Did the Fed Create the Mother of All Moral Hazards?

Sure sounds like it here:

The Fed and Treasury created the mother of all moral hazards by the way they resolved the Bear collapse: they did not fully wipe out the Bear shareholders; they did not fire any of the senior management; they bailed out the creditors of an insolvent Bear; they subsidized heavily JPMorgan’s purchase of Bear; they provided a $30 billon lifeline that subsidizes Bear shareholders and management, Bear creditors and JPMorgan; and they provided – for the first time since the Great Depression – a new massive lender of last resort support to all non-bank primary dealers in the form of two new lending facilities (the TSLF and the PDCF).

Should Securities Firms be Regulated and Supervised like Banks?
Nouriel Roubini | Mar 23, 2008

The events of the last few weeks – including the collapse of Bear Stearns and of other highly leveraged, illiquid and insolvent institutions that are members of the shadow financial system – have shown that non bank financial institutions are at risk of liquidity runs in the same way as banks are. The response of the Fed to this bank-like runs on non-bank institutions has been the most radical change in monetary policy and lender of last resort support by the Fed since the Great Depression

Such lender of last resort support has been effectively extended to non-bank broker dealers that are among the primary dealers of the Fed. This radical extension of lender of last resort support to some non-banks has taken three forms: first, the $30 billion lending support that Bear Stearns received as part of its bailout/purchase by JPMorgan; second the new $200 billion facility that will allow all primary dealers to swap some of their illiquid assets (especially agency and private label MBS) in exchange for safe US Treasuries (the new TSLF facility); third allowing such primary dealers to access the Fed’s discount window at same terms as commercial banks (the new PDCF facility).

As it is well known destructive bank runs on illiquid but solvent banks can be addressed via bank holidays; but the risk that such bank holidays (freezing of deposits) may lead to runs on other depository institutions has led – historically – to two alternative ways to deal with bank runs: deposit insurance and lender of last resort support by the central banks. Since these forms of support potentially lead to moral hazard – bankers gambling for redemption and making risky loans and not managing properly liquidity risk – optimal policy management of such banking risks implies that these banking/depository institutions – that benefit from deposit insurance and central bank lender of last resort support – are also subject to strict regulation and supervision of their activities; such regulation and supervision is provided in most countries by the central bank but increasingly we see other models (a unified financial services regulator outside the central bank such as the UK’s FSA or regulation/supervision spread among a variety central or local government institutions as in the US).

Now that some non-bank financial institutions that have been deemed as too-systemically-important to be allowed to fail – i.e. Bear Stearns and non-bank primary dealers – have been effectively put under the lender of last resort support umbrella of the Fed the question arises: shouldn’t these non bank institutions be regulated and supervised in the same way as banks are? I.e. be regulated by the Fed and/or have both banks and non-bank securities firms be regulated by a common new institution? Note that currently US securities firms are supervised/regulated by the SEC and have lower capital standards than banks.

These are most complex and difficult questions that I will address in this note…

Let us start addressing these questions with a few general observations. While it may be tempting to subject all securities firms to the same regulation and supervision that banks receive it is important to note that only a few of such securities firms are systemically important and deserve the liquidity support of the Fed in case of a run on their liabilities. Since supervision and regulation on the same terms as banks would also potentially imply providing such securities firms with the same liquidity support that bank receive in the case of a run – a full blanket deposit insurance for all deposits/liabilities, access to the discount window and lender of last resort support by the central bank – it does not make sense to provide to systemically non-important securities firms such safety net as the risks of additional fiscal bailout costs of insolvent securities firms would be serious. Note that currently securities firms do not benefit from deposit insurance (as the token $500k insurance provided by SIPIC to securities firms creditors is meaningless when large creditors of such firms that are exposed to multiples of that $500k as they can withdraw billions or dozens of billions of dollars in a matter of days as it happened in the case of Bear Stearns).

While one can make the conceptual case that both banks and securities firms (and possibly even hedge funds and other members of the shadow financial system) should be subject to a uniform regulatory/supervisory environment (as they are all like banks highly leveraged institutions that borrow short and in liquid ways and lend/invest longer term and in more illiquid ways) it would be a most dangerous step to expand the lender of last resort support of the central bank to most non-bank financial institutions, even to all securities firms.

Securities firms – excluding the few that may be deemed as systemically important – should succeed or fail on their own without any explicit or implicit guarantee that they would receive liquidity support in case that they mismanage their credit, market and liquidity risks. As a rule non-bank financial institutions (with the exception of the few that are systemically important) that are illiquid should fail in case they mismanage their liquidity risk and are unable to find private source of emergency liquidity; and they should certainly fail if they are insolvent. The argument for providing lender of last resort support to non-banks can at most be made for the few institutions that – given their size, interconnectedness with the system and/or role in the payments and clearing system – are systemically important. These systemically important institutions should be regulated and supervised like banks and by the same regulator as the banks.

But since most of the creditors of such securities firms are not small and uninformed retail depositors but rather larger and more sophisticated investors a formal blanket deposit insurance of the type provided to banks should not be provided to such systemically important securities firms even if they were to be regulated like banks. Indeed sound policy suggests that securities firms should manage properly their liquidity and credit risks and that the creditors of such firms should also provide market discipline by having their claims at risk if the firm becomes insolvent: market discipline implies that such creditors should lend to such securities firms at rates that include all the relevant risks that they face. It would be a dangerous development if creditors of securities firms would be fully guaranteed in their claims as an important element of market discipline – unsecured and unguaranteed and subordinated liabilities of securities firms – would be dropped in case we were to provide deposit insurance to these firms on the same terms as banks.

This means that the only safety net that prevents destructive bank-like runs for the shadow financial system should be in the form of lender of last resort support to systemically important securities firms. Even in that case it would be most appropriate that creditors of insolvent – as opposed to illiquid – systemically important securities firms not be bailed out when such firms get in trouble. This is an important and crucial point that is relevant for the Bear Stearns case.

In the Bear Stearns case it has been argued that there was no bailout as the shareholders of Bear have been effectively wiped out. This argument is incorrect in many dimensions. First, since Bear was insolvent shareholders should have been wiped out 100%; the residual value of their equity – however little at $200m – means that they still fully own the firm and that they would benefit from increases in the market value of the firm that may derive from the liquidity support that the Fed provided if the JPMorgan deal does not go through.

Second, the Bear deal came with a huge – $30 billion – liquidity support by the Fed that has two consequences: JPMorgan was subsidized in its purchase of Bear; and creditors of Bears will not experience the losses that they would have incurred if Bear had been forced to close down. This latter point is crucial: since Bear was insolvent closing it down without the Fed loan would have implied that not only shareholders would have been wiped out 100% but also that other creditors of Bear – who lent without properly considering the significant risks that they were undertaking – would have suffered significant losses. Instead the Fed bailout made such creditors of Bear whole, a most disturbing and moral hazard laden outcome.

Third, not only Bear shareholders were not fully wiped out as they would have been if Bear had been allowed to go bankrupt; but all the senior management of Bear has been kept in place – starting with that reckless golf and bridge-AWOL Jimmy Cayne – when a proper solutions would have been to fire them all without any golden parachute or rich severance package.

So the appropriate resolution of the Bear insolvency – that would have minimized moral hazard given the Fed liquidity support – would have been to wipe out shareholders, wipe out senior management and then have Bear taken over by the government – rather than sold with a massive subsidy for JPMorgan – as public funds were being used to avoid the systemic effects of its collapse. Public money should have then be used not to bail out the creditors of Bear but rather to ensure an orderly disposal or sale of its operations including inflicting the appropriate losses on Bear’s creditors.

Instead the Fed and Treasury created the mother of all moral hazards by the way they resolved the Bear collapse: they did not fully wipe out the Bear shareholders; they did not fire any of the senior management; they bailed out the creditors of an insolvent Bear; they subsidized heavily JPMorgan’s purchase of Bear; they provided a $30 billon lifeline that subsidizes Bear shareholders and management, Bear creditors and JPMorgan; and they provided – for the first time since the Great Depression – a new massive lender of last resort support to all non-bank primary dealers in the form of two new lending facilities (the TSLF and the PDCF).

This is not the proper way to approach the serious problem of bank-like runs on insolvent or illiquid non-bank financial institutions and the issue of the appropriate redesign of a supervisory and regulatory system for a world dominated by the shadow financial system.

The reform and redesign of the now obsolete system of U.S. financial regulation and supervision is a most important policy goal. Lets leave for now aside the fact that a system where you have half a dozen or more federal regulators and fifty plus at the state level is a stone-age system that leads to a race to the bottom in terms of lower regulation and supervision. Given that most securities firms look like banks – they borrow short/liquid, they are highly leveraged and they lend/invest in longer terms and illiquid forms – it is appropriate that their regulation and supervision should be at terms similar to those of banking/depository institutions, including especially similar capital adequacy at both types of institutions.

But even if securities firms should be regulated and supervised like banks the safety net system that banks receive – deposit insurance, access to the discount window and lender of last resort support from the central bank – should not be applied in a blanket form to all securities firms. Certainly publicly provided full deposit insurance should not be provided to any securities firm, even to systemically important ones. Let the private sector provide such insurance and/or force securities firms to properly manage their liquidity risk by imposing – via regulation – greater liquidity ratios for securities firms than for banks. The only form of public support that only systemically important securities firms should receive – to avoid destructive liquidity runs – should then be an appropriately designed lender of last resort support from the central bank.

Even such support should be qualified in a number of ways: it should not be certain as some degree of constructive ambiguity would reduce the moral hazard distortions of a too-big-to-fail perception; so which securities firm is too-big or too-systemically important to be allowed to fail should remain ambiguous and the size of the support should also be uncertain. More importantly, such lender of last resort support should not lead to losses for the creditors of such securities firms only if the firm is illiquid and subject to a run on its liquid liabilities. If it turns out that the firm being provided the lender of last resort support by the central bank is insolvent any public liquidity injection should be strictly aimed at avoiding a disorderly wind-down of the firm; i.e. such support should not be provided to bail out either the shareholders or the creditors of the firm; not only the shareholders but also the creditors of the firm should suffer the full consequences of their poor lending and investment decisions. This also means that insolvent securities firms should go under the same receivership process as depository institutions, especially if public funds are provided to allow an orderly rather a disorderly disposal of their assets.

Much more needs to be done to resolve the current systemic financial crisis, the worst since the Great Depression, to fix and reform the modern financial system and its regulation/supervision to reduce the risk of future systemic crises of the sort that we are experiencing today. The above thoughts, suggestions and principles are only a small sub-set of the reform issues that need to be addressed. But since the Fed has suddenly – and without any previous consultation – now changed in the most radical way the previous safety net system for financial institutions that existed since the Great Depression – effectively extending its lender of last resort support to non-bank systemically important securities firms – it is very important that a reform of the system of regulation and supervision of bank and non-bank financial institutions be implemented rapidly and in ways that do not increase a variety of moral hazard distortions.

Securities firm will certainly aggressively resist and lobby against the new proposals to regulate them in the way that banks are (especially since the SEC regulation has been proven toothless and the capital adequacy standards for securities firms are much lower than those for banks). But as the joke goes around these days: “What is the difference between a bank and a hedge fund? The bank is more highly leveraged” the same can be said of securities firms: they are even more leveraged and engaging in risky investment/lending than banks are.

The kind of reckless high leverage, pathetic “risk management”, including massive underestimation of liquidity and credit risk, that occurred among banks, broker dealers and other securities firms and members of the shadow financial system for the last few years has been an unmitigated disaster that has led – with regulators and supervisors being asleep at the wheel – to the worst financial crisis that the US has experienced since the Great Depression, a crisis that may likely lead to the most severe economic recession of the last few decades. It is now time to punish the reckless lenders and investors and let them suffer the financial losses that they deserve – including the bankruptcy of many insolvent firms and financial institutions and the losses of their shareholders and creditors.

But since public resources – first the Fed’s liquidity support and eventually the tax-payers money – will have to be used to sort out this mess and avoid the severe collateral damage of a systemic financial crisis causing an even more severe and protracted economic recession than the one that we cannot any longer avoid, it is important to rapidly take the proper policy actions that minimize such collateral damage at the minimum cost for the taxpayer.

But so far all the actions of the Fed and of the Treasury have been concentrated in helping financial institutions that made reckless investment and lending decisions; whether you call this help a bail out of the financial system or not all the policy actions have so far targeted the support of lenders and investors rather than the suffering mortgage borrowers: Fed Funds sharp easing providing a subsidy to financial firms via a steepening of the yield curve and rising intermediation margins for banks and financial firms; the variety of Fed’s new liquidity facilities for banks and non-banks; the explicit liquidity support of non-banks; the variety of actions allowing the Fed, the FHA and Fannie and Freddie to swap or buy hundreds of billions of mortgages and mortgage backed securities; the massive support that the FHLB system has provided to mortgage lenders. So far not a penny of public money has been spent to directly help the distressed borrowers, the millions of households that are underwater and/or unable to service their mortgages and their debts. It is thus time to start implementing strong and effective policies that will resolve this crisis rather than rely on policies that have so far provided band-aid support only to the financial system.

Times of severe crisis require bold, comprehensive and effective policy action, not the piecemeal and incoherent set of actions that have so far sequentially plugged one crisis hole a day when two larger ones emerge every other day in this bloodbath of a systemic financial crisis.

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