Monday, March 17, 2008

On why Bear Stearns should have failed this time

For all the talk about 'government is the problem' and 'too much regulation stifles the free market', the events that unfolded over the weekend saw the government actually financing the purchase of a troubled investment bank (Bear Sterns) through a conduit (JP Morgan Chase) leaving one to believe ardently in the fact that, more, if not an excessive oversight of the financial markets would be the medicine for the boom-bust cycle that we seem to be living through (with a cyclic frequency approaching the 10 year mark - the last one I remember was the dot com bust).

The government yesterday evening, decided to underwrite the take-over of a troubled investment bank on Wall Street in the hopes that rescuing this one might stave off further collapse of the financial system. While, it is well intentioned, this has left me pondering on these open unanswered questions:

- In bailing out some of the key stakeholders of the financial system, isn’t the government also bailing out some of the same people who led us into this mess (people who lived and got their bonuses through promising people easy homes with no money down, interest only payments and adjustable rate mortgages)?

- By bailing out banks and institutional players in the industry, is the government also helping to prop up what might be a house of cards built upon the mortgage bubble? Shouldn’t the government just sit and wait this one out and let the structural readjustment process bring the hype to what the markets can nominally sustain? Isn’t the government just putting off for another day what might have happened today (a normal structural adjustment to prevailing levels)?

- Aren’t we, in effect, playing dice with 'free-market / market-knows-best’ principles that was embraced in better times but thrown to the winds at the first sign of trouble?

As this and other questions swirl in my mind, it is worth reading excerpts from the op-ed column by Paul Krugman in today’s Times

Between 2002 and 2007, false beliefs in the private sector — the belief that home prices only go up, that financial innovation had made risk go away, that a triple-A rating really meant that an investment was safe — led to an epidemic of bad lending. Meanwhile, false beliefs in the political arena — the belief of Alan Greenspan and his friends in the Bush administration that the market is always right and regulation always a bad thing — led Washington to ignore the warning signs.

The result of all that bad lending was an unholy financial mess that will cause trillions of dollars in losses. A large chunk of these losses will fall on financial institutions: commercial banks, investment banks, hedge funds and so on.

Nobody expects an investment bank to be a charitable institution, but Bear has a particularly nasty reputation. As Gretchen Morgenson of The New York Times reminds us, Bear “has often operated in the gray areas of Wall Street and with an aggressive, brass-knuckles approach.”

Bear was a major promoter of the most questionable subprime lenders. It lured customers into two of its own hedge funds that were among the first to go bust in the current crisis. And it’s a bad financial citizen: the last time the Fed tried to contain a financial crisis, after the collapse of Long-Term Capital Management in 1998, Bear refused to participate in the rescue operation.

Bear, in other words, deserved to be allowed to fail — both on the merits and to teach Wall Street not to expect someone else to clean up its messes

At the time of writing this, the markets and futures are still falling globally, the Federal Reserve further cut the overnight lending rate and the New York Stock Exchange just opened with a 150 point drop in the DOW.

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