Twenty First-Century Central Banking

The problem of dealing with moral hazard in twenty first-century central banking has taken an interesting twist. Twice in the past decade the Federal Reserve has intervened in cases in which specific institutions have gotten into serious trouble--specific institutions that the Federal Reserve, or at least the New York Federal Reserve Bank (lines of authority are somewhat unclear) has concluded are too big to be allowed to fail through standard processes. The two institutions are the hedge fund Long Term Capital Management--LTCM--in 1998, and the bank Bear-Stearns in 2008.

In 1998 LTCM had suffered major losses on a mark-to-current-market basis (although its long-term prospects in the event of global financial recovery from the crisis looked correspondingly good), and appeared both illiquid and--if forced to liquidate its positions at then-current values, especially if liquidation induced significant price pressure against it--insolvent. Alan Greenspan and Peter Fisher at the New York Fed gathered all of the Federal Reserve's major creditors in a room, told them that they had a problem, and told them that they should solve it: that systemic risk would be created by an LTCM bankruptcy and liquidation and that the Fed did not want to go there. The creditors agreed to cooperate and split both the liability and the upside (with the exception of Bear Stearns, that declined), and they made LTCM an offer. The only alternative bidder was said to be Warren Buffett, who claims to have not been focused on the situation because he was fishing in Alaska. With only one potential bidder, the equity of LTCM's principals and investors was confiscated--to the dismay of LTCM's principals and investors, some of whom believe that they would have been able to get a much better split of the upside had they been allowed to play their creditors off against each other.

In 2008 Bear Stearns had suffered major losses on a mark-to-current-market basis (although its long-term prospects in the event of global financial recovery from the crisis looked correspondingly good), and appeared both illiquid and--if forced to liquidate its positions at then-current values, especially if liquidation induced significant price pressure against it--insolvent. Ben Bernanke and Tim Geithner at the New York Fed declared that systemic risk would be created by a Bear Stearns bankruptcy and liquidation, that the Fed did not want to go there, and that the only deal they would fund and support would be a deal that sold Bear Stearns to J.P. MorganChase at $2 (later raised to $10) a share, and the Federal Reserve kicked into the deal a put on Bear Stearns assets that one might speculate had a full-information liquid-market value of perhaps $3 billion. Various speakers for principals and investors in Bear Stearns protested that this effective confiscation of their equity value was unfair and inappropriate, and that a better split of the upside or at least a payment of more than $2 a share was appropriate.

We now have two precedents. If the Federal Reserve judges that a major financial institution:

• is too big to fail in that its failure will generate systemic risk
• has followed portfolio strategies that have produced inappropriate and excessive leverage
• requires immediate action

then the Federal Reserve will intervene to structure and support a deal that leaves principals and investors in the offending systemic risk-creating institution with effectively zero equity. Counterparties will be rescued. Principals and investors will not--even if normal more lengthy legal and bargaining processes would give principals and investors a share of the equity value on the table.

This is not the arms-length equal-treatment impersonal-rule-of-law ideal to which a government should aspire. This does, however, seem to get the incentives about right.

Charlie Kindleberger once wrote, in Manias, Panics, and Crashes, that the key to avoiding both depression and moral hazard was for the lender-of-last-resort to always show up in a crisis but for its appearance to always be doubted until the very last moment. These two precedents suggest that the Federal Reserve is evolving a case-law-of-twenty-first-financial-crisis that is somewhat different: in a crisis the lender-of-last-resort will always show up, but investors and principals in individual institutions that need to be specially rescued will discover that the lender of last resort is not their friend.

Comments

[Neal]

(quote)

If the Federal Reserve judges that a major financial institution:

* is too big to fail in that its failure will generate systemic risk
* has followed portfolio strategies that have produced inappropriate and excessive leverage
* requires immediate action
then the Federal Reserve will intervene to structure and support a deal that leaves principals and investors in the offending systemic risk-creating institution with effectively zero entity. Counterparties will be rescued. Principals and investors will not--even if normal more lengthy legal and bargaining processes would give principals and investors a share of the equity value on the table.

(end quote)

So what does that say for the Fed re the American consumer (70% of the economy--too big to fail, followed inappropriate portfolio strategies, and require immediate action) in the current financial crisi?

[Scott Frew]

Brad--

From what I understand, the holders of Bear's debt made out pretty darn well. In fact, if you'd bought Bear debt in the time shortly before the bailout, you'd have made out extremely well indeed. The same could be said for those who wrote CDS on Bear debt. I'm not sure where you classify these people and institutions

[As I said: counterparties]

, but they seem like investors to me, and the lender of last resort in this instance was very much their very very bestest bestest friend.

Rgds.

[Matt]

When the structure can not support the volatility, then the problem will be handled in the wealthiest incomplete market, generally the Fed or the government.

This concept is what makes Soros or Buffet rich. They know when and where the screw up will be handled, and they hedge that event. The founder of PIMCO is betting on a government bailout of housing. Why does he expect that to happen?

[jerry]

When an entity becomes too big to fail, it should be broken up into pieces small enough to be allowed to fail.

If that happened, we wouldn't need any of this nonsense, or raids on the taxpayer to prop up the downside risk with no chance of the upside gain.

The Fed should not be bailing corporations out, it should be issuing guidelines, warnings, and finally takeovers of entities that become too big to fail.

[Emma Anne]

$10/share seems like rather a nice rescue of investors, compared to bankruptcy. It is particularly nice for the in-the-know types who bought the shares at a few dollars each from the suckers who didn't know about the put.

[AP]

Jerry's right. The problem starts when an entity gets too big to fail, not when it starts to fail. Can't this be taken care of with strongly progressive corporate tax structures? Companies would split themselves when it means avoiding getting bumped into higher brackets.

[DB]

So the evolving policy or policy template is the slogan of that country comedian: "Git 'er done!"

[johnchx]

"This does, however, seem to get the incentives about right."

I'd question whether a de facto guarantee against counterparty risk really gets the incentives right. Do we really want all derivatives offered by name-brand investment banks to be priced with an implicit guarantee discount (like Fannie Mae & Freddie Mac debt)?

[VennData]

I agree with the ceiling on the "too biggies" above. The regulation is easier too. Prime Directive: You can't get too big. And... you can eliminate more risk if ALL inter-party transactions are run through exchanges, then the clearing firm manages ALL the counter party risk.

While you're at it since everything else in finance can be done on the web by linux servers, simply eliminate all financial institution behavior that that creates lock-in. By making it easy to switch your banking / credit card (like your phone number is now) no lock in means no fees.

Finally, all of your portfolio should be in index funds run by a 386 machine.

All four of the above solutions wouldn't pass through our legislatures - nor all other government's legislatures which they'd have to - since that's what allows for the huge executive salaries. All their profit is 1) in being so large there are few competitors 2) those esoteric securities they create for clients 3) Charging clients fees who are too lazy to move their relationships 4) Pointless money management fees.

In short, it'll never happen.

[Matt]

If Ben is listening, perhaps we can persuade him to up a quarter the next round. The yield curve might just hold and that would give us confidence that the fast changes are over with.

Besides, being a little experimental, rather than predictable should keep us on our toes.

[christofay]

whoops, wrong about that, "Counterparties will be rescued. Principals and investors will not." Counterparties were rescued. Principals were rescued too, but they still yap. Investors the mass of retirement funds, mutual funds, and individual stock owners being of the middle class saw their equity fall to $2.

Principals were rescued. The fabulous CEO saw the stock price fall from $170 to $2, but he still had some equity to sell, and he didn't have to give back his mark to accelerated market based mega-bonus. If the firm went all the way to BK, giving back his unearned mega-bonus would have been more at risk.

Why didn't the Fed let the firm go all the way to zero, let the bond holders take a hit, and let the CDS playas take a hit too?

You are attempting a mao mao job with this construction, "mark to current market." did you think of it yourself?

And your cheerleading for the Bernanke fed will be noted.

Generally you repeat the rout "up with markets," but what really gets you excited is watching the Fed step in and try to manipulate markets.

A good paper to read is "Grant’s Spring Investment Conference, David Einhorn, “Private Profits and Socialized Risk”, April 8, 2008" at http://mrmortgage.typepad.com/blog/files/david_einhorn_private_profits_socialized_risk_40808.pdf

[Cranky Observer]

I guess I missed the part where the last five years of Bear Sterns' executives' bonuses and salaries above 100k/year were clawed back as part of the deal.

Cranky

[christofay]

Crank: Perhaps Delong means the C suite of Bear lost out on future claims on bonuses marked to current markets on the upswing.

Losses on marked to current markets on the downswing are of course for the biomass, the taxpayers. Ah, the brilliance of our central planners

[christofay]

The United States would start to have a more realistic view of money if the current president's face was printed on it rather than a portrait of a ghost.

$ 1 Fed reserve note, Bush, the clown

now would you want to hold onto it?

$ 5 Fed reserve note, Bernanke, why not? Real estate agents have their photos printed on their name cards.

$ 100 Fed reserve note, Greenspan, now many people would start to have a discussion with themselves about their relationship with the faith based paper in hand.

[a]

Scott and johnchx are correct. Bond holders in BS and counterparts to BS made out far too well. If one takes the Fed's rescue of BS by itself, risk will continue to be underpriced, with dire consequences for the financial system as a whole.

[vtcodger]

If the Federal Reserve is going to rescue some subset of large operations, it is running an insurance operation. Nothing wrong with that. But should it not charge an actuarily sound insurance premium to those companies that it insures?

[Matt]

christofay made a good, but opinionated point:

"...what really gets you excited is watching the Fed step in and try to manipulate markets. .."

We can actually formulize Brad, Paul, Mankiw the Hayeks; and the rest as economists who, fundamentally, tell us how to get better estimates of our production functions with fewer inventory updates. These people have one purpose in life, make inventory updates go as NlogN rather than the ineffecient N**2. When they do this, they reduce the energy swings in markets and provide savings.

They also provide measures of precision that let us know when aggregate volatility is out of our comfort range.

The top down affect of how their information is deployed is being fundamentally changed by the web.

[ajay]

"then the Federal Reserve will intervene to structure and support a deal that leaves principals and investors in the offending systemic risk-creating institution with effectively zero entity."

"Entity" should presumably be "equity"?

[nick gogerty]

concentrations of risk are bad. Read the book Normal Accidents.

If the FTC can argue against monopoly, perhaps a central bank can argue against concentration of risk above a certain threshold, now about Fannie Mae etc...uh oh too late.