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To
the superstitious, recent developments in global financial
markets were possible reminders that the Ides of March
had arrived. To the more rational, they proved once
again that finance capital, which pillories the state
when it steps into the economic arena, finally uses
it as a means of accumulation and leans on it in times
of crisis.
On March 14, Bear Stearns, the fifth largest investment
bank in the United States with an 85-year history, was
put on life support with what appears to be an unlimited
loan facility for 28 days delivered through Wall Street
Bank J.P. Morgan Chase. The need for life support came
when it is became clear that, faced with a liquidity
crunch, Bear Stearns would have to unwind its assets
by selling them at prices that would imply huge losses.
This would have had spin off effects on other financial
firms since the investment bank had multiple points
of interaction with the rest of the financial community.
Besides being a counterpart to a range of transactions
that would turn questionable, its efforts to liquidate
its assets would affect other investors holding the
same or related securities and derivatives through a
price decline. Fearing that the ripple effects would
lead to a systemic collapse, the Fed, in collaboration
with JP Morgan, sought to prop up the investment bank.
The Financial Times quotes an unnamed official who reportedly
declared that Bear Stearns was too "interconnected"
to be allowed to fail at a time when financial markets
are extremely fragile. According to insiders, in addition
to the loans extended to Bear Stearns, the Fed has agreed
to fund up to $30 billion of its less liquid assets,
so as to prevent a distress sale of mortgage-backed
securities.
The Fed's support was clearly driven by two objectives.
The first was to keep Bear Stearns afloat so that its
liquidation would not trigger a financial collapse.
The second was to restore the firm to a condition where
it could find an appropriate suitor willing to take
it over. In fact, speculation was rife that with JP
Morgan being chosen as the conduit to deliver funds
to Bear Stearns, it would be in a privileged position
to take over the firm at an appropriate time.
That time arrived in two days. Clearly JP Morgan was
convinced that the support being offered was good enough
to help revive the enterprise from its pathetic position.
And a takeover when the firm is going through a crisis
and shareholders are looking to exit promises a better
bargain than when its health has been restored. Thus,
in a deal negotiated over a weekend and clinched on
a Sunday, JP Morgan agreed to buy Bear Stearns for $236
million in shares, or at a price of $2 a share. The
deal took Wall Street and the financial community by
surprise, not just because of the speed with which it
was executed. Rather, what was stunning was the price
- a 93 per cent discount on the price at which it was
being quoted at closing on the immediately preceding
Friday and way below the $169 at which the shares were
being traded just over a year ago. Further, the deal
gave JP Morgan ownership of Bear's headquarters in Manhattan's
Madison Avenue—a piece of real estate valued at $1.2
billion. The Fed's move had provided the basis for a
deal that would put prices quoted in bargain basements
to shame.
The import of the Fed's decision to support Bear Stearns
needs noting. The philosophy that rules financial markets
and financial policy today is that bail-outs by the
government of institutions that are weakened by wrong
financial decisions are inimical to the proper functioning
of markets in the long run. Such bail-outs are expected
to result in moral hazard problems, or the tendency
for agents protected against risk to behave recklessly,
that destroy markets. Moreover, they are seen as legitimising
interventionism, which then that leads to distortions
and financial repression that increases market inefficiency.
Indeed, the very financial liberalisation that created
the problems epitomised by the sub-prime crisis was
predicated on a critique of the efficacy and correctness
of intervention by the state. The "problem"
that liberalisation was directed to "solve"
could not itself become the solution to the problems
that liberalisation creates.
Further, even those who see in the Federal Reserve and
similar institutions a lender of last resort which must
step in when liquidity dries up and threatens financial
failure, see this role as relevant only to the commercial
banking sector, which takes deposits insured by the
deposit insurance corporation. Even that was a responsibility
that was linked to rights to regulate the commercial
banking system. The responsibility of ensuring liquidity
to unregulated or lightly regulated merchant banks and
other such segments of the financial system does not
conventionally rest with the central bank. In the circumstances,
the Federal Reserve had to adopt the unusual route of
routing its support through J P Morgan—a commercial
bank—in a back to back transaction that promises the
bank the liquidity needed to service demands from Bear
Stearns. According to a statement from JP Morgan: "Through
its discount window, the Fed will provide non-recourse,
back-to-back financing to JPMorgan Chase. Accordingly,
JPMorgan Chase does not believe this transaction exposes
its shareholders to any material risk."
According to one report, the Fed claims that it was
acting under section 13.3 of the Federal Reserve Act,
which gives it authority to lend to any individual,
partnership or corporation "in unusual and exigent
circumstances". But that authority has not been
invoked since the 1960s and loans under that regime
were actually disbursed only during the Depression in
the 1930s.
As opposed to liquidity problems that could afflict
a conventional bank, Bear Stearns' predicament was the
result of wrong decisions encouraged by a liberal or
lightly regulated and ostensibly "innovative"
financial framework. Though successful in the past,
it was a highly leveraged institution holding assets
valued at $395.4 billion in November 2007 on an equity
base of just $11.8 billion. Bear was also heavily exposed
to the "lucrative" sub-prime loan market that
has been on the decline since the middle of last year.
Eight months earlier the bank had declared that investments
in one of its hedge funds set up to invest in mortgage
backed securities had lost all its value and those in
a second such fund were valued at nine cents for every
dollar of original investment. Since then, the bank's
exposure to the mortgage market has been shown to be
substantial. The resulting losses were huge and creditors
were unwilling to keep providing the finance to back
investments that were dwindling in value. The bank broke
when hedge fund Carlyle Capital Corporation, to which
it was heavily exposed, went bankrupt. So would Bear
Stearns have, if the Fed had not stepped in with its
life support arrangements.
But this use of the state to rescue a mismanaged financial
enterprise (or system) does not begin or end with Bear
Stearns. The problems the latter faced eight months
back were a strong indicator of a sub-prime-led crisis
that had burgeoned because of financial greed, poor
and faulty financial practices and weak regulation.
What soon became clear was that the potential for crisis
in the mortgage market was huge, and the direct and
indirect exposure of leading financial firms to that
market was widespread both in terms of institutions
and geography. The entangled financial system that liberalisation,
securitisation and structured products of various kinds
had generated had put a wide variety of institutions
in the net. Since the base problem was massive the consequences
could be devastating.
The response was a decision across the world, but especially
in the US and the UK, for the state to step in, stall
a crisis and restore normalcy at the expense of the
tax payer if necessary. This whole strategy is based
on the idea that if financial institutions have enough
liquidity at relatively low costs to meet their needs
and do not have to unwind their assets at declining
prices the problem would in time go away. The net result
is huge cuts in interest rates and efforts to beef up
liquidity in the system. What the Bear Stearns experience
indicates is that the Fed is willing to reach that liquidity
‘almost' directly to unregulated institutions other
than commercial banks.
The problem these institutions faced was that the short
term financing they obtained from the market was in
exchange for the assets or securities they held, temporarily
sold only to be repurchased later. But with the value
of these securities declining, banks providing such
loans were asking for larger discounts or more collateral
or in fact were unwilling to lend against certain kinds
of securities. Just days before the near-collapse of
Bear Stearns the Fed had announced a facility under
which it would lend primary dealers in the bond market
$200billion in Treasury securities for a month at a
time and accept ordinary triple-A rated mortgage-backed
securities as collateral in return. That is, the Fed
was swapping good paper for paper which everybody believes
was wrongly rate and is as good as junk. The dealers
themselves could then use the Treasury securities to
borrow from the market. Unfortunately for Bear Stearns,
this rescue attempt came too late for it to exercise
the option.
But it is still unclear that this effort by the Fed
to break all rules and take on junk created by a malfunctioning
financial system would solve the problem. It leaves
the base problem of a mortgage crisis reflected in rising
defaults unresolved. That makes the assets sitting in
the books of many financial institutions worthless.
The issue is not just one of illiquidity but of insolvency.
But there is reason to believe that if easy and cheap
liquidity, which allows financial firms to access cheap
short term funds to finance higher return medium or
long term investments, does not help neutralise other
losses, the state would step in to restructure the capital
of these institutions at taxpayers' expense. This was
what was done during the savings and loan crisis in
the US. And this seems to be what was done in the case
of Northern Rock in the UK.
Northern Rock, the fifth largest mortgage lender in
the UK was also trapped in rising mortgage defaults,
and had to be rescued by the Bank of England with access
to liquidity against collateral in the form of mortgages
or mortgage backed securities. Sensing failure, depositors
queued up to withdraw their savings necessitating rapid
increases in lending to the institution. When it was
clear that it was insolvency that threatened Northern
Rock, the Bank of England and the Chancellor tried to
find a suitor who would buy into the bank. For that
purpose it declared that it was willing to convert the
£25 billion ($49 billion) Bank of England debt
it had incurred into bonds that would be backed by a
government guarantee so that they could be sold to investors.
The issue was how long the government would have to
guarantee the bonds, what would be the fee that would
be paid to the government as guarantor and what would
be the equity stake the government would get to make
a profit from equity appreciation when viability is
restored. Three private bidders who expressed an interest
in the deal were looking for a major sop from the government
that would guarantee them huge profits. When that was
not forthcoming, all but one (Richard Branson's Virgin
Group) withdrew, and the last was holding out for a
bargain. In the end the government had to nationalise
the bank rather than subsidise the private player to
earn the profit that the government helps generate.
Nationalisation of course implies that the institution
is being restructured with taxpayer funds that would
be recouped, if at all, only in the medium term. How
much private shareholders, include major funds, should
be compensated for what is a worthless enterprise without
government guarantees is being debated. Finance capital
seeks every means possible to accumulate at the expense
of the state, even in the midst of a crisis it has created.
Meanwhile, arguments from Northern Rock's private competitors
that government support makes the playing field unequal,
are being used to limit the lender's activities. This
could mean that the tax payers' money would not be recouped.
Martin Wolf, the conservative columnist for the Financial
Times (February 17, 2008) has to his credit supported
nationalization and opposed compensating shareholders.
But he has a rather intriguing suggestion as to where
the government should go from here: "The bank should
be nationalised and then closed for new mortgage business.
That is the only way to ensure that its continued existence
does not distort the mortgage market as a whole. It
would be the least bad end to this depressing saga."
But what about recouping the financing provided by the
government to cover loans from the central bank? The
government must wait, he says. Even if the loan book
is run down, "When the financial markets recover,
it should be possible to sell the residual loan book.
Provided its quality is as good as the auditors and
the Financial Services Authority have suggested, the
government should get back all the money it has lent
the bank." In sum: let the state we pillory carry
and pass the burden of preventing a financial collapse
to the tax payer for the present, and hope the markets
would compensate it for its good work in due time. |
