacerbate the current credit crunch by creating more confusion and barriers to liquidity. But in the long term, the U.S. government will be obliged to regulate investment banks the way they do regular banks, as the former increasingly compete against the latter, and they all obtain similar insurance guarantees. If regulations are not extended to investment and securities firms, those firms would be able to access the Fed as banks do but without submitting to oversight and risk assessments. If policymakers begin to demand that the Fed or another body have an active role in investment banks' activities, the final critical question will be the degree to which these houses will have to open their book to regulators, as other banks already do. In the past 10 years, most have opened their books a crack in order to list on the New York Stock Exchange — a move that many insiders fought. Any increased Fed support will require more openness than just a crack.
Global Market Brief: The Bear Stearns Bailout and Calls for Oversight

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