The BS Bailout
“For the government to print money at the expense of taxpayers as opposed to requiring or going about a receivership and wind-down of any insolvent institutions should be troubling to taxpayers and regulators alike,” said Josh Rosner, an analyst at Graham Fisher & Company and an expert on mortgage securities. “The Fed has now crossed the line in a very clear way on ‘moral hazard,’ because they have opened the door to the view that they are required to save almost any institution through non-recourse loans — except the government doesn’t have the money and it destroys the U.S.’s reputation as the broadest, deepest, most transparent and properly regulated capital market in the world.”The key is to find some way to accomplish the Fed's goal of reducing financial contagion without risking taxpayer money to help some of the least needy members of society--an action that sacrifices both the goal of efficiency (via moral hazard) and the goal of equality.
A few days ago, the Wall Street Journal reported a suggestion from economist Myron Scholes about structuring bailouts of financial institutions:
Here is another off-the-wall idea that someone proposed to me: Why not make senior management personally guarantee the loans made in any such bailout? (I presume they have significant assets beyond their equity stake in the firm.) Given the sums involved, that won't offer the taxpayer a lot of protection. But at least it will make some of the guys responsible for the mess squirm just a little bit more.
there's a conundrum. If the government guarantees or buys debt from the bank, it makes the equity holders better off. If it buys equity and dilutes existing shareholders, it makes debt holders better off.
Mr. Scholes's solution: Let government invest both in debt senior to existing debt and in preferred stock senior to existing shares. Neither is advantaged versus the other. The bank doesn't dump assets and expands lending. If all goes well, the government gets out with a profit.
Update: A reader more knowledgable than I am tells me:
the Fed action is like spraying foam on the runways -- the plane is still going to crash and not fly again, but the people on board will hopefully walk away with just bruises. Or in english, having Bear collapse in a day would have led to problems with people who rely on them for clearing trades. The Fed action won't save Bear but will avoid fallout that disrupts markets by even more.This analysis is turning out to be right: The WSJ now reports that JP Morgan will buy Bear Stearns for $2 a share, compared with $30 at Friday's close and about $100 a few months ago.
This paragraph from the WSJ story, however, is worrisome:
To help facilitate the deal, the Federal Reserve is taking the extraordinary step of providing as much as $30 billion in financing for Bear Stearns's less-liquid assets, such as mortgage securities that the firm has been unable to sell, in what is believed to be the largest Fed advance on record to a single company. Fed officials wouldn't describe the exact financing terms or assets involved. But if those assets decline in value, the Fed would bear any loss, not J.P. Morgan.Someone (I forget who) recently called the Fed "the pawnbroker of last resort."