March 31, 2008
The crisis in the sub-prime mortgage market in the US became headline news when a couple of hedge funds, managed by Bear Stearns, the fifth largest investment bank in the US, collapsed under the weight of the mortgage securities it had invested in.
A couple of weeks back, in a takeover supported and partly engineered by the US Federal Reserve, Bear Stearns was acquired by J P Morgan. Could this signal the beginning of the end of the crisis in the credit market, the most visible manifestation of which has been the extreme reluctance of banks to lend even to each other?
There are some signs of this: stock markets seem to be stabilising and so has the dollar on the exchange market (but threats remain); possible downgrading of the bond insurance companies, which have guaranteed hundreds of billions of dollars of municipal and other bonds, is no longer making headline news; but despite lower interest rates and house prices 10 per cent below their peak, the downside continues.
Bear Stearns was a haughty investment bank specialising in the packaging and selling of mortgage securities. It was much less global than its bigger competitors (Goldman Sachs, Morgan Stanley, Merrill Lynch and Lehman Brothers), and had famously refused to participate in the rescue of Long Term Capital Management (LTCM), the hedge fund, also engineered by the Federal Reserve just about a decade back. (One wonders whether the gods of banking punish those displaying hubris - remember how the Allied Irish Bank suffered a trading loss of $700 mn, a few years after boasting publicly that what happened in Bearings would never happen in AIB?
More recently, Societe Generale had for long prided itself on its sophisticated models and systems.) The Fed's involvement in the rescue of an investment bank, as distinct from a commercial bank, has raised several eyebrows and questions about the role and responsibilities of central banks.
While acting as lenders of last resort and rescuers of commercial banks is a traditional and well accepted function (only recently, Bank of England had to put in as much as �30 bn in Northern Rock, a troubled British Bank, since taken over by the government), putting public money in the rescue of an investment bank is hardly a normal central bank function.
And, make no mistake: a lot of public money, as much as $30 bn, is involved in the takeover of Bear Stearns by J P Morgan. This is the amount lent by the Fed to the now defunct investment bank in return for its highly questionable assets in the form of mortgage securities. In fact, Morgan's own investment is quite modest. It had originally bought the bank at just $2 per share or an enterprise value of less than $250 mn - a year back, the share was valued at $170, and at $30 barely one week before the takeover. (The book value is $80 per share!) Morgan has since increased the price to $10 per share, and also agreed to pick up the first $1 bn of losses resulting from the bank's asset portfolio - still, not a bad deal.
It seems the hands of the Fed were forced by Bear Stearns' inability to raise money even in the overnight repo market! After all, Bear Stearns was counterparty to derivatives with an aggregate notional principal of as much as $10 trillion! Clearly, a major systemic risk was involved in its collapse and hence the use of public money in its rescue. The case once again emphasises the hollowness of market fundamentalism - no wonder the Chief Executive of Deutsche Bank recently expressed that he is no longer confident in the market's ability to correct its own excesses. (Keynes 1, Friedman 0?) Another point is worth taking note of. It is increasingly fashionable to argue about separating banking supervision from the central bank function of creating and curtailing the supply of money. The credit default swap spreads with banks as reference entities are ruling much higher than even some BBB rated corporates! The accepted jargon is to refer to financial markets in Europe and the US as "mature" (even commentators in India use the term). The implication of course is that the other markets, India and China for example, function in less than mature (childish?) fashion. What happened in the dotcom bubble in the late 1990s, and in the mortgage market recently, to quote only two instances, clearly raise questions about the so-called maturity of the US financial market.
What the experience in the cases of Northern Rock in the UK and Bear Stearns in the US suggests that, when the crunch comes, the ability to put in money is crucial! A couple of other interesting points:
One thought: the plight of a million people thrown out of their houses because of mortgage defaults in the current crisis, has not found even a 100th of the space occupied by the plight of the banking system.
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