Bear Stearns and the N-Word: Nationalization

( – promoted by buhdydharma )

Today, the United States will do something which it hasn’t done since the New Deal: it will nationalize a corporation.  Bear Stearns is the new Tennessee Electric Power Company.

After a weekend of intense negotiations, the Federal Reserve approved a $30 billion credit line to help JPMorgan Chase acquire Bear Stearns, one of the biggest firms on Wall Street, which had been teetering near collapse because of its deepening losses in the mortgage market.

In a highly unusual maneuver, Fed officials said they would secure the loan by effectively taking over the huge Bear Stearns portfolio and exercising control over all major decisions in order to minimize the central bank’s own risk.

President George Bush is responding to the disasters of one of Wall Street’s most reckless firms by echoing the actions which he has so passionately criticized in Evo Morales and Hugo Chavez.  When the high-stakes financial gamblers of derivatives trading are exposed, the true face of Bush Republicanism has been revealed: they are nothing less than communists.

There are two major issues which are at the root of this financial crisis in the United States, which is now the cause of such drastic action as to be unprecedented in nearly all of our lifetimes.  Both need to be at the fore of the upcoming debate about who is best suited to be elected to the Presidency and Congress this fall.

First, the reason why this crisis in investment banking is of such concern to the nation is the explosion in the nearly unregulated derivatives market over the last two decades.  This growth is based in economic policy at the Federal level, largely due to the active encouragement of Alan Greenspan.

Last December, Mr. Greenspan wrote in the Wall Street Journal:

Arbitragable assets–equities, bonds and real estate, and the financial assets engendered by their intermediation–now swamp the resources of central banks. The market value of global long-term securities is approaching $100 trillion. Carry trade and foreign exchange markets have become huge.

In theory, central banks can expand their balance sheets without limit. In practice, they are constrained by the potential inflationary impact of their actions. The ability of central banks and their governments to join with the International Monetary Fund in broad-based currency stabilization is arguably long since gone. More generally, global forces, combined with lower international trade barriers, have diminished the scope of national governments to affect the paths of their economies.

Mr. Greenspan is correct to a degree.  There is a limit to which the Federal Reserve can control the path of the economy.  Which is why they are reduced now to taking such drastic action, which still can be easily scuttled if the shareholders of Bear Stearns refuse to be bought out for less than a tenth of the book value of their stock.

But Greenspan says all of this as if it was not at the direction of the Fed, under his watch, that this expansion in these markets took place.  But he had been the leading champion of the growth of these markets.  Here is Greenspan in 1999, shortly after the last major crisis in derivatives trading due to the collapse of Long-Term Capital Management:

While nothing short of a major economic adjustment is likely to test the underlying robustness of the derivative markets, there are reasons to believe that there are some fundamental strengths in these markets. First, despite the growing use of more exotic over-the-counter instruments, the vast majority of trades are relatively straightforward interest rate and currency swaps. The market risk on such swaps is presumably less daunting to individual counterparties than their underlying exposures, or presumably the swaps would never have been initiated. Moreover, the credit risks are increasingly subject to comprehensive netting and margin requirements that, although they do not fully remove the risk, significantly ameliorate it. And so far as banks are concerned, capital requirements are applied to such risks as they are to loans that create credit risks quite similar to those of derivatives.

Hence, although one may harbor concerns about the overall capital adequacy of banks and their degree of leverage, there is little to distinguish such concerns between risk adjusted on- and off-balance sheet claims.

Some may now argue that the periodic emergence of financial panics implies a need to abandon models-based approaches to regulatory capital and to return to traditional approaches based on regulatory risk measurement schemes. In my view, however, this would be a major mistake. Regulatory risk measurement schemes are simpler and much less accurate than banks’ risk measurement models. Consequently, they provide banks with the motive and the opportunity to engage in regulatory arbitrage that seriously undermines the regulatory standard and frustrates the underlying safety and soundness objective. Specifically, they induce banks to reduce holdings of assets where risks and regulatory capital are overestimated by regulators and increase holdings of assets where risks are underestimated by regulators.

In 2005, shortly before leaving his post at the Federal Reserve, Greenspan was still championing these vehicles for their stabilizing effect:

As is generally acknowledged, the development of credit derivatives has contributed to the stability of the banking system by allowing banks, especially the largest, systemically important banks, to measure and manage their credit risks more effectively. In particular, the largest banks have found single-name credit default swaps a highly attractive mechanism for reducing exposure concentrations in their loan books while allowing them to meet the needs of their largest corporate customers. But some observers argue that what is good for the banking system may not be good for the financial system as a whole. They are concerned that banks’ efforts to lay off risk using credit derivatives may be creating concentrations of risk outside the banking system that could prove a threat to financial stability. A particular concern has been that, as credit spreads widen appreciably at some point from the extraordinarily low levels that have prevailed in recent years, losses to nonbank risk-takers could force them to liquidate their positions in credit markets and thereby magnify and accelerate the widening of credit spreads.

Clearly, Greenspan was incorrect in his analysis.  Careful work must be done to understand and untangle the means by which the Fed encouraged the spectacular growth in the size of the derivatives markets, which has now required such radical rescue by the government.

Second, the Gramm-Leach-Bliley Act of 1999, which repealed the Glass-Steagall Act, permitting commercial banks and investment banks to merge is showing itself to be a disaster.  By allowing the same major banks to hold the complicated investment vehicles of hedge funds and the savings accounts and such of ordinary American, the Federal Deposit Insurance Corporation (the entity which gives all Americans deposit insurance to prevent the bank runs of the Great Depression) suffers extraordinary exposure should risk-taking firms like Bear Stearns fail.  By permitting the risking of deposited funds backed by the Federal government, we have encouraged the sort of moral hazard which makes nationalization of assets risked by speculators appealing.  Why not risk another $200 billion when we already have $100 billion on the line?

The Gramm-Leach-Bliley Act, signed by former President Bill Clinton, needs immediate attention by the next Congress.  Of crucial importance will be the position of the new President, who will almost certainly need to support the legislation for it to be possible.  Sen. Clinton, Sen. Obama, and Sen. McCain need to be asked and forced to answer on their views of the Gramm-Leach-Bliley Act, and their opinions of what steps need to be taken to limit the dangerous exposure American citizens currently have to the actions of Wall Street’s most reckless speculators.