Let the Market Regulate Investment Banks

In the recent credit meltdown, the Federal Reserve has made emergency financing available to investment banks which is normally reserved for commercial banks. Treasury Secretary Henry Paulson says, according to the New York Times, that there will need to be more “oversight” (meaning regulation) of the investment banks since they are getting protections which used to be reserved for their heavily regulated commercial brethren.

Investment “banks” are companies like Bear Stearns, Morgan Stanley, Lehman Brothers etc. Although they have to follow the law and all kinds of SEC regulations, they are allowed to keep many more secrets than commercial banks and do not have to be transparent about their assets. They are also not subject to the kind of proactive auditing and examination that commercial banks undergo. They are, by design, more freewheeling than commercial banks are allowed to be. Often that freedom is a good thing and has made possible creative (in the good sense) financing of growth. Sometimes that freedom is a bad thing and it lads to creative (in the bad sense) financing of dubious (as opposed to risky schemes) and the invention of incredibly elaborate “investment” vehicles with a suspicious resemblances to Ponzi schemes which yield more in fees to the bankers than yield to the participants – especially once they unwind (the schemes, that is; bankers never unwind).

Paulson is right that the investment banks shouldn’t be allowed the backstopping services of the Fed (like the $30 billion credit line JP Morgan gets to help it buy Bear Stearns) without getting regulated in the bargain. If they get public “investment”, the public gets to protect its investment. But, IMHO, the solution is don’t give them the public help in the first place.

The prospect of market failure should be the regulator of the investment banking market. No matter what the short term pain, the country would have been better off letting Bear Stearns fail than bailing it out – and enriching JP Morgan further in the bargain. Yes, other investment banks might then have failed as well. Stock prices probably would have plummeted in the short term. On the other hand, investment banks might have become more creative in working things out with the homeowners whose mortgages are underwater. Now the banks can take a tough line with the borrowers knowing that the Federal Reserve is behind them.

If we bail them out, we encourage irresponsible behavior so we then need to regulate. But regulation discourages risk taking – and we need risk taking. We actually need investment banks. Moreover, regulation of the 24 hour worldwide online market the investment banks operate in is impractical. Regulators would have to slow the flow in order to watch it which would simply mean a faster exodus of the financial community to more hospitable shores. Only the lazy who like bailouts and regulation will be left here.

The market’s a cruel but effective regulator. It’ll remove the foolish (and the unlucky) and allow the wise (and the lucky) to survive even bad times. The prospect of failure will lead to an appropriate degree of both risk-taking (because you’ve got to make money) and caution (because you’ve got to survive). Might even be that without the prospect of a Fed bailout the banks would reduce executive compensation or defer bonuses until the long term consequences of short-term profits are more clear.

The best way to assure that the credit crisis is not quickly resolved is to shield investors in both houses and mortgages (and lots of other risky stuff) from the consequences of their actions. The best way to assure that the economy does not become robust again is to increase both regulation and bailouts.

The best course for the economy is to let failure take its toll and clear the decks for further growth.

Comments

[steve gelmis]

Well Tom, it's a tear and a half later and I have to say I now see it your way. The Fed may have delayed the consequences but they will ultimately be that much larger when they arrive.

[Alex]

The problem with this approach is the negative externalities associated with allowing Bear to fail. Yes, an investment bank failing is painful. But the issue is that there is pain that goes beyond managers/shareholders/creditors of Bear. The decision-makers at Bear don't take the risk of disruption to the worldwide financial system into account when they make decisions, they only take into account the pain that they will face.

[Tom Evslin]

Steve:

Thanks for your long and thoughtful reply. I think your fire analogy is a good one but the lesson maybe that there's no way to prevent a fire in a tinderbox.

A tempting analogy is our apparently misguided forest fire policy in which we put out all the small fires so that we end up with a woods of very old trees and few young ones plus lots of underbrush. Then we get huge fires we can't control.

I'm afraid the Fed is trying to control the uncontrollable and that, whartever the consequences of a Bear Stearns failure now, the consequences of postponing the rekoning for the underlying financial missteps will be even greater.

[Steve Gelmis]

Tom,

I would like to completely agree with you. The problem is that your analysis appears to overlook the elephant in the room.

Bear is counter party to $13 trillion in derivatives and their own bonds are the subject of an unknown number of derivative bets (between third parties) many times the size of their debt itself. What the Fed was in no position to calculate is the size of the tsunami which would result if Bear were to default on those positions. It would at minimum thouggh be many times the face value of their shareholders stock.

Now the conventional expectation is that net losses on Bear's direct book of derivatives might be as little as 1-2% of the face amount (2% based on Warren Buffet's description of unwinding General Re's derivatives a few years ago), but that is still $130B (excluding the CDS payoffs between parties betting on Bear's debt defaulting). That's more than 3 times the value of their stock the week before they imploded. Bear bond-holders would take a pretty nice haircut as well.

But Buffet's 2% loss experience was based on an orderly run-off process for an individual company by a well capitalized parent, and within a properly function market. It seems more likely, if that set of dominoes started to fall today, the percentage losses would be much higher, and would take down many other players in a chain reaction.

If you think the risk models for sub-prime mortgage have failed when risks turned out to be correlated rather than the diversity (geographic, price level, FICO score range) they were imagined to represent, you haven't seen anything yet.

So in the end, the Fed's dilemma was not about whether to make the shareholders, or even the bond holders whole. It was about the risk of blowing up a much larger ($500+ T), mostly unregulated shadow economy, the scale of which is now in uncharted territory in all of history.

It turns out that for the past decade the finance industry has been delivering out-sized profits (and management fees, and bonuses) not based on productivity growth in any respect other than finding new off-balance sheet ways to bypass regulations which attempt to limit the amount of leverage applied to their collective capital base.

Enron, which played in that same sandbox, was a lab experiment by comparison.

So, even feeling as you do, I'm not sure I'd have the nerve to pull that trigger if I were in Bernanke's position.

Not that he's necessarily prevented that day of reckoning from coming. JP Morgan's book of derivative business was $90+ trillion -- before taking on Bear's own.

the clearest mental picture I can offer is that our economy is like Chicago before the great fire: Boom-town growth, but pre-building code and mostly made of wood.

Oh...and the fire department's capabilities is based on horse drawn wagons and hand pumps.