Developments in Economic Theory and Policy

5th International Conference

Bear Stearns, the Fed and the Slow March Towards an American Fobaproa

Gregorio Vidal[1]

(Universidad Autónoma Metropolitana – Iztapalapa)

Wesley Marshall

(Universidad Nacional Autónoma de México)

As taught by hundreds of years of history and various perspectives of economic theory, unregulated financial markets tend toward self destruction. If an economy undergoes prolonged periods of financial asset gains, a growing number of actors perceive the incentive to bet, or to increase existing bets, on financial assets that appear to always increase in value. Under such circumstances, banks act as the principle promoters of growing levels of speculation, not only by increasing their own bets, but also by extending debt to other speculators so that they can leverage their bets. In these moments, aggressive banks gain the largest market share. In part, larger winning bets increase their size relative to more cautious banks, and in part more prudent banks are subjected to strong pressure to assume more aggressive positions, none more so than the buyout of a cautious bank by a quickly expanding rival. The combination of more aggressive banks and greater numbers of non-bank actors that enter into financial markets with ever larger bets results in a growing fragility of the financial system. Larger debts among a larger number of bank clients, whose own debt and bets have increased, set the stage for an inevitable financial crisis once the value of financial assets begins to fall.

But while the development of this type of bank-led crisis is a historically and theoretically reproduced and reproducible event, the same can be said of the failed resolution policies for this type of crisis. As will be further analyzed, when banks assume risky positions during the boom that precedes the crisis, it is imperative that they register commensurate losses during the resolution of the crisis and that their activities be limited and strictly monitored. In the absence of these conditions, banks are given incentives to undertake actions that can cause damage to the financial system at a greater cost than the crisis itself. However, the implementation of policies of this nature is fraught with complications. On the one hand, as influential political actors, bankers tend to resist any measures that may restrict their economic liberties. On the other hand, the way in which a crisis develops is highly dependent on the perception of economic actors. As such, even if a government is fully aware that a banking system is immersed in a situation of illiquidity or insolvency, upon enacting measures that transmit this recognition to the public in general, the pressures on the banking system can significantly increase. Stock prices can fall, and runs on banks may develop, whether they be traditional as seen with the case of Northern Rock or of a different nature, as happened with Bear Stearns’s collapse. Therefore, for a bank-led crisis to be resolved in a reasonably successful fashion, the authorities must walk a fine line between supporting and protecting the banking system and limiting the scope and breadth of banking activities. While these two general goals often enter into direct conflict, if authorities vigorously pursue one set of objectives and disregard the other, the chances of a successful banking crisis resolution diminish drastically.

This presentation will focus on the current financial crisis in the United States. As it is a crisis that was generated in the banking system, obviously in conjunction with government policy, US authorities currently find themselves in the difficult position just described. And as will be detailed, the government of the US has strayed from the fine line necessary to successfully resolve the banking crisis, and is currently applying resolution measures that strongly favor the protection of the banking sector. Using the recent historical experiences of Mexico and other general considerations, this presentation will argue that a bank rescue that is heavily biased towards the protection of the banking sector creates a series of incentives for bankers that all but ensure that this type of resolution will not be able to restore the health of the banking sector at a reasonable price to the taxpayer.

Although the US financial crisis began to show its first signs during the beginning of 2007, it only developed into a systemic threat in August of the same year. From that moment onwards, the Federal Reserve of the US has maintained a very active presence in the implementation of mechanisms to manage the crisis. On the one hand, the Fed has tried to reduce the general cost of capital by lowering the federal funds rate more than 3 percentage points from 5.25 percent to 2 percent between August of 2007 and April of 2008. Particularly noteworthy was the 75 point emergency rate cut on January twenty-second. On the other hand, the Fed has undertaken a series of actions aimed at unfreezing the interbank markets. In chronological order, the Fed has raised its lending limits to individual banks; it has established the Term Auction Facilities, under which all banks, even investment banks that are neither regulated nor supervised by the Fed can access its financial support. The Fed began loaning money to primary dealers; it widened the criteria which financial assets were eligible as collateral for Fed support. JP Morgan Chase was allowed to borrow from the discount window in place of Bear Stearns, which as an investment bank was not permitted access to the facility, which represented the first time since the depression that a bank acted as an agent for another one in order to access Fed financing. The Fed guaranteed 29 billion of the 30 billion dollar purchase of Bear Stearns by JP Morgan Chase. And finally, as a result of Bear Stearns’s precipitous collapse, the Fed implemented the Primary Dealer Credit Facility and the Term Securities Lending Facility, both aimed at providing further funding to the remaining four major investment banks and other broker-dealers.

The sum of these operations have been interpreted in a variety of ways. In August of 2007 and particularly in March 2008 with the collapse of Bear Stearns, the US financial system witnessed two heart attacks. Without the action of the Fed, these episodes could have easily provoked a collapse of the system. However, even though maintaining the system of payments in working order is perhaps the most important objective of a central bank during a crisis, it is not the only one. Another concern must be the fiscal cost of the bail out and restoring the health of the banking system. But as mentioned, the first objective often enters into conflict with the other two. Up to this point, the Fed has prioritized the security of the principal actors of the financial system over any other consideration. In the process, the conditions have been set for banks to undertake various strategies of betting for resurrection. As several authors have pointed out, when the net value of a bank falls below a certain thresh-hold, bankers switch from a risk averse to a risk loving position. In other words, when a banker sees that his assets are losing value at such a pace that his capital and very ownership of the bank will soon vanish, he must act in an aggressive way so that this eventuality does not become reality. Even if many US banks had behaved very aggressively during the pre crisis boom, all incentives favor a doubling down of bets during the crisis’s resolution. However, in the uncertain environment of the financial crisis, bet are substantially more difficult to win, and if the activities of banks are not significantly limited, the losses stemming from gambles for resurrection can greatly increase the costs of the rescue, as well as hindering efforts to restore the banking system’s health.

Such dynamics are greatly magnified when bankers are able to operate under a state guarantee. A fundamental element of Glass Steagal’s logic was the elimination of the perverse incentives that arise when financial risk taking does not carry the corresponding possibility of financial losses. While the Glass Steagal act was in existence, the US banking system was divided between commercial and investment banks, the latter of which could engage in speculative activity, but they were excluded from any government guarantee or protection. As such, when their bets lost money, investors lost money, and as a consequence, investment banks operated under incentives to minimize losses and a certain risk aversion was maintained.

However, with the measures recently approved by the Fed and European Central Banks, there is an evident and growing state guarantee for financial assets of low and decreasing value. On the one hand, under programs such as the term auction facilities, central banks have dramatically increased their holdings of such assets. While central bank’s possession of these assets in itself represents an important first step towards their outright purchase, it is also changing the behavior of the banks. For example, so called zombie Collateralized Debt Obligations have been issued by British banks Lloyds and HBOS. These structured finance products have been created not for their sale in private capital markets, but rather with the sole purpose of exchange with central banks for government paper. On the other hand, the rescue of Bear Stearns has also established the important precedent that the Fed will not permit the fall of any large bank in the system, further increasing risks associated with moral hazard.

As mentioned, guaranteeing the integrity of the system of payments must be a high priority objective of any central bank. Without a doubt, the collapse of Bears posed a systemic risk; not necessarily because of the size and value of its assets, but rather for the huge counterparty risks its bankruptcy would entail, particularly in the opaque Credit Default Swap market. Currently estimated at over 60 trillion dollars, this market has never experienced an event of the magnitude of a Bear Stearns bankruptcy. The acquisition of Bear Stearns by JP Morgan Chase prevented this episode from becoming the first test of the Credit Default Swap market in its current dimensions. Other aspects of the fusion between the two banks were equally unusual. While the collapse of a bank can be rapid, the fact that Bear Stearns, then the fifth largest investment bank in the US, could have almost all its lines of credit closed and could lose almost all of its stock market value in a span of only four days points to the extreme volatility that characterizes today’s financial system. Faced with its almost spontaneous collapse and the possible massive secondary effects of its bankruptcy, the Fed was the only actor capable of organizing and financing Bear Stearns’s rescue, under the transparent veil of a private sector fusion.

But the Fed’s actions must also be measured against other possible options. While the bankruptcy of Bear Stearns could not have been permitted, the Fed could have also opted to finance the bank without increasing its regulatory and supervisory presence. This option would have generated a very delicate situation, due to the perverse incentives already described. However, these incentives were far from eliminated. More accurately, they were in large part transferred to JP Morgan Chase. In theory, the fact that this bank was in a position to acquire another bank should point to its relative strength and ability to absorb any losses generated by Bear Stearns’s books. As such, at no cost to the state, the bankers that sunk Bear Stearns would be gone, eliminating moral hazard concerns, and a stronger bank would replace a weaker bank in the system, therefore fulfilling all of the major objectives of bank crisis resolution. But due to the fact that the Fed financed the transaction eliminates these possible benefits of a private sector fusion. While Bear Stearns’s upper management now cannot bet for the banks resurrection, JP Morgan Chase now holds the entire portfolio of the bank under an absolute guarantee from the Fed. Therefore JP Morgan Chase’s upper management has every incentive to bet as heavily as it can with these assets. Therefore, the forced fusion between these two banks does not escape from the contradictions inherent in the rescue of a bank-led crisis. The integrity of the payments system was maintained, but at the cost of creating the perverse incentives that tend to make bank bailouts more costly and less effective in terms of restoring the health of the banking system.

The bias that the Fed has shown toward the rescue of banks and the absence of any signs of any type of purge of the financial system, including confronting the ongoing and growing risks posed by structured finance, creates a very delicate panorama. In the words of the former chairman of the Fed, Paul Volcker, "The Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers, transcending in the process certain long-embedded central banking principles and practices." Yet even so, the lack of trust between banks that has characterized the crisis has not abated, and interbank lending rates remain close to their highs during the most tense moments of the current crisis. If the Fed maintains its position in favor of the almost unconditional rescue of banks and continues to ignore the moral hazards that its actions are creating, the next step to be implemented will be the outright purchase, or even more probable, a slowly evolving permanent borrowing of the valueless financial assets of US banks.

If this likely scenario indeed unfolds, the experience of the Mexican bank bailout, known as Fobaproa for its initials in Spanish, will be of utmost relevance. Until now, both crises show many important elements in common. In both cases, the banks were the primary drivers behind the development of the banking crisis, and in both cases, the bankers wielded strong political positions. In the Mexican experience, the government protected the bankers in an absolute fashion. No bank closures were permitted in the years immediately following the crisis; all banks received state financing, and no bank was subject to sufficiently strict regulatory measures. As such, the basic conditions were in place for one of the most ill-fated bank rescues in modern history. In the current US case, all evidence suggests that the government is also doing everything in its power to protect the majority of bankers that were responsible for the crisis, which are equally well positioned politically. However, the one element that has not presented itself so far in the case of the US is the purchase of private sector assets by the government, which was precisely the measure that prompted the greatest amount of damage to be done to the Mexican banking system.

In the months following the eruption of the crisis, and with the knowledge that all non-performing loans would be absorbed by the state, Mexican bankers followed the incentives given to them and issued large amounts of credit to family, friends, business associates, and to themselves in many cases. So while many bankers lost their banks, they did not lose their fortunes. Amongst the banks that were eventually shuttered or fused, the ratio of related credit to total credit more than doubled during the first six months of the implementation of Fobaproa. 88% of these loans were deemed unrecoverable.

The rescue of the Mexican banking system represented a total socialization of bank losses. While no Mexican banker sustained financial losses that corresponded to their gains during the previous moments of expansion, the government sent hundreds of billions of dollars in losses to the state. These losses have signified a sharply reduced financial capacity for the government, and other activities have, and will be foregone for generations, in order to pay off the debt left by the banking sector bailout. But perhaps an even more dire consequence of the failed crisis resolution was that the constant weakening of bank balance sheets made a recovery of the banking system’s health almost impossible. Indeed, the system never recovered, and was later almost entirely transferred to foreign banks. Mexico has therefore lost all capability of carrying out a coherent credit policy, and the banking system now functions as a money making operation for the headquarters of foreign banks and does not attend to the necessities of the local economy.

Even in the absence of a program for the direct purchase of banks’ assets, the bailout of the US banking sector is similar to the Mexican bank rescue in that the bankers whose imprudent actions caused the crisis have pocketed huge amounts of wealth while their institutions were collapsing, as is the case of Countrywide’s CEO, Angelo Mozilo, who cashed out share options for almost 500 million dollars over the last few years. In the US, financial losses are being absorbed almost exclusively by the state, and the capitalization of the banking system depends to a growing degree on foreign actors, although at the moment an internationalization of the US banking system comparable to Mexico’s seems highly unlikely.