21st Century Central Banking

The problem of dealing with moral hazard in 21st-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 (BSC) 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, which 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 (JPM) 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 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.

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-21st-century-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

[fatcat]

Is this ,like , the financial Peter Principle in reverse? How else would you keep these assholes in line?

[icandoitdon]

the federal reserve is not our friend either. by rescuing counterparties the fed is perpetuating the problem, which is excess leverage in the financial system and the excessive use of complex financial instruments that can neither be understood by investors or priced.

let em go broke. the system will fix itself, thank you very much.

[bearfund]

All this assumes that "systemic risk" is really a grave threat. The banking system as a whole adds far less value than those who participate in it would presume and certainly far less than its size would indicate. Most healthy economies are focused on productivity, savings, and investment, and use credit sparingly. That the banking sector is so large is an indication not of its worth but of the sickness of the economy. Allowing large parts of it to fail would be a form of heroic medicine.

[investorslive]

What are your thoughts for the rate cut? or will they leave it alone?

Have you checked out www.investorslive.com/.../

[ponchovilla]

The moral of this story is be like Warren Buffet: get far away from these folks and go fishing.

[sivere]

In order for the banking system to survive further into the 21st century, we need to

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