Investment Bank Regulation: Beware the Dawn of This New Era

In yesterday's New York Times, Andrew Ross Sorkin draws attention to the fact that the Fed was calling the shots behind the Bear Stearns (BSC) "bailout." This point was obvious last week. Just because the price moved from $2 to $10 and there is speculation about whether or not the Fed set the offer prices does not make this any more or less of a "bailout." It was pretty obvious the Fed was pulling the strings from the beginning. Just take a look at the original $30bn backstop (now $29bn with JP Morgan (JPM) on the hook for first losses of $1bn on risk derived from illiquid BS assets). By meddling in the Bear Stearns mess again the Fed has entered a quagmire of competing interests. The parties it must politically handle are Bear Stearns’ shareholders, J.P. Morgan, Wall Street, neo-liberal economists who want the Fed to stay out of this mess, those that want to give relief to homeowners, and congressmen trying to figure this out. To wit, the consequences of Bear going bankrupt would have been catastrophic for economies and markets around the world. However, The Prince doubts chapter 11 was ever an option for a Bear Stearns, which was careening towards insolvency (he is not alone and BS could only seek Chapter 7 with the trustee being SPIC). Were the actions the Fed took in the "national economic interest" of the U.S.? It does not matter much to The Prince. What is done is done, and its implications are enormous.

After reading Mssr. Sorkin’s column, The Prince is convinced that by focusing on the intrigues of how the Fed called the shots on the offer, Sorkin is missing the long term implications of the Federal Reserve’s actions in the Bear Stearns debacle. It is interesting that the Fed did not inform Bear of its plans to open the discount window the night it signed JP Morgan’s bid. These actions clearly favor the argument that the Fed preferred the first bid, as Mssr. Sorkin points out. The Prince couldn’t agree more with Sorkin when he states the fact that, "The Fed is officially in the deal-making business." But why is this problematic?

Most of the stories about this mess have spoken vaguely about "moral hazard" and setting a precedent which will increase risk taking in the future etc. Very few columnists, journalists, or bloggers have looked at what the actions of the Fed forebode for investment bank regulation going forward. The Prince does not care what happens with the Bear Stearns takeover because the long-term implications of the actions taken by the Fed in this debacle are far more ominous and important. Please allow The Prince to illustrate some of the most problematic implications.

First, the Fed has now become the lender of last resort to the entire financial system, not just the bank holding companies that it normally regulates. This is a landmark event in American monetary and economic policy. The Fed as a lending last resort has fundamentally altered the on-the-ground reality of counterparty risk, and this will forever change the environment in which investment banks operate. The Prince does not know when the current credit crisis will end or when Bear Stearns will be put down, but one thing is beyond clear. At the end of this mess the regulatory environment governing the financial sector will be dramatically different from what we have now. While many on Wall Street may like the safety that the Fed provides as a lender of last resort, many on Wall Street will not like the changes that are coming.

Let’s analyze the situation more closely. The Fed has rescued an entity with almost $30bn in credit and the entity is not regulated by the Fed. Remember BS is regulated by the SEC. The SEC’s required capital levels are roughly a third of what the Fed requires of the commercial banks it regulates. The Fed has taken these steps because of its concerns over counterparty risk. That is the worry that Bear Stearns' liquidation would impose enormous burdens on its counterparties and throw the financial system into a frenzy. This is the second time The Fed has done this (the first time being LTCM where it helped to orchestrate a Wall Street bailout of the hedge fund).

We will soon learn that the Fed has learned its lesson when it comes to counterparty risk. Such risk will have to be managed much better by banking regulators around the globe. This will bring an end to the free-wheeling days of fixed income derivatives. The Prince predicts that most of these derivatives are pretty much over and will be the whipping objects of many analysts of what went wrong at the investment banks. More robust (regulated) settlement and clearing processes are coming, and it will be the Fed/Treasury driving these changes, not the ISDA, the SEC, or the broker dealers themselves. Fixed income derivatives are likely to go the way of other securities markets. This means they will be non-levered hedging and speculation tools. Leveraging through derivatives will probably end with an order from the regulators against such actions.

Second, the Fed has crossed the Rubicon in regards to the type of financing it is providing for the transaction. The financing of $29bn is almost equity type financing. It is a $29bn non-recourse line to finance toxic parts of the balance sheet of Bear Stearns, only protected by $1bn cushion of first loss collateral from JP Morgan. What would happen if a broker deal is going down and there is no other broker dealer to buy the company like JPM? This BS deal had better work or we may be seeing the Fed explicitly recapping financial institutions by directly injecting equity or taking over the institution.

Third, the days are gone when an independent investment bank could have a large trading book. The Fed will ensure that if it is required to bail out such institutions, not having regulatory or capital jurisdiction over such entities would be wholly unacceptable. The Prince also sees no real way for the investment banks to opt out of the protection that the Fed has now extended, because any investment bank is subject to counterparty risk in the financial marketplace. Investment banks will turn into banks, through consolidation driven by non-stressed, distressed, or regulatory realities. Under this new regulatory system Goldman Sachs (GS), with its large trading book, is no longer the model investment banking and JP Morgan now assumes that title. JP Morgan is the correct model to the Fed in an "everybody is too big to fail" regulatory regime. As a result of this new regulatory regime, a big round of consolidation among financial services is coming in the U.S. and probably globally.

To conclude this argument, The Prince must say that the credit risk of any modestly sized financial institution, that is a player in the capital markets, is a good buy, now that we are living in an era free of moral hazard. If a company is big enough, there is no credit risk with the Fed waiting there with a bailout. So go forth and sell protection on LEH, GS, and MS CDS at these levels. Also go out and buy Agency credit risk. It may be some of the last good money to be made before the regulators begin to burn and pillage the investment banking community. If BS is too big to fail and the Fed has to provide $30bn in effective equity in a bailout then what large financial institution is a credit or a counterparty risk? That is all, my loyal subjects.

Comments

[GerrySullivan]

Very good analysis. Leverage in financial institutions caused the problem and will not be allowed at these levels again in our lifetimes.

Very high margin (money borrowed from brokers as a % of account equity in the 1920s) led to the 1929 stock market crash. 75 years later, we still have regulation of margin accounts by the Federal Reserve and a 50% margin requirement.

The Fed did get $30 billion of BSC assets (quality unknown) and JPM is paying the Fed 2.5% on the entire $30 billion. Time will tell how that works out.

[spragus]

Agreed! The Fed seems to have grabbed the regulatory reins in the absence of any other viable player. Sarbanes-Oxley anyone?

[MattGanucheau]

Do you know of any publicly traded companies that will directly benefit from the coming increased regulation of the investment banks? That is what I would like to know. Thanks for the good piece.

[BalanceSheetChecker(BSC)]

All of this assumes the deal as has been announced will actually go throught. My suspicion is that it won't actually go through because it was designed not to. See my comment here:
seekingalpha.com/artic...

I suspect the courts will decide it was illegal and business will resume as normal for Bear Stearns (but it will take time). It is important in these cases that the Fed's role doesn't get challenged but rather JPMorgan's - that way the next time a crisis happens (in a few decades) the Fed still has all it's (percieved) tools to manage the crisis.

[one saneperson]

When will this insanity stop. "Moral Hazard," "Bailouts," Fed conspiracy theories. When will people stop believing everything they read in newspapers. Let me try to point a few things out that have an actual basis in facts and not sensationalist headlines.
1) Bear came to the Fed not the other way around. Bear was facing a run on the bank, which almost by definition cannot be stopped other than a step-in by a bigger entity guaranteeing its counterparty obligations. If the Fed opened the discount window to Bear, the run on the bank would not stop short of an explicit bailout, which precisely what the Fed wanted to avoid and did. Remember Bear burned through 17Bn in liquidity in 4 days, just access to cash would not help its situation.
2) To avoid this bailout and any of these "moral hazard" problems JPM and potentially a few others were encouraged to bid for Bear. JPM was the only one who had the balance sheet and the wherewithal to do so.
3) The tax payers are not on the hook for anything! I repeat the tax payers are not in any way affected by the 29Bn of special financing that the Fed has provided to JPM. For all we know not all of this money is even going to be used. This is a lending facility, and a complex one at that, structured as a swap between treasury securities (the only form Fed's liquidity takes) and certain illiquid mortgage and asset-backed securities which appear on Bear's balance sheet. And btw these securities have been marked dramatically below par as a result of 3 quarters worth of markdowns Bear has already taken.
4) In the modern financial era of BASEL 1 & 2 the Investment Banks' balance sheets are already so regulated that quite frankly it can hardly get any worse. RegCap charges for Banks' trading books are enormous. In fact in the current regulatory framework Investment Banks are at a massive disadvantage relative to Commercial Banks, which have access to very cheap funding via their M1 deposits, Fed discount window (no longer only the case for commercial banks), and better lending terms from other banks. One of the reasons Bear was levered 30-1 is because for an Investment Bank to conduct normal business operations it needs to have a high degree of capital, whether liquid or illiquid--it needs it bottom line. Trading, lending, underwriting all require an historically unprecedented amounts of capital to compete in the Investment Banking arena.
5) Do not delude yourself that commercial banks take on less risk. Trading and prop books of guys like JPM, BAC, CSFB, and Deutsche, dwarf their Investment Banking counterparts. Commercial Banking Conglomerates take on enormous risk, and not only through their broker-dealer arms, commercial lending and underwriting is just as risky in the current environment as Goldman-style prop trading. True Goldman's VaR historically is much higher than competition, but that depends more on their scope and volume of investments, than the asset classes they invest in. In an environment that we are in right now, all risky assets have a near 1 correlation with each other.

Bottom line, the Fed did what it had to do in order to maintain stability and liquidity in the financial system. It is in fact a lender of last resort to the entire financial system and has to be one as mandated by its charter-this is not a current development btw. The senators may investigate these moves by the Fed all they want, their goal isn't to get justice for the U.S. taxpayer, who so far is benefiting from the Fed's moves, but rather to get their names in the various news stories describing these developments.