Tuesday, March 18, 2008

Big Ben

You have to give Ben top marks for imagination at least.

Policy makers have been fretful for weeks about how to stop the market carnage without being seen as bailing out all those “reckless,” “opportunist,” even “fraudulent” I-bankers who helped create the mess in the first place.

So, over the weekend, Ben came up with a fine idea: “I can have my cake, and eat it too!” he thought.

Which, in the Fed’s lingo, translates into: “I’ll let a few “bad guys” go bust, but then come in Big to stop the bleeding.”

And so it went. Bear Stearns was allowed to collapse; its owners left in disbelief as they saw their shares plummeting from $86 a share in early January, to $30 last Friday, to a staggering $2 on Sunday—the price JP Morgan offered to pay for the company and “save” it from winding up. Then comes Ben’s turn.

“We have a situation here,” he thought. “If Morgan starts fire-selling all the crappy securities in Bear’s books in order to reduce its risk, this will lead to a new bloodbath. What to do?.... I’ll take it over!”

So comes the Fed and basically tells Morgan not to worry, it will assume the credit risk for $30 billion worth of (precisely!) the crappiest securities in Bear’s books that Morgan would rather not hold. Mainly mortgage-related, but also some corporate debt.

“To put it plainly, Morgan, do NOT go out and sell these in the market! If things go bad and their prices plummet, I’ll be there for you, I’ll cover the losses.” No, no bailout here. We’ll just call it a 30-billion-dollar “non-recourse facility.”

But Ben had a second ace in his sleeve, which looks like of the spades variety. He called that one the “Primary Dealer Credit Facility” (or PDCF). “We will now allow you I-bankers to come to our windows and borrow directly from us. The hell with tradition!”—whereby the only institutions that could borrow from the Fed are “depository institutions” (aka commercial banks or savings and loans institutions)… “These are exceptional times!”

“Indeed, we’ll break with tradition in more than one ways!” So not only can investment banks now borrow directly form the Fed, but the collateral they have to commit has been expanded to include securities that are less safe than the high-quality Treasury bills or Fannie and Freddie debt.

Now, let me say, this is Big! Extraordinary and BIG!

Big because it allows those in the eye of the storm to run directly to the Fed for help. Big because these guys can now pledge a larger set of securities as collateral, and therefore borrow more if they need to. And big because the Fed set no limit to the amounts it’s prepared to lend, though penalty fees (and potentially the Fed’s own balance sheet) may ultimately constrain the amounts lent.

To give you an idea: Let’s say I’m a bank and I hold pretty large amounts of securities whose prices are discovering new nadirs every day. So my creditors get nervous and start calling, demanding that I put in more capital in my margin account (remember those margin calls that brought Carlyle Capital down?) Now, if I fail to find the cash to pay them back, I’ll be forced to close down, even though I am solvent in principle. And that would be a rather unfortunate event of value destruction, wouldn’t it?

So here comes Ben and says “If it’s just liquidity you need, I will lend you the money, I will lend you unlimited amounts of money! But will the real insolvent ones among you please... fail?”

Now is Ben showing signs of genius here or is he just creating fancy synonyms for “bailout”? History will give the final verdict, obviously, though at least from a semantics point of view I would dare answer “a bit of both.” You see, a bailout is defined as a “rescue from financial distress” but there is a catch: That you, who bail me out, will pick up the bill. (Better yet, you pass it on to someone else!)

In this case, the Fed is picking up the “bill” of riskier securities on its balance sheet and the implications of potentially higher (much higher) liquidity in the system. The former could lead to market losses by the Fed (which would be ultimately be picked by you and me in the form of higher inflation and/or taxes); and the latter could lead to higher inflation, the cost of which would, once again, be picked up by you and me.

Yet, life is short, growth is the current mantra, and, if anything, markets seem a touch more comfortable as they are digesting the news. And in this kind of environment, it may turn out to be the case that the only ones to get whacked are the Bears.

Glossary: bailout, liquidity, solvency, inflation, Big Ben.

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