June 5, 2008

Finance Geeks will be pleased to learn that I have finished my post Expected Losses and the Assets to Capital Multiple. All other will simply let their eyes glaze over and look forward to a resumption of PrefBlog’s regular schedule of news and snarky comments.

Bear Stearns controversy is reaching new heights:

Richmond Federal Reserve Bank President Jeffrey Lacker, challenging Chairman Ben S. Bernanke’s unprecedented actions to stem a financial panic, warned that lending to securities firms raises the risk of future tumult.

“The danger is that the effect of the recent credit extension on the incentives of financial-market participants might induce greater risk taking,” Lacker said in a speech to the European Economics and Financial Centre in London. That “in turn could give rise to more frequent crises,” he said.

Bernanke and New York Fed President Timothy Geithner have defended the central bank’s extraordinary moves as preventing a cascading financial panic. A growing group of Fed bank presidents, who are charged with direct supervision of financial institutions, are saying limits now need to be drawn around the Fed loan facilities.

If investors anticipate an official intervention to limit losses in “situations of financial stress,” firms will be less likely to take “costly” measures to protect themselves, Lacker said.

Lacker in his remarks distinguished between “fundamental” runs on financial institutions where creditors have good economic reasons to question their investments, and “non-fundamental” runs typified by panics.

Types of Runs

He said a case can be made for intervention to stem disorderly non-fundamental runs. He doesn’t see a case for action when a crisis is unavoidable based on a deteriorating credit or business plan. “Instances of run-like behavior since last summer appear to be attributable to real fundamental causes,” Lacker said in his speech.

In the case of Bear Stearns, Lacker said in the interview that it’s hard to tell whether the New York-based firm’s crisis was due to fundamental reasons or a creditor panic.

In Lacker’s actual speech he said:

Researchers have found it useful to distinguish between what I’ll call “fundamental” and “non-fundamental” runs. Non-fundamental runs are of the self-fulfilling variety; if all depositors who do not need their money right away believe that other such depositors will not withdraw their money, then no run occurs. In another potential equilibrium, the belief that other patient depositors will withdraw nonetheless induces all patient depositors to withdraw, thus confirming their beliefs. Fundamental runs occur when people seek to remove their money from an intermediary because they have information that makes them mark-down their valuation of the intermediary’s assets; waiting is not a reasonable option (that is, not an equilibrium). This distinction is important because the two types of runs have very different policy implications. Preventing a non-fundamental run avoids the cost of unnecessarily early asset liquidation, and in some models can rationalize government or central bank intervention. In contrast, in the case of runs driven by fundamentals, the liquidation inefficiencies are largely unavoidable and government support interferes with market discipline and distorts market prices.

However, in most instances of runs that we have observed — for example, the wave of U.S. bank runs in the Great Depression — careful analysis has shown that banks that experienced runs tended to be in observably worse condition than those that did not.3 That is, there usually appears to be some fundamental impetus behind a run.

… significant concerns were circulating publicly regarding mortgage-related assets on Bear Stearns’ balance sheet, making money market counterparties (short-term investors) reluctant to continue dealing with the firm.

It’s a good speech, worthy of reading in full. I will certainly agree that institutions that experience runs are observably worse than ones that do not – the markets are not wholly irrational! However, you don’t need to watch the markets for very long before you conclude that markets are excitable and will make mountains out of molehills at every opportunity.

I think we’re now in the “political football” of Bear Stearns discussion and that we’ll remain there for quite some time … at least until the new president, whoever he is, makes a policy decision and attempts to sell it. It looks to me – from the careful avoidance of any mention of the SEC in any of the Fed representatives’ discussion of the Bear Stearns affair – that the Fed wants to take over supervisory authority of the investment banks. By not mentioning SEC supervision – and what I would call the certainty that Bernanke called Cox at some point during the critical weekend and asked ‘Is it solvent?’ – the Fed’s turf-fighters will create the impression that there’s nobody minding the store at all. It also seems to me that the SEC is constrained from defending its turf due to fear of the disingenuous observation ‘But BSC was going BK!’

We can only hope that – whoever the actual supervisor ends up being – the rules continue to recognize a distinction between banks and investment dealers. Layers, that’s what we need, layers! Banks – safe! Investment Banks – risky! Hedge Funds – Wild!

Added: I came under a certain amount of eerily familiar sounding criticism in the comments to Accrued Interest’s Bailouts, Wall Street, and the Bad Motivator for daring to suggest that Bear Stearns was probably solvent at the time of its demise. It’s not a particularly strong addition to my argument, but I will suggest that Bernanke is far too rigorous a central banker to bail out an insolvent institution. See, for example, US Bank Panics in the Great Depression, with particular attention to the references in the last paragraph of the conclusion. Also, see The Discount Window: Good or Bad? for some of the current thinking.

A poor day in the markets as prices declined with a decline in volume to average levels.

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet 4.19% 4.20% 57,067 17.0 1 +0.0394% 1,113.7
Fixed-Floater 4.90% 4.67% 62,778 16.06 7 -0.6494% 1,021.1
Floater 4.05% 4.10% 62,707 17.14 2 +0.1475% 932.9
Op. Retract 4.82% 1.81% 87,357 2.67 15 +0.1347% 1,058.6
Split-Share 5.26% 5.39% 71,765 4.21 15 -0.0467% 1,056.9
Interest Bearing 6.09% 6.08% 49,777 3.80 3 +0.0669% 1,118.9
Perpetual-Premium 5.84% 5.76% 419,444 8.29 13 -0.1846% 1,024.5
Perpetual-Discount 5.68% 5.73% 223,941 14.07 59 -0.2018% 923.3
Major Price Changes
Issue Index Change Notes
BCE.PR.G FixFloat -1.9780%  
CIU.PR.A PerpetualDiscount -1.4493% Now with a pre-tax bid-YTW of 5.68% based on a bid of 20.40 and a limitMaturity.
GWO.PR.I PerpetualDiscount -1.1933% Now with a pre-tax bid-YTW of 5.45% based on a bid of 20.70 and a limitMaturity.
RY.PR.A PerpetualDiscount -1.1724% Now with a pre-tax bid-YTW of 5.55% based on a bid of 20.23 and a limitMaturity.
BCE.PR.A FixFloat -1.0526%  
Volume Highlights
Issue Index Volume Notes
TD.PR.O PerpetualDiscount 286,200 Now with a pre-tax bid-YTW of 5.49% based on a bid of 22.35 and a limitMaturity.
TD.PR.R PerpetualPremium 127,200 Now with a pre-tax bid-YTW of 5.67% based on a bid of 25.21 and a limitMaturity.
BMO.PR.L PerpetualPremium 62,140 Now with a pre-tax bid-YTW of 5.88% based on a bid of 25.10 and a limitMaturity.
BMO.PR.J PerpetualDiscount 58,350 Now with a pre-tax bid-YTW of 5.64% based on a bid of 20.11 and a limitMaturity.
GWO.PR.I PerpetualDiscount 56,205 Now with a pre-tax bid-YTW of 5.45% based on a bid of 20.70 and a limitMaturity.

There were sixteen other index-included $25-pv-equivalent issues trading over 10,000 shares today.

One Response to “June 5, 2008”

  1. […] Capitalism reports on the Lacker speech I mentioned yesterday, with a greater emphasis on the Fed’s independence: But there has been another thread mixed […]

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