Wednesday, March 14, 2018

Bear Stearns Anniversary

Justin Baer and Ryan Tracy have an excellent article in the Wall Street Journal commemorating the tenth anniversary of the Bear Stearns bailout.
The Federal Reserve tried to limit the damage with extraordinary actions, first extending the firm credit before forcing it into a hasty weekend shotgun marriage to JPMorgan Chase with $29 billion in assistance.
More specifically,
Ten years ago, Bear’s crisis week began with rumors of liquidity problems following steep losses from mortgage bonds. Mr. Schwartz, the CEO, phoned JPMorgan Chief Executive James Dimon to ask for a simple overnight loan. By that Thursday, Bear’s lenders and clients had backed away, and the firm was running out of cash. Mr. Schwartz called Mr. Geithner for more help.
Fearing a Bear-induced panic could spread throughout the banking system, the Fed arranged a $12.9 billion emergency loan routed through JPMorgan. It ultimately agreed to purchase $29.97 billion in toxic Bear assets.
First, Bear lost a lot of money in mortgage backed securities. Second, like Lehman to follow, Bear was mostly financing that investment with borrowed money, and short-term borrowed money at that, not with its own money, i.e. equity capital. Small losses then made it more likely Bear would not be able to pay back its debtors. Third, there was a run.  Short term creditors ran out the doors just like Jimmy Stewart's depositors in a Wonderful Life. More interestingly, Bear's broker-dealer clients started running too. Just how investment banks like Bear were using their broker-dealer clients to fund investments is a great lesson of the event.  Darrell Duffie lays this out beautifully in The failure mechanics of dealer banks and later How big banks fail.

So, if you want to stop a run, you need to convince creditors that their money is safe. Usually, you do that by issuing more equity, "recapitalization,'' But at this point, new equity holders understand that most of their money will go to pay off creditors who otherwise aren't getting anything, "debt overhang." So we need to find a source of new equity for whom the firm will be valuable enough that it's worth paying off the creditors to get it. That's the idea of one of these last minute sales to another firm, JP Morgan.

In this case, that failed too. There wasn't enough value in the firm left. It took $29 billion more to give the appearance of a buyout which would keep Bear going as part of JP Morgan, and more importantly to pay off the creditors. (That word "reacapitalization" more and more in the passive voice, tends to mean money from the government.)

Bailouts are not of the company or the management. It is all about making sure creditors get paid, so they don't run. Bailouts are always creditor bailouts.

Needless to say, this bailout did not in the end stop the financial crisis, and $29 billion would soon seem like couch change.

So, where are we now?
"Key players in the bailout, many of whom remain in finance, have spent the last decade arguing about what was done, defending decisions made then and wondering whether it could happen again. The consensus: It would be unlikely for another big firm to get into such trouble, or for the government to orchestrate such a bailout"
I found this interesting, especially the last statement. For the other universally held truth (false in my view, but I'm a tiny minority) is that letting Lehman go under was a huge mistake and led to the financial crisis. If only the Fed had saved Lehman as it did Bear, the story goes, things would not have been so bad. So why would the government not orchestrate a bailout?
"Veteran Wall Street lawyer Rodgin Cohen, who helped shape the deal for Bear Stearns, says that if a crippled firm were on the brink today, none of its peers would arrive with a rescue. “Nobody will ever again buy a severely troubled institution,” he says. “Period.”"
Many officials in Washington feel another bailout is just as unlikely. 
Why not?

The first line of defense has always been one of these arranged last-minute marriages, in which a healthier firm takes over a failing one. This will not happen again.
Nearly everyone in charge on Wall Street today, including JPMorgan’s Mr. Dimon, says they would never buy a collapsing firm like Bear.
“No, we would not do something like Bear Stearns again—in fact, I don’t think our board would let me take the call,” Mr. Dimon wrote in his 2014 letter to shareholders. “These are expensive lessons I will not forget.”
In addition to the cost of bringing the two firms together, JPMorgan was saddled with billions of dollars in legal bills and regulatory penalties. Months after the Bear deal, JPMorgan made a similar last-minute agreement to buy Washington Mutual Inc. Of JPMorgan’s nearly $19 billion in legal costs from the mortgage crisis, some 70% stemmed from Bear and WaMu, Mr. Dimon wrote.
There were many other such deals in 2008. Wells Fargo & Co. bought Wachovia Corp., Bank of America Corp. acquired Merrill Lynch & Co. and Countrywide Financial Corp., and Toronto-Dominion Bank bought Commerce Bancorp. Today, many of these Wall Street executives say they feel betrayed by the government for hitting them with penalties tied to actions by firms they were pressured to acquire.
These days, a big financial firm rescuing another would also have to consider new restrictions on risk-taking. Banks today must pass regulatory tests before paying out profits to shareholders. In that environment, executives may be more reluctant to buy assets from a desperate seller. 
Loud and clear. Over and over, the government asks a big bank to help out by taking over a failing bank, which means agreeing to pay all that failing bank's debts.  But this time, after the fact, the government made the new owners pay billions in fines for the old company's debts. Take my trash out, asks your neighbor, and you say "sure," then he calls the EPA to report on the toxic waste now in your trash barrel. Not again. And if that weren't enough, the government's own regulations will prohibit it.

So if a bailout is needed, private help won't be there.

Well, what about government help? We got $700 billion of that too last time.
Fed help like that would be illegal today. The 2010 Dodd-Frank financial-regulation law stipulates that emergency Fed lending must be “broad-based” and cannot be “established for the purpose of assisting a single and specific company.” Financial firms, like other corporations, are supposed to go bankrupt, not get bailed out.
So what is supposed to happen? "Orderly liquidation."
If regulators and the Treasury secretary assert a bankruptcy would destabilize the financial system, Dodd-Frank provides a new backstop called the Orderly Liquidation Authority. The government would take over the failing firm, wiping out shareholders. After a weekend of work by federal officials, a new company, owned by creditors of the old firm, would open Monday morning. The government would be able lend money to the new company to keep the lights on while the government sells it off in pieces.
That is supposed to prevent a panic because people who had been doing business with the failing firm would know they could continue to do so, at least for a while.
In sum, the lifejackets (shotgun marriages) and lifeboats (government bailouts), distasteful as they are, are likely gone. Speedy bankruptcy isn't here yet. We are relying on a new and untested idea, the watertight compartments.

I have long been suspicious of "orderly liquidation." The whole premise is that big banks are too complicated to go through bankruptcy court. So, the Treasury Secretary, Fed Chair and a few other officials are going to figure out who gets what over a weekend? What would you do if a big bank owed you a few billions, was on the brink, and you suspected these fine officials would be meeting this weekend to divvy up the carcass? How about run now?
What if orderly liquidation doesn’t prevent a panic? In a crisis, problems at one firm can lead investors to “run” to cut their exposures everywhere. Even healthy companies can’t get credit, damaging Main Street as badly as Wall Street. In that scenario, there may be little U.S. regulators can do on their own. Congress might be asked to reinstate the bailout authority it took away after 2008.
“Drafting big books, massive documents, having big teams—that’s all a good idea,” says Gary Parr, a longtime deal maker who advised Bear on its sale to JPMorgan. “But when you have a company get into a liquidity crunch, if things are going really fast, you don’t have time to study a book.”
The best of all worlds is one in which nobody expects a bailout, it comes once to stop a run, and then we put the moral hazard genie back in the bottle. The worst of all worlds is one in which everyone expects a bailout, but then either by legal restriction or decision it does not come. Nobody has fire extinguishers any more, and the fire house has burned down.

Where will the next crisis come from? It always comes from a new and unexpected source, so don't plan on subprime mortgages funneled through investment banks. Look instead and ask, where is there a mountain of debt that can't be paid back, a bunch of really obscure accounting, off the books credit guarantees? China's great wall of debt suggests one answer.

The other worry  " Congress might be asked to reinstate the bailout authority it took away after 2008." Yes, but even that was authority to use borrowed money. The last crisis cost us something like $5 to $10 trillion. If the US asks for that much money again, can we get it?

But all of this ignores the basic point. Financial crises are not about the failure of specific institutions. Financial crises are about runs. One way to stop runs is to convince short term creditors that no institution will ever lose money again, or that there is a big bailout ready. The other way is to fund risky investments with lots more equity. Not to beat a dead horse over and over again, but the real lesson of Bear Stearns and Lehman is what happens if you fund  risky investments with a huge amount of short term debt. That can be fixed.

(Actually, subprime mortgages aren't even very risky. Google's self driving car is way more risky. All corporate cashflows are way more risky. Why are we spending all this money policing pools of mortgages, about the safest asset there is? Answer, because they are funded by huge amounts of run-prone short-term debt.)


  1. John, what is the market failure that is leading these banks to not be funded with "enough" (quote unquote) equity? Or is it a government failure, due to the subsidization of debt over equity?

    1. Anonymous,

      Most major U. S. banks are part of a network called the primary dealers. As such, they are REQUIRED to submit bids at U. S. government debt auctions. John suggests that any bank should be "forced" to fund lending operations through the sale of equity shares rather than through maturity transformation - borrow short / lend long.

      I think you should see the problems here.

      Problem #1 - Money is fungible. When you have a bank that engages in both risky private lending and riskless lending to the federal government, there is no way to identify which funding source is used for which lending activity.
      And so the only way to prevent short term borrowing from funding risky activity is to eliminate short term borrowing altogether.

      Problem #2: Now that we have eliminated short term borrowing altogether, consider how many private for profit banks would remain as primary dealers if they were told by the federal government to hamstring their own shareholders so that the federal government can borrow money on the cheap. My guess is that the list of primary dealers would drop to 0 participants.

      The failure isn't a "market failure" so to speak. It is a failure of economic competence at the highest levels. To eliminate the need for short term borrowing by banks to purchase debt sold by the federal government, you need to eliminate the debt sold by the federal government (across all maturities).

      Then everything else John says falls into place, ALL lending by banks is financed with the sale of equity and / or retained earnings.

  2. Great post.

    The People's Bank of China already once purchased about $1 trillion of sour loans from the Chinese banking system.

    As China is below their inflation target anyway this seems not to have caused a problem and left a functioning banking system in place.

    It is difficult to know anything about China but it appears that the bad debt for PBOC cash swap was something of a QE program also.

    Chinese banks keep about 17% in reserve but there are also questions about shadow banking.

    There is political poison in Beijing today, but I suspect the banking system is solid.

  3. The system works with bailouts. Why change? Justy make the TBTF a formal banking system, with all the bailouts included.

    The worst result is when we pretend to have fixed it but a wink and a nod later, taxpayers are one the hook, unexpectedly.

  4. A good discussion with good points -- I am aware and have heard (but not read his book) Darrell Duffie talk about 2008 at Stanford conferences. The missing discussion point here is the fraudulent financial products -- starting with mortagaes made in the retail market and bundled into MBSs -- that were put into the international money markets and used as collateral. This makes it more of a problem than just a question of managing reserves. Remember the warning when BNP froze funds in 2007 -- due to the suspicion of fraudulent products in their accounts. Damion Silvers gave a respone to a conference that Peter Wallison held in 2016 -- where he addressed the public/private sectors and misplaced incentives.

  5. John,

    What do you mean by "the last crisis lost us ..." Is that just sarcastic? Not clear to me what you meant. Other than bailing out The UAW by helping the auto cos., we made money on the bailouts.


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