Tuesday, March 18, 2008

Moral Hazard, the Federal Reserve, and Solvency

Yesterday's Outside The Box by John Mauldin provides an overview of the NY Fed's actions around Bear Sterns, along with commentary on the current "credit" crisis.

This is not a bailout. The shareholders at Bear have been essentially wiped out. Note that a third of the shares of Bear were owned by Bear employees. Many of them have seen a lifetime of work and savings wiped out, and their jobs may be at risk, even if they had no connection with the actual events which caused the crisis at Bear. Don't tell them there was no moral hazard.


The Fed is taking $30 billion dollars in a variety of assets. They may ultimately take a loss of a few billion dollars over time, although they may actually make a profit. When you look at the assets, much of it is in paper that will likely get close to par over time, and the good paper will pay premiums mitigating the potential loss. The problem is, as the essays below point out, no one is prepared to take that risk today.

- John Mauldin, Editor: Outside the Box

John correctly points out that the NY Fed's actions will not create a moral hazard problem. Bear shareholders lost 90% of their equity from Friday's close, after Bear closed down ~50% from Thursday.

He also notes taxpayers won't likely be stuck with a huge bill. The Fed is doing exactly what its supposed to - act as a lender of last resort. Perhaps they're following the cliche, "buy when there's blood in the streets." I think that characterizes the current state of the credit markets pretty well.

What may be lost in the excitement of the moment, as markets attempt to digest these latest actions, is that were taken by the Board of Governors through the Federal Reserve Bank of NY to address issues of financial stability. These were NOT actions taken by the Federal Open Market Committee (FOMC). Their main responsibility is the conduct of monetary policy for the country.


It is time to step back and recognize that the current situation isn't a liquidity issue and hasn't been for some time now. Rather there is uncertainty about the underlying quality of assets which is a solvency issue driven by a breakdown in highly leveraged positions. Many of the special purpose entities and vehicles are comprised of pyramids of paper assets supported by leverage whose values are now unknown.
- Bob Eisenbeis, Cumberland Advisors

These two paragraphs by Mr. Eisenbeis make an essential point that some continue to miss: this is not a liquidity issue. As he notes, these actions were not taken by the FOMC to address a monetary policy issue.

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