Bear Stearns Better Than U.K. Bailout
March 19, 2008
by Diana Furchtgott-Roth
The dollar is weak and falling, oil prices have climbed to undreamed of levels, credit markets are seizing up, and global stock markets are losing ground. Can Federal Reserve Chairman Ben Bernanke successfully avert a crisis?
Yesterday the Fed again lowered the benchmark interest rate on overnight loans between banks by three-quarters of a percentage point to 2.25%. Since September 2007 the central bank has driven down this bellwether borrowing rate by 3 percentage points, slightly less than the former Fed chairman, Alan Greenspan, did over a seven-month period in 2001.
Dallas Federal Reserve President Richard Fisher and Philadelphia Federal Reserve President Charles Plosser dissented due to inflation concerns. In spite of their concerns, or perhaps because of their moderating influence, the S&P 500 soared to a 54 point gain and the Dow gained 420 points. Of equal importance, on Sunday the Fed announced that it would allow primary dealers of the Federal Reserve Bank of New York, including major investment banks, to borrow directly from the central bank, as ordinary banks are already allowed to do. It extended the term of loans by two months to 90 days. The Fed has made hundreds of billions of dollars of credit available to allow almost unlimited borrowing by the financial sector.
This makes the Fed the lender of last resort to investment banks, as they can make loans in exchange for a broad range of collateral, including the mortgage-backed securities that started this whole problem.
The extra borrowing capacity would particularly help Lehman Brothers, the weakest of the remaining four major investment banks, which would otherwise not be eligible to borrow from the Fed. Lehman's share price rose substantially yesterday after falling on Monday.
The Fed's new role as lender of last resort to investment banks ensures that the flow of funds will continue. Without Fed support, if one lender is considering backing out, they all back out together, because no lender wants to be the last one servicing a distressed firm. There's a clear advantage to being the first to leave, a disadvantage to being the last in.
A fifth investment bank, Bear Stearns, was sold at fire-sale prices over the weekend with Fed credit as an indispensable catalyst. The Fed's role in the sale was a model of efficiency. On Friday, Bear Stearns announced that it was accepting a cash infusion from JP Morgan. Two days later, on Sunday, JP Morgan bought Bear Stearns at $2 a share, with a loan by the Fed.
This was not a "bailout" because shareholders incurred heavy losses. Bear Stearns shareholders lost most of their value but the market as a whole was protected from the contagion effect of outright failure.
The expediency of the Fed's recent actions can be positively contrasted with those of the British government in the case of Northern Rock, the British bank that experienced a loss of confidence in September 2007. The British government took more than five months to decide what to do with Northern Rock, increasing investors' anxiety about the overall banking system. Lloyd's Bank, another leading British financial institution, offered to purchase Northern Rock for $8 per share at the time, but the government did not allow it to do so and ended up nationalizing the bank last month, by which time the share value had fallen to $2.
Commercial banks are now in a far better financial position than investment banks. They were regulated between 1933 and 1999 by the Glass-Steagall Act, which prohibited them from participating in brokerage and investment banking activities. In exchange for Federal insurance of deposits and for the ability to use the Fed as a lender of last resort, commercial banks were required to constrain their activities.
Glass-Steagall was repealed in 1999 to allow banks to diversify into broader areas, and commercial banks can now enter investment banking. Yet, their privilege to borrow from the Fed remains. Although since 1999 these banks have been permitted to engage in new activities — only through affiliates that lack deposit insurance — their risk-averse tendencies have generally remained.
Moreover, the existence of FDIC insurance of up to $100,000 per account protects depositors and banks from panicked withdrawals, the "runs" that led to the brief "bank holiday" imposed by President Roosevelt in 1933. And so, commercial banks are less likely to suffer financial losses.
Some well-run commercial banks are awash in liquidity as cash searches for a safe home, and are beginning to use this liquidity to bring onto their balance sheets their off-balance sheet vehicles. The structured investment vehicles designed to arbitrage between long- and short-term investments are being unwound and their cash assets placed in banks. Banks such as HSBC are rock-solid, because they have a lot of cash and are willing to lend only to the best risks. The disadvantage of the Fed's swift, authoritative intervention is the risk of inflation. As the central bank creates credit and lowers rates, the dollar loses value. A falling dollar drives up the price of commodities, especially oil, and of imported goods, from sneakers to computers.
In yesterday's statement the Fed acknowledged inflation dangers, yet said that it expects "inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization." Let's hope that the Fed is right.
This Op-Ed was featured in The New York Sun of March 19, 2008.
Diana Furchtgott-Roth, former chief economist of the U.S. Department of Labor, was a Senior Fellow at Hudson Institute from 2005 to 2011.