Saturday, March 29, 2008

Privatizing gains, socializing losses

Roger Lowenstein, author of When Genius Failed: the rise and fall of Long Term Capital Management, writes cogently about the credit crisis and government intervention in the Times Magazine.

I'd like to hear a believer in efficient markets try to tell the story of Bear Stearns' demise. One week it was OK for them to be levered 30 to 1, the next week it wasn't? When the stock was at 65 people were comfortable with their exposure to mortgages, but then suddenly they weren't? Come on. When the stock was at 65, what was the implied probability of a total collapse, based on out of the money puts? Zero.

Markets are complex dynamical systems that undergo phase transitions. Even sophisticated institutional investors are mostly just following the herd. Prices can disconnect wildly from real value for long periods of time, until suddenly they jump, often overshooting in the other direction. Huge risks, which in hindsight are obvious, build up in plain view while escaping notice from all but a few Cassandras. Robert Rubin, the Chairman of Citigroup, former co-head of Goldman, former Treasury Secretary, doesn't know what a SIV is until after the crisis has hit. Tens of trillions of dollars in off the books credit default swaps are traded (often recorded on scraps of paper!) before Wall St. CEOs, central bankers and regulators realize the instabilities involved.

More from James Surowiecki in the New Yorker. (I love this month's cover :-)

NYTimes: ...Government interventions always bring disruptions, but when Washington meddles in financial markets, the potential for the sort of distortion that obscures proper incentives is especially large, due to our markets’ complexities. Even Robert Rubin, the Citigroup executive and former Treasury secretary, has admitted he had never heard of a type of contract responsible for major problems at Citi.

Bear is a far smaller company, and, it would seem, far simpler. But consider that as recently as three weeks ago, it was valued at $65 a share. Then, as it became clear that Bear faced the modern equivalent of a bank run, JPMorgan Chase negotiated a merger with the figure of $10 a share in mind. Alas, at the 11th hour, Morgan’s bankers realized they couldn’t get a handle on what Bear owned — or owed — and got cold feet. Under heavy pressure from the Fed and the Treasury, a deal was struck at the price of a subway ride — $2 a share.

It is safe to say that neither Jamie Dimon, Morgan’s chief executive, nor Ben Bernanke, the Fed chairman who pushed for the deal, know what Bear is really worth. For the record, Bear’s book value per share is $84. As Meredith Whitney, who follows Wall Street for Oppenheimer, remarked, “It’s hard to get a linear progression from 84 to 2.”

Capitalism isn’t supposed to work like this, and before the advent of modern finance, it usually didn’t. Market values fluctuate, but — in the absence of fraud — billion-dollar companies do not evaporate. Yet it’s worth noting that Lehman Brothers’ stock also fell by half and then recovered within a 24-hour span. Once, investors could get a read on financial firms’ assets and risks from their balance sheets; those days are history.

Firms now do much of their business off the balance sheet. The swashbuckling Bear Stearns was a party to $2.5 trillion — no typo — of a derivative instrument known as a credit default swap. Such swaps are off-the-books agreements with third parties to exchange sums of cash according to a motley assortment of other credit indicators. In truth, no outsider could understand what Bear (or Citi, or Lehman) was committed to. The thought that Bear’s counterparties (the firms on the other side of that $2.5 trillion) would call in their chits — and then cancel their trades with Lehman, perhaps with Merrill Lynch and so forth — sent Wall Street into panic mode. Had Bear collapsed, or so asserted a veteran employee, “it would have been the end: pandemonium and global meltdown.”

Perhaps. Or perhaps, after some bad weeks or months, Wall Street would have recovered. What is scary is the degree to which the Fed assimilated the alarmism on the Street: “These guys are so afraid of an economic cycle,” a hedge-fund manager remarked. And without public airing or debate, it stretched the implicit federal safety net under Wall Street.

To question intervention is not to dispute that markets need rules. But for nearly two decades, Washington has trimmed its regulatory sails. The repeal of Glass-Steagall, which once separated banks from securities firms, and the evolution of new instruments that circumvent disclosure rules have loosened the market’s moorings. Huge pools of capital have been permitted to operate virtually unregulated. Mortgages have been written to the flimsiest of credits. Swelling derivative books have made a mockery of disclosure.

The relaxation of oversight has implied an unholy bargain: let markets operate unfettered in good times, confident that the feds will come to the rescue in bad. In 1998, the Fed intervened to cushion the collapsing hedge fund Long-Term Capital Management; dot-com stocks immediately began their dubious ascent. Then, when the tech meltdown led to a recession and the Fed cut rates to 1 percent, adjustable-rate mortgages became as hot as the iPod. One rescue begets the next excess.

It is true that Bear’s shareholders have suffered steep losses. But the Fed went much further than in previous episodes to calm the waters. Notably, it announced it would accept mortgage securities as collateral for loans — enlarging its role as lender of last resort. (Wall Street jesters had it that the Fed would also be accepting “cereal box-tops.”) Then the Fed extended a backstop line of credit to JPMorgan to tide Bear over; finally, it agreed to absorb the ugliest $30 billion of Bear’s assets.


jck said...

"Come on. When the stock was at 65, what was the implied probability of a total collapse, based on out of the money puts? Zero."
It wasn't zero if you looked at the CDS.

Anonymous said...

Steve, just wanted to take a moment to comment and say how much I love your blog and your commentary and your really great highlighting of excellent articles and speeches, etc. Keep it up! I always look forward to your newest posts, as they are some of the most thought-provoking in my RSS basket.

Steve Hsu said...

Sam: thanks for the kind words! Hope you are enjoying Yale :-)

JCK: good point... I doubt the implied prob. from equity puts was really zero, but probably much smaller than from CDS.

Anonymous said...

Enjoyed your article. I have been telling everyone for years that the us economy is headed fully toward what I call a perception based economy. People believe almost anything if more than a couple of people we think are smart agree. Even during this housomg mess. I remember an article in, I believe it was time or money that said what if the housing market collapsed. That was like two years ago. I even got caught up in one of Blackstone's botched buyouts. Do people ever look at real numbers anymore?

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