Sunday, April 6, 2008

Systemic Risk Squad

If Hollywood ever makes a movie on the “rescue” of Bear Stearns, I bet you the title will feature two words: “Systemic risk.” Not your typical box office mega-hit title, you might think, but I can assure you that “Systemic Risk Squad” can be at least as “sexy” as “Live Free or Die Hard.”

Perhaps a first step in this direction would be to define what systemic risk is—admittedly a bit of a challenge. There is more than one definitions floating around policy-making and academic circles which, despite sharing common elements, are far from identical. So before getting there, I’ll first give you the “you’ll know it when you see it” version.

Let’s say you are a homeowner in suburban Detroit and, with the economy going downhill, you’ve just lost your job at the nearby Chrysler plant. Suddenly, the cost of keeping up with your mortgage payments, on top of feeding your two kids, wife and poodle, becomes unaffordable. So you stop paying, your bank gets upset, your home goes into foreclosure and you get kicked out. But… who cares? Your wife and kids, surely, your local barber perhaps, possibly the poodle. But that’s about it. Put it simply, you’re not of “systemic” importance.

Bear Stearns though… that’s another story. First of all Bear is big—multibillion-dollar-big. And in the context of a closely intertwined financial system, “big” means interconnected with a large number of market players, both as a matter of fact and as a matter of association. By matter-of-fact connections I mean those guys who would get directly smacked by a Bear bankruptcy… Like Bear’s trading counterparties (e.g. fixed income traders or other investment banks); hedge funds who use Bear as an intermediary to borrow money or clear trades (and who therefore keep cash with Bear); or money market funds who have invested in Bear Stearns debt.

By matter-of-association I mean those hit indirectly, because of owning similar types of securities as those held by Bear—say mortgage backed securities (MBS), a Bear favorite. The danger being that, if Bear went bust and were forced to liquidate its (huge) MBS holdings, MBS prices would go into a tailspin, and this can’t be good for anyone owning them.

Worse, a Bear bankruptcy could start breeding suspicions in investors’ minds that what went wrong at Bear could also go wrong at other banks with similar investment portfolios. And with markets crashing, investors nervous and information about who-holds-what blurry at best, “speculation” becomes the word du jour and people start pulling out of banks that (poor guys!) might have been solvent otherwise (think “Lehman Brothers”!). Speculations thus become self-fulfilling, more banks go bankrupt, fire sales ensue, markets crash.

Now that’s systemic!

And by the way, in case you were thinking: “Rich bankers getting hammered…. who cares?” Well, you, actually. You may not hold mortgage-backed securities, but you likely have a mortgage (or aspire to one). And, unfortunately, if those bankers stopped buying MBS, your mortgage rates would go up. In fact it’s bigger than that. With banks going down, and stocks markets copying them, the cost of borrowing will shoot up for absolutely everyone—a rather lousy outcome whether you’re called Alan Scwartz, Ben Bernanke or Joe Schmoe.

But let’s go back to our movie. We have a trigger event (the subprime meltdown); collateral damage (crisis spreading to “prime” securities); panic and fear (market stampede); a looming fatality (Bear Stearns); the threat of a catastrophic chain of explosions (stock markets spiraling down, other banks going bust); the clock ticking (solution must be found before the Asian market open, else...); inspector squads dispatched; accountants on the scene (checking how “fatal” Bear’s portfolio really is) ; sleepless nights at the New York Fed; 5am phone calls; coldblooded negotiations; clandestine deals; relief!!... a brave rescuer emerges (JP Morgan Chase)…. Just in time of course!

There you go. The broad outline of “Systemic Risk Squad.” True, not enough romance perhaps. Though you can always fit in some sultry brunette trickling herself into her near-demise while running on her bank in her Jimmy Choo’s. At which point the unassuming-yet-intrepid Tim Geithner throws himself to her rescue. Len Wiseman prepare!

Still.. you might wonder. Bear Stearns is “systemic” alright, so let’s save it. But in a world where capital markets and non-banks such as hedge funds, conduits, SIVs and the like are increasingly important (see “systemic”) in the capital allocation game, why should we just save banks? Applying the “Bear logic”, the Fed might as well proceed with the “model bail-out:” Step in and buy the ailing MBS securities directly from the markets. Why not? In fact, the parallel has been drawn many a time, and the present crisis has raised the urgency of adapting the existing regulations to better reflect the shift of financial intermediation away from banks.

Better yet.. You can extend the Bear case beyond Wall Street, to Main Street. Think of this scenario: More foreclosures; a higher inventory of unsold homes; pressure on house prices builds up; the downward spiral continues; more homeowners enter the negative-equity territory; more foreclosures ensue, etc etc. Hmmm.. rings a bell. A “trigger event”.. a “chain of bad consequences”… house prices into tailspin.. many fatalities… Smells “systemic” enough for willing (and/or politically-expedient) politicians to use it as the rationale for direct government intervention to save homeowners from losing(/leaving) their (unaffordable) homes.

And yes, in that case, even Joe Schmoe can be an action movie hero!

Glossary: systemic risk, self-fulfilling expectations, fire sales, Jimmy Choo, Die Hard.

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