Leaning on the State C.P. Chandrasekhar

To the superstitious, recent developments in global financial markets were possible reminders that the Ides of March had arrived. To the more rational, they proved once again that finance capital, which pillories the state when it steps into the economic arena, finally uses it as a means of accumulation and leans on it in times of crisis.

On March 14, Bear Stearns, the fifth largest investment bank in the United States with an 85-year history, was put on life support with what appears to be an unlimited loan facility for 28 days delivered through Wall Street Bank J.P. Morgan Chase. The need for life support came when it is became clear that, faced with a liquidity crunch, Bear Stearns would have to unwind its assets by selling them at prices that would imply huge losses. This would have had spin off effects on other financial firms since the investment bank had multiple points of interaction with the rest of the financial community. Besides being a counterpart to a range of transactions that would turn questionable, its efforts to liquidate its assets would affect other investors holding the same or related securities and derivatives through a price decline. Fearing that the ripple effects would lead to a systemic collapse, the Fed, in collaboration with JP Morgan, sought to prop up the investment bank. The Financial Times quotes an unnamed official who reportedly declared that Bear Stearns was too “interconnected” to be allowed to fail at a time when financial markets are extremely fragile. According to insiders, in addition to the loans extended to Bear Stearns, the Fed has agreed to fund up to $30 billion of its less liquid assets, so as to prevent a distress sale of mortgage-backed securities.

The Fed’s support was clearly driven by two objectives. The first was to keep Bear Stearns afloat so that its liquidation would not trigger a financial collapse. The second was to restore the firm to a condition where it could find an appropriate suitor willing to take it over. In fact, speculation was rife that with JP Morgan being chosen as the conduit to deliver funds to Bear Stearns, it would be in a privileged position to take over the firm at an appropriate time.

That time arrived in two days. Clearly JP Morgan was convinced that the support being offered was good enough to help revive the enterprise from its pathetic position. And a takeover when the firm is going through a crisis and shareholders are looking to exit promises a better bargain than when its health has been restored. Thus, in a deal negotiated over a weekend and clinched on a Sunday, JP Morgan agreed to buy Bear Stearns for $236 million in shares, or at a price of $2 a share. The deal took Wall Street and the financial community by surprise, not just because of the speed with which it was executed. Rather, what was stunning was the price – a 93 per cent discount on the price at which it was being quoted at closing on the immediately preceding Friday and way below the $169 at which the shares were being traded just over a year ago. Further, the deal gave JP Morgan ownership of Bear’s headquarters in Manhattan’s Madison Avenue—a piece of real estate valued at $1.2 billion. The Fed’s move had provided the basis for a deal that would put prices quoted in bargain basements to shame.

The import of the Fed’s decision to support Bear Stearns needs noting. The philosophy that rules financial markets and financial policy today is that bail-outs by the government of institutions that are weakened by wrong financial decisions are inimical to the proper functioning of markets in the long run. Such bail-outs are expected to result in moral hazard problems, or the tendency for agents protected against risk to behave recklessly, that destroy markets. Moreover, they are seen as legitimising interventionism, which then that leads to distortions and financial repression that increases market inefficiency. Indeed, the very financial liberalisation that created the problems epitomised by the sub-prime crisis was predicated on a critique of the efficacy and correctness of intervention by the state. The “problem” that liberalisation was directed to “solve” could not itself become the solution to the problems that liberalisation creates.

Further, even those who see in the Federal Reserve and similar institutions a lender of last resort which must step in when liquidity dries up and threatens financial failure, see this role as relevant only to the commercial banking sector, which takes deposits insured by the deposit insurance corporation. Even that was a responsibility that was linked to rights to regulate the commercial banking system. The responsibility of ensuring liquidity to unregulated or lightly regulated merchant banks and other such segments of the financial system does not conventionally rest with the central bank. In the circumstances, the Federal Reserve had to adopt the unusual route of routing its support through J P Morgan—a commercial bank—in a back to back transaction that promises the bank the liquidity needed to service demands from Bear Stearns. According to a statement from JP Morgan: “Through its discount window, the Fed will provide non-recourse, back-to-back financing to JPMorgan Chase. Accordingly, JPMorgan Chase does not believe this transaction exposes its shareholders to any material risk.”

According to one report, the Fed claims that it was acting under section 13.3 of the Federal Reserve Act, which gives it authority to lend to any individual, partnership or corporation “in unusual and exigent circumstances”. But that authority has not been invoked since the 1960s and loans under that regime were actually disbursed only during the Depression in the 1930s.

As opposed to liquidity problems that could afflict a conventional bank, Bear Stearns’ predicament was the result of wrong decisions encouraged by a liberal or lightly regulated and ostensibly “innovative” financial framework. Though successful in the past, it was a highly leveraged institution holding assets valued at $395.4 billion in November 2007 on an equity base of just $11.8 billion. Bear was also heavily exposed to the “lucrative” sub-prime loan market that has been on the decline since the middle of last year. Eight months earlier the bank had declared that investments in one of its hedge funds set up to invest in mortgage backed securities had lost all its value and those in a second such fund were valued at nine cents for every dollar of original investment. Since then, the bank’s exposure to the mortgage market has been shown to be substantial. The resulting losses were huge and creditors were unwilling to keep providing the finance to back investments that were dwindling in value. The bank broke when hedge fund Carlyle Capital Corporation, to which it was heavily exposed, went bankrupt. So would Bear Stearns have, if the Fed had not stepped in with its life support arrangements.

But this use of the state to rescue a mismanaged financial enterprise (or system) does not begin or end with Bear Stearns. The problems the latter faced eight months back were a strong indicator of a sub-prime-led crisis that had burgeoned because of financial greed, poor and faulty financial practices and weak regulation. What soon became clear was that the potential for crisis in the mortgage market was huge, and the direct and indirect exposure of leading financial firms to that market was widespread both in terms of institutions and geography. The entangled financial system that liberalisation, securitisation and structured products of various kinds had generated had put a wide variety of institutions in the net. Since the base problem was massive the consequences could be devastating.

The response was a decision across the world, but especially in the US and the UK, for the state to step in, stall a crisis and restore normalcy at the expense of the tax payer if necessary. This whole strategy is based on the idea that if financial institutions have enough liquidity at relatively low costs to meet their needs and do not have to unwind their assets at declining prices the problem would in time go away. The net result is huge cuts in interest rates and efforts to beef up liquidity in the system. What the Bear Stearns experience indicates is that the Fed is willing to reach that liquidity ‘almost’ directly to unregulated institutions other than commercial banks.

The problem these institutions faced was that the short term financing they obtained from the market was in exchange for the assets or securities they held, temporarily sold only to be repurchased later. But with the value of these securities declining, banks providing such loans were asking for larger discounts or more collateral or in fact were unwilling to lend against certain kinds of securities. Just days before the near-collapse of Bear Stearns the Fed had announced a facility under which it would lend primary dealers in the bond market $200billion in Treasury securities for a month at a time and accept ordinary triple-A rated mortgage-backed securities as collateral in return. That is, the Fed was swapping good paper for paper which everybody believes was wrongly rate and is as good as junk. The dealers themselves could then use the Treasury securities to borrow from the market. Unfortunately for Bear Stearns, this rescue attempt came too late for it to exercise the option.

But it is still unclear that this effort by the Fed to break all rules and take on junk created by a malfunctioning financial system would solve the problem. It leaves the base problem of a mortgage crisis reflected in rising defaults unresolved. That makes the assets sitting in the books of many financial institutions worthless. The issue is not just one of illiquidity but of insolvency.

But there is reason to believe that if easy and cheap liquidity, which allows financial firms to access cheap short term funds to finance higher return medium or long term investments, does not help neutralise other losses, the state would step in to restructure the capital of these institutions at taxpayers’ expense. This was what was done during the savings and loan crisis in the US. And this seems to be what was done in the case of Northern Rock in the UK.

Northern Rock, the fifth largest mortgage lender in the UK was also trapped in rising mortgage defaults, and had to be rescued by the Bank of England with access to liquidity against collateral in the form of mortgages or mortgage backed securities. Sensing failure, depositors queued up to withdraw their savings necessitating rapid increases in lending to the institution. When it was clear that it was insolvency that threatened Northern Rock, the Bank of England and the Chancellor tried to find a suitor who would buy into the bank. For that purpose it declared that it was willing to convert the £25 billion ($49 billion) Bank of England debt it had incurred into bonds that would be backed by a government guarantee so that they could be sold to investors. The issue was how long the government would have to guarantee the bonds, what would be the fee that would be paid to the government as guarantor and what would be the equity stake the government would get to make a profit from equity appreciation when viability is restored. Three private bidders who expressed an interest in the deal were looking for a major sop from the government that would guarantee them huge profits. When that was not forthcoming, all but one (Richard Branson’s Virgin Group) withdrew, and the last was holding out for a bargain. In the end the government had to nationalise the bank rather than subsidise the private player to earn the profit that the government helps generate.

Nationalisation of course implies that the institution is being restructured with taxpayer funds that would be recouped, if at all, only in the medium term. How much private shareholders, include major funds, should be compensated for what is a worthless enterprise without government guarantees is being debated. Finance capital seeks every means possible to accumulate at the expense of the state, even in the midst of a crisis it has created. Meanwhile, arguments from Northern Rock’s private competitors that government support makes the playing field unequal, are being used to limit the lender’s activities. This could mean that the tax payers’ money would not be recouped.

Martin Wolf, the conservative columnist for the Financial Times (February 17, 2008) has to his credit supported nationalization and opposed compensating shareholders. But he has a rather intriguing suggestion as to where the government should go from here: “The bank should be nationalised and then closed for new mortgage business. That is the only way to ensure that its continued existence does not distort the mortgage market as a whole. It would be the least bad end to this depressing saga.” But what about recouping the financing provided by the government to cover loans from the central bank? The government must wait, he says. Even if the loan book is run down, “When the financial markets recover, it should be possible to sell the residual loan book. Provided its quality is as good as the auditors and the Financial Services Authority have suggested, the government should get back all the money it has lent the bank.” In sum: let the state we pillory carry and pass the burden of preventing a financial collapse to the tax payer for the present, and hope the markets would compensate it for its good work in due time.