Rescuing Bear Was a Waste of Time and Treasure, Says Roubini

Nouriel Roubini's Global EconoMonitor

Step 9 of the Financial Meltdown: "one or two large and systemically
im****tant broker dealers" will "go belly up"
Nouriel Roubini | Mar 14, 2008
In my February 5th piece on 12 Steps to a Financial Disaster I
predicted - as Step 9 of the meltdown - that "one or two large and
systemically im****tant broker dealers" will "go belly up" and that
other members of the "shadow financial system" - i.e. non-bank
financial institutions that look like banks in terms of liquidity/
rollover risk - will also go bankrupt. As I put it then:

Ninth, the "shadow banking system" (as defined by the PIMCO folks) or
more precisely the "shadow financial system" (as it is composed by non-
bank financial institutions) will soon get into serious trouble. This
shadow financial system is composed of financial institutions that -
like banks - borrow short and in liquid forms and lend or invest long
in more illiquid assets. This system includes: SIVs, conduits, money
market funds, monolines, investment banks, hedge funds and other non-
bank financial institutions. All these institutions are subject to
market risk, credit risk (given their risky investments) and
especially liquidity/rollover risk as their short term liquid
liabilities can be rolled off easily while their assets are more long
term and illiquid. Unlike banks these non-bank financial institutions
don't have direct or indirect access to the central bank's lender of
last resort sup****t as they are not depository institutions. Thus, in
the case of financial distress and/or illiquidity they may go bankrupt
because of both insolvency and/or lack of liquidity and inability to
roll over or refinance their short term liabilities. Deepening
problems in the economy and in the financial markets and poor risk
managements will lead some of these institutions to go belly up: a few
large hedge funds, a few money market funds, the entire SIV system
and, possibly, one or two large and systemically im****tant broker
dealers. Dealing with the distress of this shadow financial system
will be very problematic as this system - stressed by credit and
liquidity problems - cannot be directly rescued by the central banks
in the way that banks can. [bold added]

And today the first one of these large broker dealers - Bear Stearns -
in on the verge of bankruptcy. Let us be clear: given its massive
exposure to toxic MBS and ABS product Bear Stearns is insolvent; the
decision by the NY Fed to try to bail out Bear Stearns would make
sense if this firm was only illiquid; the trouble that it is insolvent
and thus such attempted bailout is altogether inappropriate. It is
true that Bear is a large broker dealer; but its systemic im****tance
is much smaller than that of much larger institutions. The world and
financial market can survive if Bear disappears.

So the only possible justification for such Fed action is to engineer
an orderly rather than a disorderly shutdown of this institution. But
unfortunately the Fed is behaving as if Bear Stearns is illiquid but
solvent. That is delusional and the official sector sup****t of an
otherwise insolvent institution will end up - like many other recent
Fed actions - being paid for by the US tax-payer.

As discussed months ago in this column non-banks institutions don't
have access - based on the Federal Reserve Act - to the lender of last
resort sup****t of the Fed unless a very special and unusual procedure
and vote is taken. So for the first time in decades - possibly since
the Great Depression - the Fed had to rely on this exceptional rule to
bail out a non-bank financial institution. So what is next? Bailing
out hedge funds, bailing out money market funds, bailing out SIVs?
When is enough enough? This when the Fed has already committed this
week to swap 60% ($ 400 bn) of its balance sheet of Treasuries for
mortgage backed securities of dubious quality and value.

And Bear is only the first broker dealer to go belly up. Rumors had
been circulating in the market for days that the exposure of Lehman to
toxic ABS/MBS securities is as bad as that of Bear: according to Fitch
at the beginning of the turmoil Bear Stearns had the highest toxic
waste ("residual balance") exposure as percent of adjusted equity on
balance sheet; the exposure of Bear was 54.5% while that of Lehman was
only marginally smaller at 53.3%; that of Goldman Sachs was only 21%.
And guess what? Today Lehman received a $2 billion unsecured credit
line from 40 lenders. Here is another massively leveraged broker
dealer that mismanaged its liquidity risk, had massive amount of toxic
waste on its books and is now in trouble. Again here we have not only
a situation of illiquidity but serious credit problems and losses
given the reckless exposure of this second broker dealer to toxic
investments.

We will leave aside for today the fact that a growing number of
members of the "shadow financial system" have gone belly up in the
last month alone: the entire SIV scheme is being wound down and
brought back on balance sheet; a few hedge funds are now closing shops
(for details see the web site The Hedge Fund Impode-O-Meter) ); a few
money market funds that had exposure to toxic MBS have experienced
runs and had to be bailed out; a highly leveraged private equity bond
fund has gone belly up; a major near prime mortgage lender is
bankrupt. In all these cases a poisonous combination of liquidity risk
and credit risk was exacerbated by reckless leverage.

So the question is: if Bear Stearns screwed up big time - as it did -
with huge leverage, reckless investments, lousy risk management and
massive underestimation of liquidity risk why should the US taxpayer
bail out this firm and its shareholders? First fully wipe out those
shareholders, then fire all the senior management and have the
government take over such a bankrupt institution before a penny of
public money is wasted in bailing it out. Instead now the use of
public money to bail out financial institutions is spreading from
banking ones to non banking ones. The Fed should at least give a clear
and public explanation of why such extremely exceptional - and almost
never used - intervention was justified.