Bear and Moral Hazard

The news that the American bank which drew the short straw and was told to rescue Bear Stearns, JP Morgan Chase, is upping its offer to five times what it originally offered has caused a fair bit of confusion among financial commentators. One pointed out that under the original terms Bear was worth less than David Beckham, which must have been wrong, although he didn’t say why. Some say it is welcome and it must be.. what? About right now? Others say Bear screwed up and it is the shareholders who must suffer.

When the Northern Rock debacle broke, the Governor of the Bank of England, Mervyn King, introduced us to the concept of moral hazard. This dictum is that if a bank screws up there must be suffering, otherwise other banks will free to do as they wish, confident in the knowledge that if they blow it all the taxpayer will come to the rescue. And it is the taxpayer in the case of Bear Stearns: the Federal Reserve are supplying JP Morgan with the money; JPM will ‘only’ take the first billion dollars of risk.

There is an interesting stance taken by Anatole Kaletsky in the Times however. He points out that the last couple of hedge funds to go bust had in fact called the subprime crisis right. They had gone into quality investments but couldn’t find the funding for them. The same appears to be true in large part of Bear Stearns: even though it pretty well invented the subprime market it had a largely high quality investment portfolio. What has sent them under is that there is no liquidity in the market. No one wants to lend against even top quality security.

Now this is a different matter. I am not saying they are completely not to blame, but the element of moral hazard, the morality of the thing, is different. Northern Rock didn’t go under because it had invested in rubbish – its assets were largely high quality British mortgages. Its problem was that it had borrowed in the short term money markets and these had dried up, so it simply ran out of money. So it was partly to blame for having a borrow short – lend long business model, but not to blame for the money markets collapsing. It is the job of a central bank to keep the markets open.

So how much should shareholders suffer? Fortunately there is no court to apportion blame, like in an industrial injury case. It is in the public, and therefore the taxpayer’s interest that the markets remain open, so the Central Bank should supply plenty of short term money against the security of long term assets and keep the banks trading. The shareholders suffer a low valuation and lose something but not all. The USA seems to have got this about right. The British didn’t get it right, in part because the government, with no business people in it, panicked that a bank might go under in an area full of Labour seats. Add to that Gordon Brown’s tripartite scheme for overseeing banks so that nobody knew who was in charge and you have the worst financial disaster Europe has seen.

Let’s keep the politicians out of this; I think that's the first lesson we have to learn from the USA.