Deposit Insurance For Sophisticated Investors?

Posted by John Carney, Mar 19, 2008, 3:30pm

Has the bailout of Bear Stearn’s creditors created a precedent that implies a government guarantee for sophisticated investors doing business with investment banks? That’s what Nicole Gelinas argues in the editorial pages of the Wall Street Journal today.

[C]ounterparties on Bear's derivatives and other creditors like Bear's short-term financiers… should have known that they were taking on credit risk. Well, creditors are creditors; in a bankruptcy, they line up. What the Fed has done instead for these sophisticated investors is to offer them a rough approximation of FDIC insurance, even though they are not depositors and knew going in to the deals they had no such insurance.

For all the vague talk of “moral hazard” it’s nice to see Gelinas nail down one of the precise mechanisms. The Federal Reserve, with the help of JP Morgan, are rewarding lenders who extended financing to Bear Stearns and counter-parties who entered into complex derivative trades with the company despite—or perhaps out of ignorance of—the company’s shaky financial position. When you reward behavior, you get more of it. When you guarantee risk-taking, you get more risk. If Gelinas is right, the Fed’s intervention in the collapse of Bear Stearns may end up creating more risk rather than less in the financial markets.

The Bear Precedent [Wall Street Journal]

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Posted in: Bear Stearns

Comments

Posted by guest, Mar 19, 2008 3:39PM

ugh..what would von mises say...

Posted by Investorcluzo, Mar 19, 2008 4:25PM

if we must continue to speak about this topic…while nicole does make some good points, she also makes certain assumptions that don’t hold water. people do learn from past mistakes. lehman, for example, was much better positioned for this liquidity crisis as a result of their experience in 1998. do you think the banks will go back to their lax lending standards any time soon? just because the fed came in this time, doesn’t mean that people will assume they’ll do it again. let’s not forget how this all began – rumors. if the fed didn’t step in, I believe the next one would fall with greater alacrity because no one would want to be left holding the bag. perhaps you wouldn’t even get rumors first, just redemptions as the “smart” money looked to get out before the herd.

let’s be honest here, everyone knew what the big bad bear was doing: mortgages 24/7. how long have we known that RMBS/CMBS/CDO’s and the like were black boxes? at the very least, it’s been a year - and we still don’t know the value of the bear portfolio. in the final analysis, it will be worth what someone is willing to pay for it – we just don’t know who that “someone” is…yet (wilbur/warren?). soooo, should we punish everyone to make a point to the hedgies and the well to do? not in an election year!

Posted by guest, Mar 19, 2008 4:57PM

There's no moral hazard in pushing a feedback loop to a different stable state. The risk the Fed wants investors to price lower is the risk of a run on the bank, or of illiquidity. These aren't the sort of exogenous risks that entail moral hazard when investors are incented to misprice them. Multiple pricings can be correct, with different results for the economy.

Posted by diablo, Mar 19, 2008 5:00PM

The thing is that the SEC is the regulator for the securities dealers. But then the Fed gets involved and saves one from bankruptcy. Someone is getting something for nothing. If the Fed is going to stick its neck and rescue such outfits, then such outfits should be regulated by the Fed.

Posted by guest, Mar 19, 2008 8:48PM

From Nicole Gelinas:

To Guest #1: it was absolutely not a run on the bank. Bear Stearns's accountholders, as opposed to its creditors, would have been protected. Bear, by SEC law, is not allowed to commingle accountholders's assets with their own or to pledge them against liabilities. Therefore, even if every single accountholder pulled out at once, if Bear was adhering to regulations, the institution could have withstood such an event. It is simply not comparable to a real run on the bank, because banks don't have 100 percent capital to back up depositors' money. Custodial brokerages, including Bear, do (or are supposed to). Nor would these assets be frozen in a bankruptcy; creditors have absolutely no claim on them.

What really happened at Bear was a fleeing of creditors, including trading counterparties -- and there is no reason for the Fed to protect an institution against the flight of creditors. Banks and their counterparties understand this risk when the banks borrow short-term to lend long-term, or when they use their credit to back up their trades. Or, both parties should understand this risk; the ultimate risk you face on a trade is credit risk of the counterparty. Now the Fed has stepped in to give Bear's counterparties a better credit risk, JPM. This is unprecedented and very dangerous.

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