Yesterday morning in the New York Times, Andrew Ross Sorkin drew 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 JPMorgan (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, JPMorgan, Wall Street, neo-liberal economists who want the Fed to stay out of this mess, those that want to give relief to homeowners, and congressman 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 BSC could only seek Chapter 7 with the trustee being SIPC). 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 Mr. Sorkin’s column, The Prince is convinced that by focusing on the intrigues of how the Fed called the shots on the offer, he 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 JPMorgan’s bid. These actions clearly favor the argument that the Fed preferred the first bid, as Mr. 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 the lender of 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 the 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 BSC 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 liquidating 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 the Fed/Treasury will be 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 a $1bn cushion of first loss collateral from JPMorgan. What would happen if a broker-dealer is going down and there is no other broker-dealer to buy the company like JPM? This BSC deal better work, or we are 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 control of 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 banker and JPMorgan now assumes that title. JPMorgan 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 BSC 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 legitimate credit or a counterparty risk? That is all my loyal subjects.