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Bear Stearns: The Fed's Original 'Systemic Risk' Sin

 

ALG Editor's Note: As ALG News previously reported, the federal government's unprecedented interventionism of 2008 began with the Federal Reserve's $29 billion loan to JP Morgan to purchase Bear Stearns, and as noted in the following featured commentary, it was their original sin not to allow market forces to assert themselves:

By James Freeman

One year ago today, the Federal Reserve saved Bear Stearns from bankruptcy. The central bank's agreement to invest $30 billion (later reduced to $29 billion) in Bear's opaque securities greased a sale of the firm to J.P. Morgan Chase. For the first time since the 1930s, the federal government was putting taxpayers at risk to rescue a Wall Street investment bank. To this day, the government has not explained precisely why.

Regulators were concerned about the "systemic risk" of a potential Bear failure. At the time, observers on the left and right respected the fact that federal officials acted in the heat of market turbulence, and with information not available to the public.

The Fed has since filled in very few blanks. Was there a formula that regulators used to measure systemic risk? Without a law to guide them, did federal officials develop a definition for this risk? Maybe there was a chart showing Bear Stearns in the middle with lines out to securities dealers and hedge funds, and equations showing how they affect the markets? To avoid runs on surviving institutions, banking regulators shouldn't name names. Still, more data might help explain how the also-ran among Wall Street's major banks could possibly have dictated the fate of the American economy.

Oddly, given that this is a question of finance, government explanations following the Bear deal involved lots of adjectives and very little math. At an April 3, 2008, Senate Banking Committee hearing, one particular adjective was frequently used to justify government intervention. Fed Chairman Ben Bernanke described "fragile" financial conditions. Timothy Geithner, New York Fed president at the time, also saw "fragile" conditions, as well as a "fragile" economic situation and a "fragile time in global financial markets." Mr. Bernanke, when describing the "interconnectedness" of Bear Stearns, said that regulators decided to act "given the weakness and the fragility of many markets."

We'll leave for another day the question of how much systemic risk is created when central bankers say that the financial system is fragile. History provides ample evidence of a robust American economy and market system. Yet in March 2008 the fragility thesis won the day, creating new uncertainty about the government's role in capital markets.

Until 2008, diversification of risk was considered a good thing. If pain was to be shared among a thousand broker-dealers and hedge funds that chose to do business with Bear, that sounds like a system working as it should, not one at risk. Hedge funds are particularly well suited to suffer the consequences of their decisions. Under SEC rules, such funds are only available to institutions and affluent individuals, who are better able to bear losses than the average taxpayer. Moreover, sophisticated hedge-fund investors understand that they may not enjoy the state and federal legal protections available to those who stay in mutual funds. Yet those who invested in Bear counterparties received a protection they might not have imagined before the events of last March.

Several senators at the April hearing questioned whether regulators had performed adequate due diligence in valuing the $29 billion of Bear assets. Unexplained was whether the government performed due diligence to arrive at its finding that America could not survive the loss of Wall Street's fifth largest firm.

Bear's collapse caught regulators by surprise, at least according to their congressional testimony. Perhaps this was because, according to the Fed's yardstick for measuring the health of banks, the firm was well capitalized. In fact, up until the moment it failed, Bear was compliant with the Basel banking standards, which the Fed has actively promoted for years. Investors who paid attention to the credit default swap market, however, had seen warnings about Bear since the summer of 2007. Given that Bear had bet heavily on mortgages, sellers of CDS wisely demanded increasing premiums to insure against the risk of a Bear default. Now the central bank is due for a Beltway promotion to systemic regulator, as the failed Basel standards it championed are quietly rewritten. Meanwhile, Congress is preparing to shoot the CDS messenger.

Mr. Bernanke warned at the April 2008 hearing that "a default by Bear Stearns could have been severe and extremely difficult to contain." At the time of the Bear rescue, other officials whispered that if the government didn't bail out Bear, Lehman Brothers could be the next to fall.

One could argue that the Bear bailout not only didn't prevent the failure of Lehman and AIG six months later, but it may have contributed to the autumn meltdown. If nature had been allowed to take its course, Bear's directors and executives would have faced the liability tsunami of bankruptcy, and creditors would likely have suffered as well. Watching this horror show, would the leadership at AIG and Lehman have spent more of the next six months seeking to avoid this fate?

Bear stockholders ended up receiving $10 for each of their shares. Responding rationally to this government intervention, and knowing that their firms were each significantly larger than Bear, executives at AIG and Lehman might have believed that the feds had just built a floor under them.

Come the reckoning in September, Lehman CEO Richard Fuld was stunned to discover that Washington was willing to see his firm go bankrupt. Given how little value was left at Lehman's bankruptcy, perhaps it would have failed in any case. But false expectations created by Washington didn't help the firm's decision makers.

As for AIG, when the New York Fed was preparing to rescue the firm, CEO Robert Willumstad was reportedly surprised to learn that he wouldn't be running the company anymore. If he believed that he could preside over a meltdown triggering a federal bailout and keep his job, how motivated was he to make difficult decisions in the spring of 2008?

Since Washington's cure for financial markets has turned out to be more than an order of magnitude more expensive than the bill presented in March 2008, taxpayers have good reason to ask what happened. About all we can say with certainty since the announcement that the Fed would rescue Bear is that unemployment has risen, GDP growth has turned sharply negative, and the Dow has fallen close to 5,000 points.

James Freeman is assistant editor of the Wall Street Journal's editorial page.


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