Fed's Intervention

Minutes from a high-stakes Federal Reserve meeting on the emergency rescue of Bear Stearns are out this morning, and they are revealing.(Video can be found on YouTube)

They provide fresh detail on what went on behind the scenes of the Fed-orchestrated shotgun wedding between JPMorgan Chase and Bear Stearns, including fears of a “contagion” spreading through the market if Bear Stearns was allowed to collapse.

The contagion here refers to the fact that Bear Stearns operated one of the country’s largest clearing operations, and a collapse would have cascaded through the system, causing calamity in counterparty trades.

Let’s recap. Bear Stearns had $360b in assets and liabilities at the time it went belly-up. It had $12b in shareholder equity, or net worth, to support that book of business.

The bonds on its books were getting crushed by the subprime crisis, so much so that two of Bear’s own hedge funds went belly-up last July, with the two former hedge fund managers subsequently arrested for alleged securities fraud and conspiracy, among other things. A cash run on the bank leading up to its St. Patrick’s day rescue put Bear Stearns on the brink of bankruptcy.

JPMorgan Chase’s chairman and chief executive Jamie Dimon initially balked at the thought of his bank taking on Bear’s colossal balance sheet, and rejected a deal. “I tell people that buying a house is not the same as buying a house on fire,” Dimon testified before Congress later (Dimon sits on the board of governors of the New York Federal Reserve).

The Fed then stepped in with an initial $30b loan, and then JPMorgan agreed to buy Bear Stearns for $2 a share, or $236m. JPMorgan increased its offer to $10 a share a week later amid a revolt by the smaller firm’s shareholders.

Back to the $30b loan JPMorgan got from the Fed to seal the deal, supported by Bear securities that the two sides say were valued, or marked to market, at $30b as of March 14.

The Fed came up with as novel a rescue as it could. Using a creative read of section 13A of the Federal Reserve Act, the New York Fed agreed to lend JPMorgan $30 bn over 10 years at a small 2.5% rate, a loan backed by a similar amount of Bear Stearns’ assets. Never before had the Fed taken on mortgage-backed securities as collateral. The Fed is now holding those assets to maturity and is not marking them to market, analysts note.

JP Morgan subsequently agreed to absorb the first $1b of losses on that $30b if the value of the assets backing its loan declines. Again, if that portfolio drops in value, JP takes the first $1b in losses. If the portfolio zeroes out, the Fed takes a $29b hit. The assets now sit in a Delaware limited liability company.

The Fed minutes show that JPMorgan “had requested assistance in financing a specific pool of assets that Bear Stearns had difficulty financing in the market” and that JPMorgan Chase “believed added significant uncertainty to the level of risk it would assume” in its acquisition of Bear Stearns.

To seal the deal, the minutes show that the Fed gave JPMorgan Chase, among other things, an 18-month exemption from the Fed’s statutes requiring banks to hold a certain amount of capital on its books against its risk-weighted assets. Banks also must adhere to international debt to capital ratios under the Basel accords. The capital ratio is the percentage of a bank’s capital to its risk-weighted assets.

The Fed let JPMorgan “exclude the assets and exposures of Bear Stearns” from its risk-weighted assets for purposes of applying the risk-based capital requirements” at the bank. The Fed also let JPMorgan “exclude the assets of Bear Stearns from the denominator of its tier 1 leverage capital ratio” requirements, noting that “each exemption would be reduced over time.”

The relaxation of the standards was necessary to stop a disaster the Fed says it saw coming if Bear went under.

Also, “by agreeing to lend against a portfolio of securities, we reduced the risk that those assets would be liquidated quickly, exacerbating already fragile conditions in the markets,” New York Federal Reserve Bank president Timothy Geithner testified before Congress in defending the deal.

A fire sale would have created chaos in an already crazy market.

Now the debate is just what is in that $30b pool of assets, given that the Fed is taking on this credit at a time when the government is already levered to the hilt, what with what is going on at Fannie Mae and Freddie Mac. The New York Fed hired Black Rock, 49% owned by Merrill Lynch, to cherry pick the best assets off of Bear’s books to use as collateral. Both sides signed a confidentiality agreement covering those assets–-why tip your hand to the market and invite unwanted arbitrage?

Only broad descriptions are available. The Bear assets are collateralized mortgage obligations, the majority of which are obligations backed by the likes of Freddie Mac, as well as asset-backed securities with things like adjustable rate mortgages, as well as commercial mortgage-backed securities, collateralized bond obligations, and cash assets consisting of investment grade securities rated BBB- or higher.

But how sound is that $30b worth of collateral?

JP’s Dimon testified: “We could not and would not have assumed the substantial risks of acquiring Bear Stearns without the $30b facility provided by the Fed.”

That comment led Sen. Robert Menendez to ask: “JP Morgan would have never gotten involved [in the deal] but for your [the Fed's] guarantee” that it would swallow $29b in Bear’s assets and not hit up JPMorgan for other collateral if those Bear assets zero out. Menendez wondered, is that a vote of confidence in these assets?

And remember what Geithner said in testimony before Congress, in defending the central against criticisms that it should have opened its Fed window to investment banks, not just commercial banks, to help Bear Stearns survive. “We only allow sound institutions to borrow against collateral” at the Fed’s discount window, he testified, adding, “I would have been very uncomfortable lending to Bear given what we knew at that time.”

What suddenly turned Bear’s assets golden as collateral for the Fed’s $29b loan to JPMorgan, what turned those sows ears into silk purses over night?

Efficient Market Hypothesis and Economic Punditry

OVER the past few weeks, I've been reflecting on my field, and asking myself the question that every economically literate person tortures themselves with:
But is it efficient?
For those of you who have no background in Economics ,let me briefly explain what I am talking about. According to the “efficient market hypothesis” (EMH), financial markets incorporate and reflect information quickly enough that investors cannot consistently outperform the market (unless they have information not known to the market, which may raise different issues under insider trading laws). Numerous academic studies support this conclusion, particularly showing that actively managed mutual funds do not outperform the market (after accounting for expenses) in any consistent way. Accordingly, a corollary of EMH is that investors are generally better off investing in vehicles that try to replicate a broad market (such as index funds) rather than trying to use individual judgment in trying to outperform the market.

Now,a similar approach may be advisable in the field of economic punditry. Let’s presuppose that the two main goals of any aspiring economic pundit are to be (a) correct and (b) quoted. (I will leave it as an excercise for the reader to guess which one is the primary goal, which one the secondary.) It seems that a pundit who changes his or her opinions as reactions to economic events runs the same risk as an investor trying to keep up with the market: unlikely to “outperform” the market of economic pundits. The best way to ensure being correct at least some of the time may be to simply always follow a consistent approach in economic commentary. Given that the business cycle has not yet been repealed, either consistent optimism or pessimism will be correct at least some of the time. Once the commentary matches up with the business cycle, the pundit’s reputation should be made – at least enough to ensure a permanent placement on journalists’ lists of people to call for a quote to support or balance a story.
While this method should equally apply to consistent optimistic or pessimistic commentary, the competition is probably fiercer on the optimistic side (cf. the mass of stock-pushers on CNBC at any given time). A strategy of consistent pessimism is thus probably the most efficient way to achieve success in the field of economic punditry.* (But do not assess the value of this strategy based on the dismal economic news of recent weeks.)


*The best example of this strategy is probably Henry Kaufman, former senior economist at Salomon Brothers whose consistent pessimism throughout the 1970s was regularly borne out by events, thus earning him the nickname “Dr. Doom” (together with his equally pessimistic counterpart at First Boston, Albert Wojnilower, who was dubbed “Dr. Gloom”) and a permanent designation as a source of pessimistic quotes whenever one was needed to balance out a story, notwithstanding the fact that Mr. Kaufman’s pessimism was rarely borne out by events for almost two decades thereafter. More recently, Stephen Roach of Morgan Stanley rarely had a good word to say about the economy throughout the expansion of the late 1990s and the inflation of the technology bubble, and he generally has not become more optimistic since the bursting of that bubble. The heir to Messrs. Kaufman and Roach for this economic cycle may be Nouriel Roubini, whose commentary seems carefully calibrated to avoid any hint that economic disaster may be avoidable.

No Free Lunch

WHILE out to lunch this weekend, I noticed a note at the bottom of the menu:
“We add a 15% gratuity to every bill, you are welcome to subtract or add more”
Restaurant patrons were being defaulted into tipping with an opt-out clause. Though I found it far more offensive when I leaned that my lunch companion’s employer defaults her into charitable giving. Her firm automatically subtracts a fraction of her salary and uses the proceeds to donate to several charities of its choice. She can opt out, but most employees do not. She claims few will have the audacity to say to HR, “I don’t want to give to charity.”
We often find ourselves defaulted into many things, such as our choice of power company. But actually taking money out of our pockets by default strikes me as especially presumptuous. The default option has become popular amongst policy makers and employers to induce desirable behaviour. The 2006 US Pension Protection Act gives employers incentives to automatically enrol their employees in a pension plan. Automatic pension enrolment substantially increases participation. Most economists agree the default enrolment, when it comes to saving, is beneficial. Many people need to save more if they want a comfortable retirement. They may not save as much as they should because time inconsistent preferences, procrastination, or they just feel over-whelmed by planning for retirement. Defaulting people into a pension plan facilitates a decision in the employees’ best interest, a decision they might not otherwise make. If they feel strongly about not participating, they can easily opt out.
However, defaulting employees into charitable giving makes my libertarian sensibilities uneasy. Giving to charity is a wonderful thing and has many externalities for the firm in terms of being a stronger presence in the business and social community. Employees may even indirectly benefit from it. But there seems something, well tacky, about automatically taking money from your employees and giving it in the firm’s name.
You can argue defaulting into a pension plan serves the employees’ interest and is not completely inconsistent with their preferences. I am not sure how neatly this rational applies to philanthropy. Also opting out of charitable giving carries a social stigma, which means employees feel pressured to donate even if they don’t want to.
If there does exist a benefit to encouraging executives to donate more to charity, it would be better to have employees opt in to giving. Perhaps give employees an explicit option to donate from their pre-tax income. Employees could even choose amongst a list of causes the firm supports. This would facilitate giving and the employees and firm still reap the tax and community benefits.
Default behaviour is a strong tool. Using it to elicit any behaviour we define as desirable, be it tipping wait staff, saving, or philanthropy becomes a slippery slope. All the more reason we should use it sparingly.

Time Inconsistency Problem

I friend of mine send me this:

I RECENTLY overheard an interesting conversation between two co-workers. After a female economist returned from a sun-filled holiday a male colleague (also an economist) remarked, “You look much hotter tan.”
She thanked him, but noted the decision to tan may suffer from time inconsistency. “A tan marginally increases your attractiveness now, but you will regret it in twenty years when your skin looks like leather. One day I will look back and think: why did I bother? I looked fine tan or pale in my youth. You fool yourself tanning now and thinking you won’t care about the consequences in the future.”
He argued the value of looking your best when young is greater than the value of looking better when old. Beautiful women attract more suitors. Thus, looking great now improves a woman’s marriage prospects. The dividends of which will pay off for the rest of her life (securing the necessary botox). He suspected her discount rate is too low.
She countered as you get older the marriage market become more competitive for women, all the more reason to maintain a smooth complexion. Also vanity does not diminish as you age.

No complement between two economists goes unpunished.