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Public Risk, Private Gain

By Steven Pearlstein
Tuesday, March 18, 2008

The story so far: With the acquiescence of federal regulators, Wall Street went hog wild, earned gobs of money and, in the process, created a whopping mess that the federal government now has to clean up.

In the words of Nouriel Roubini, the New York University economist who's been predicting this debacle for more than a year, we've mastered the art of "socializing risk and privatizing gain."

With the Fed's decision to put $30 billion behind the rescue of Bear Stearns and open its lending window to investment banks, we're deep into bailout territory. Considering the alternative -- a global financial market meltdown that takes the global economy down with it -- this was probably the right thing to do.

The underlying problem is that, over the past 20 years, we've allowed the process of credit creation to be shifted from banks, which are regulated and required to keep a minimum capital cushion, to largely unregulated securities markets with no limits on the amount of leverage they take on.

Like banks, these markets borrow short and lend long, which creates profit margins but makes them vulnerable to an old-fashioned bank run if that short-term capital suddenly dries up. The first victims in such a scenario run the gamut from mortgage lenders like New Century and Countrywide, hedge funds such as Peloton Partners and Carlyle Capital and even venerable investment banks like Bear Stearns.

Some will see poetic justice in the fact that a white-shoe bank that is a direct descendant of J.P. Morgan and John D. Rockefeller has come to the rescue of the financial swashbucklers at Bear Stearns.

In agreeing to buy the Bear for about a quarter of the value of its headquarters building, J.P. Morgan's Jamie Dimon may have made the deal of a lifetime, picking up a prime brokerage and half-dozen other profitable operations while getting the Federal Reserve to take on all the risks from its heavily discounted financial holdings until they can be sold at a more reasonable price.

In that sense, it's more dollar-holders rather than taxpayers who are on the hook if things don't work out, but my guess is that the Fed will actually wind up making money in the end.

Make no mistake: The Fed was at the center of these negotiations, not only because of the need to limit the buyer's downside risks, but also because of the Fed's determination to get a quick resolution to Bear Stearns's fate. The Fed's preference was for a buyer with access to a large balance sheet with whom it could work closely, which pretty much limited the pool to the major banks. And because J.P. Morgan was the only one willing to step forward, it was pretty much able to dictate the price.

Some disgruntled Bear Stearns shareholders have pointed out that Warren Buffett or some private-equity fund would surely have been willing to pay more for Bear's assets in a protracted but orderly liquidation overseen by a bankruptcy court. They may be right. But in the end, the interests of the global economy needed to take precedence over those of Bear Stearns shareholders and executives.

If Bear is to become a template for future Fed rescues, the logic seems to be that while the government has no interest in bailing out shareholders and executives for their poor judgments, it has no choice but to bail out those who have lent money or entered into credit default swaps and other bets with the troubled entity. The reason for the distinction is simple: If shareholders lose their money, it's a shame for them, but their losses won't cause credit markets to collapse. Not so for creditors and counterparties.

That is not to say that the losses of Bear Stearns shareholders won't matter. One of the major challenges for banks and investment houses is to attract more equity to give them better cushions against losses or protection against a sudden withdrawal of liquidity from the market. Given the experience of Bear Stearns, however, that equity capital will be more expensive, and shareholders in other firms may be unwilling to dilute their own shares to obtain it. No matter. Now that the government is in bailout mode, it has both the right and the obligation to require financial institutions that are undercapitalized for the current environment to find new investors.

While they are at it, regulators also ought to clamp down on banks and investment houses that are providing loans or repo agreements to hedge funds and others whose short-selling and other speculative strategies are making fragile markets even more fragile. Certainly that was the case last week when short-selling of Fannie Mae and Freddie Mac mortgage-backed securities helped to drive down their prices, triggering widespread margin calls. You can be sure the wise guys are plotting similar squeezes involving credit default swaps and the dollar. But they should not be able to pursue these highly leveraged strategies with the extra liquidity the Fed is now providing to banks and prime brokers.

Finally, the Fed needs to resist the insatiable demands of financial markets to cut the federal fund rate today by another full percentage point.

In its role as the lender of last resort, the central bank has its dollar printing presses working overtime, with negative consequences for the value of the currency. And given the desire of banks to hoard cash and shrink their balance sheets, it's not clear that cutting the federal funds rate will do much to lower the cost of borrowing for anyone else. A symbolic quarter-point reduction is all the economy or the financial system requires.

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