Friday, March 21, 2008

Bare Stearns?

"What are the consequences of a world in which regulators rescue even the financial institutions whose recklessness and greed helped create the titanic credit mess we are in? Will the consequences be an even weaker currency, rampant inflation, a continuation of the slow bleed that we have witnessed at banks and brokerage firms for the part year? Or all of the above? ... Agreeing to guarantee a 28-day credit line to Bear Stearns [BS], by way of JPMorgan Chase, the Federal Reserve Bank of [NY] conceeded last Friday that no sizable firm with a book of mortgage securities or loans out to mortgage issuers could be allowed to fail right now. ... But why save [BS]? ... Bear's default rates on so-called Alt-A morgages that it underwrote also indicates that its lending practices were especially lax during the real estate boom. ... And the firm tried to dump toxic mortgage securities it held in its own vaults onto the public last summer in an initial public offering of a financial company called Everquest Financial. ... If [BS] failed, for example, it would result in a wholesale dumping of mortgage securities and other assets onto a market that is frozen and where buyers are hiding. ... As of last Nov 30, [BS] had on its books approximately $46 billion of mortgages, mortgage-backed and asset-backed securities. Jettisoning such a portfolio onto a mortgage market that is not operative would, it is plain to see, be a disaster. But, who knows what those mortgages are really worth? According to [BS's] annual report, $29 billion of them were valued using computer models 'derived from' or 'supported by' some kind of observable market data,. the value of the remaining $17 billion is an estimate based on 'internally developed models or methodologies utilizing significant inputs that are generally less readily observable,' In other words, your guess is as good as mine. ... 'For the government to print money at the expense of taxpayers as opposed to requiring or going about a receivership and wind-down of any insolvent institutions should be troubling to taxpayers and regulators alike,' said John Rosner, an analyst at Graham Fisher & Company and an expert on mortgage securities. 'The Fed has now crossed the line in a very clear way on "moral hazard", because they have opened the door to the view that they are required to save almost any institution through non-recourse loans'. ... Here, is the bind the Fed is in: Like the boy who puts his finger in the dike to keep sea water from pouring in, the Fed finds that new leaks keep emerging", my emphasis, Gretchen Morgenstern (GM) at, 16 March 2008.

GM blew this one. BS failed a few days later. At least GM sees the Little Dutch Boy analogy. How does GM know BS's failure would result in a "wholesale dumping" of assets? If BS filed for bankruptcy, what would the judge do? Insist BS trustee auction off the assets at the best price. Given this is the counterfactual, I assume: this is what the Fed wanted to avoid: having market values for these assets that could be applied to other financial institutions. Rosner is right about "moral hazard", but wrong about the Fed's saving financial institutions. BS was not "too big to fail". It was sacrificed to protect the still bigger boys.

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