Page 1of 5 Too big to fail versus moral hazard
By Henry C K Liu
"Too big to fail" is the cancer of moral hazard in the financial system. Moral
hazard is a term used in banking circles to describe the tendency of bankers to
make bad loans based on an expectation that the lender of last resort, either
the Federal Reserve domestically or the International Monetary Fund globally,
will bail out troubled banks.
Barely 48 hours after US Treasury Secretary Henry Paulson declared his firm
commitment against the danger of "moral hazard" by promising that no more
taxpayer money would be used to bail-out failing financial firms on Wall Street
except in extreme situations, US authorities succumbed to the "too big to fail"
syndrome in the case of American International Group Inc (AIG), the giant
global insurance conglomerate founded in
Shanghai in 1919. Paulson's moral hazard aversion had prevented Lehman Brothers
Inc, the country's fourth-largest investment bank, from getting a government
bailout. Without a needed government guarantee to limit the exposure of
potential buyers, Lehman was forced to file bankruptcy protection at midnight
on Sunday, September 14.
To recap, in March, JPMorgan Chase had been provided with a US$29 billion
credit line from the Federal Reserve discount window in its purchase of Bear
Stearns arranged by the Treasury. In early September, the US Treasury seized
control of two troubled government sponsored enterprises (GSEs) Fannie Mae and
Freddie Mac with a $200 billion capital injection against a $4.5 trillion
liability, concurrent with another government arranged "shotgun marriage" that
induced Bank of America to acquire Merrill Lynch at a firesale price of $50
billion. The Treasury has been criticized and is now sensitive to criticism of
bailing out private Wall Street firms that should have been allowed to fail
from irresponsible market misjudgments, and Paulson is eager to show that going
forward it is not government policy to increase moral hazard.
The best minds on Wall Street had been engaged to seek a private-sector
solution for AIG. Goldman Sachs was hired to assess the potential losses on
AIG's bad assets to set a fair market value for the firm. JPMorgan Chase and
Blackstone were advising AIG on finding buyers among private equity firms
and/or foreign sovereign funds, while Morgan Stanley was helping the Federal
Reserve to consider rescue options.
After frantic efforts to raise funds from private sources to restore the giant
insurer's credit rating failed, the Federal Reserve, reportedly overriding
Secretary Paulson's moral hazard reluctance, arranged a last-minute deal on
Tuesday night (September 16) to provide AIG an $85 billion two-year "bridge
loan" from the central bank to keep it afloat and give it time to dispose of
billions of dollars of valuable assets in a more orderly manner. It was an
unprecedented move for the Fed, both in kind and scale. Normally, insurance
companies are regulated by state insurance commissions, not the Federal
Reserve.
In addition to collateral in the form of illiquid AIG assets for the bridge
loan, which carries a usurious interest rate of 8.5 percentage points above
LIBOR (the London Interbank Offer Rate - at which banks lend to one another and
a widely used short-term interest benchmark - was at 2.75% on September 17),
the Fed would receive equity warrants, technically known as equity
participation notes, for a 79.9% stake in AIG. The issuance of the warrants
(contracts to buy the shares at a pre-agreed price) to the Fed is designed to
prevent existing AIG shareholders from profiting from a government rescue of
the company, which has been hobbled by massive losses from exposures on complex
structured finance instruments backed by mortgages and other debts. Aside from
the high interest rate, the Fed can veto any dividend payments, and AIG is
expected to sell assets over the next two years to repay its debt. Senior AIG
management will be replaced.
The Fed repeated a pattern established with Bear Stearns in March and with
Fannie and Freddie earlier this September of wiping out shareholders while
protecting holders of debt. By now, investors have learned the pattern and bet
on future bailouts by selling stock and buying bonds in distressed firms. The
results push down a company's share price, which can exacerbate its troubles.
Both Morgan Stanley and Goldman Sachs became targets of this strategy.
By all accounts, AIG qualifies as a "Too big to fail" candidate. What made Fed
and Treasury officials apprehensive was not simply the prospect of another
giant bankruptcy on Wall Street, but AIG's role as an extensive provider of
esoteric financial insurance contracts to investors who wanted to hedge
potential losses on complex debt securities they bought. The problem insurance
contracts take the form of credit-default swaps (CDS), which effectively
required AIG to cover losses suffered by the buyers in the event of
counterparty default. AIG was potentially liable for billions of dollars of
risky securities that were considered safe in normal time.
An AIG collapse would cause it to default on all of its insurance claims.
Institutional investors around the world would instantly be forced to
reappraise the value of securities insured by AIG against counterparty losses.
This would require them to increase their capital to maintain their credit
ratings. Small investors, including anyone who owned money market funds or
pension funds that hold AIG issued securities, could suffer losses.
On the day before the AIG bailout became news after market closing, the New
York money market firm Reserve Primary Fund, with $62 billion under management,
announced that it "broke the buck", meaning that its net asset fell below the
standard $1 per share, a development all mutual funds normally would do
everything to avoid.
During a day of emergency meetings at the New York Fed, the Treasury and Fed
reversed initial reluctance to bail out another financial institution. Though
unspoken, the underlying conclusion was that this was not a takeover, not a
bail out. If anyone is being bailed out, it is the central bank, which is
desperately trying to create a fire break to prevent a global capital market
collapse that it may not have enough financial resources on its balance sheet
to support. The Treasury had to announce that it is issuing $40 billion of
45-day Treasury Bills to help buttress the Fed's balance sheet. More will be
issued as needed by the Fed.
There are signs that the government's firefighting measures are less than
effective. Market sentiment suggests that more financial firms can be expected
to fail before the crisis crests. Mark-to-market requirements for valuing
structured finance instruments and portfolios that are structured to appear
safe in long-term probability models reduce the prospect of disaster to a very
short fuse. A hedge that would be considered safe over a period of a year can
suddenly be reduced to a position of high risk in a matter of days or even
hours by market volatility. In such a market environment, the Fed, rather than
its traditional role of market stabilizer over the long term, is often reduced
to an emergency fire fighter in raging forest fires in a financial landscape
infested with elements that practice arson for profit.
Still political opposition surfaced even before the Fed made its final decision
to take over AIG after the market closed. Richard Shelby, ranking minority
Republican on the Senate Banking Committee, warned on television during the
day: "I hope they don't go down the road of a bailout, because where do you
stop?''
Representative Barney Frank, Democrat of Massachusetts and chairman of the
House Financial Services Committee, echoing rising populist criticism against
deregulation, said Treasury Secretary Paulson and Fed chairman Bernanke had not
requested any new legislative authority for the bailout at Tuesday night's
meeting. Frank complained: "The secretary and the chairman of the Fed, two Bush
appointees, came down here and said, 'We're from the government, we're here to
help them [private firms].' I mean this is one more affirmation that the lack
of regulation has caused serious problems. That the private market screwed
itself up and they need the government to come help them unscrew it."
Staggering sum
House Speaker Nancy Pelosi quickly criticized the AIG rescue, calling the $85
billion a "staggering sum". Pelosi said the bailout was "just too enormous for
the American people to guarantee." Her comments suggested that the Bush
administration and the Fed would face sharp questioning in congressional
hearings. The White House said President Bush was briefed earlier in the
afternoon. Actually, to put things in perspective, $85 billion, though no small
sum, is what the US is spending on the wars in Iraq and Afghanistan each week.
Abroad, the AIG bailout was viewed as a milestone marking US rejection of
free-market fundamentalism to resort to government intervention, after decades
of ideological hypocrisy. In Asia, it has not been forgotten that during the
1997 Asian financial crisis, the IMF, dominated by US ideology, set draconian
conditionality for pledging $20 billion to help South Korea from defaulting on
its foreign currency obligations, to require the government to let ailing banks
and industrial companies to fail without government help. Many South Korean
banks and companies were taken over by foreign competitors as a result. Now the
US has suddenly transformed itself as the leading practitioner of state
capitalism and economic nationalism in the name of saving the global
free-market economy.
AIG's plans for a private-sector capital infusion fell apart after its credit
ratings were cut sharply on Monday, September 15, which caused a liquidity
crisis that would leave AIG defaulting on its outstanding obligation by Tuesday
night in New York before markets in Asia opened on Wednesday morning there. New
York governor David Paterson said earlier that AIG had only "a day" to solve
its problems, and that its collapse would cause serious dislocation for the
economies of New York State and New York City, not to mention the rest of the
nation and the world. Estimates of losses for US financial institutions could
reach over $200 billion as a result of AIG default.
For the short term, the market breathed a sigh of relief from the AIG bail out.
But going forward, uncertainty, already causing destructive market turmoil,
will be increased by doubt over when the Fed will have to intervene again and
in which new firm, on what terms and under what conditions. Each Fed move has
been accompanied by comforting announcements that the step in question would
stabilize the market, only to have the credibility of the central bank chipped
away further by the appearance of new crises days later.
Two days later, as the market had time to digest the still murky details of the
Fed takeover of AIG, panic in world credit markets reached historic intensity,
prompting a frantic flight to safety of the kind not seen since World War ll.
Barometers of financial stress hit peaks across the world. Yields on short-term
US Treasuries reached their lowest level since World War II. Lending between
banks in effect dried up and investors scrambled to pull their funding from any
institution or sector whose safety has been called into doubt.
The $85 billion bridge loan to AIG failed to curb the surge in risk aversion.
Instead, markets were hit by a fresh wave of anxiety. Speculation mounted that
the Federal Reserve, which refused to cut rates on Tuesday, could be forced
into an embarrassing U-turn. Amid the chaos, traders were pricing in 32 basis
points of rate cuts by the end of September - in essence betting that there was
a 60% chance the Fed would cut rates by half a percentage point in coming days.
All thought of profit faded as traders piled in to the safety of short-term
Treasuries. The yield on three-month bills fell as low as 0.02% - rates that
characterized the "lost decade" in Japan. The last time they were this low was
January 1941. At one point, the intraday rate was temporarily negative. The
government was charging investors for lending it money as a safe haven.
Shares in the two largest surviving independent investment banks, Morgan
Stanley and Goldman Sachs dropped 24% and 13.9% respectively as the cost of
insuring their debt from default soared several percentage points to threaten
their ability to finance their own debts in the market.
A wave of merger talks reflected the need of investment banks to seek shelter
in large commercial banks. Morgan Stanley was reported to be holding
preliminary merger talks with Wachovia, itself a troubled regional bank. Rumors
were circulating that China Investment Corporation (CIC), China's $200 billion
sovereign fund, which already owns 9.5% of Morgan Stanley, or Citic
International Finance Holdings Ltd have been approached again to come to the
aid of Morgan Stanley. Citic announced on Wednesday, September 17 that it has
hired Morgan Stanley as its new financial adviser to replace collapsed Lehman
Brothers on the planned buyout offer for Citic shares by Citic's parent in
Beijing after Hong Kong securities regulators restricted Lehman's four Hong
Kong operating units from dealing with clients following the bankruptcy filing
of its US parent. Washington Mutual, a distressed regional lender, reportedly
retained Goldman Sachs to approach potential buyers, including JPMorgan Chase,
Citigroup and Wells Fargo.
Newspapers headlined the shocking news that lending between banks in effect
halted after the AIG bail out. The TED spread - the difference between
three-month LIBOR and three-month Treasury bill rates - moved above 3%, higher
than the record close after the
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