Monday, March 17, 2008

Bracing for a rocky day...

JPMorgan Chase announced today that they'd in fact be buying Bear Stearns. No, not for the $15-$20 a share earlier speculated. They're paying $2 a share.

Now there has been a lot of ire raised by the Fed's bailout of the "brass-knuckles" investment bank. They've played the risky hand and they've lost, hard. Should they be bailed out? Should any large investment bank?

The question is one of externalities. The Fed financed the bailout because they fear gravely that a full-blown collapse of BSC will lead to a bank run elsewhere. Others will overreact (or, perhaps, react accordingly) and pull their money from similarly over-leveraged, high-risk, subprime-touching, perhaps-starting-to-experience-liquidity-issues investment funds.

Bank runs are never good. Banks don't ever have the liquid assets necessary to pay out all of their accounts, a nifty concept called Fractional-reserve banking. When
everyone tries to pull out their money at once because they fear the bank has or might become insolvent, the bank can no longer pay out all of the requests and becomes insolvent. This is the basis of the FDIC, which insures on a federal, government-backed level that your deposits are safe in FDIC-insured accounts. Even if your bank bottoms out its liquidity and nears insolvency, the FDIC has your back. The confidence this provides can help avoid bank runs entirely. The problem is, investment banking accounts like those at BSC aren't FDIC-insured. (With good reason.) So in effect, the Fed is backing up the funds in order to keep BSC solvent and operational long enough to get things in order.

The other side of the coin is that without the risk of epic failure, a bank's investment managers will act more in the interest of themselves and attempt much higher risk behavior. If you've ever played a "play money" stock market or poker game, you know that there are people willing to throw all of their money towards something nonsensical, just for the hell of it. Maybe it'll pan out, and it doesn't cost anything. This is an exaggerated scenario, but without real risk and true negative reinforcement, fund managers may subconsciously or worse, consciously, consider the Fed a safety net to protect them while they try far riskier activities than they've considered before.

Now, if the failure of Bear Stearns truly were about to cause a run on several other similar-profiled but not-as-illiquid funds/banks, then the Fed did the right thing. I'm just not sure that would happen. This didn't come out of the blue. BSC announced massive liquidity issues days after having lied about their "liquidity cushion" at the highest level. The other firms haven't, though the "cushion" reassurance did come from an SEC officer, which concerns many more than a little. Still, I'm typically in favor of letting the market dole out its punishment. This was a body blow that BSC earned themselves. They were smug and indignant with Long Term Capital Management experienced a bank run and completely collapsed in 1998, saying that the Fed should have nothing to do with it and that they'd offer no help whatsoever. Well, their risky chickens have come into roost and damn if they're not more than a little diseased.

Tomorrow may be a very rocky day. Or the JPMC deal could be a shot in the arm for many who see that the BSC problem is no longer a federal one and that it will be dealt with soon. Watch the Dow, JPM and BSC tomorrow. (And enjoy another Fed rate cut, sure to impact your savings account rate soon.) I'm expecting the former more than the latter.

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