Northern Rock and Bear Stearns - How the Fed solves a problem
When the Federal Reserve Bank facilitated the takeover of Bear Stearns by JP Morgan, they provided an object lesson in central bank responsibility which the Bank of England should study and digest.
The Fed's intervention is startling due to the fact that Bear Stearns is not a bank. It is a financial intermediary, that is, an investment company. There were no lines of retail customers outside their New York office, waiting to withdraw their life's savings.
23 March 2008
The speed at which events unfolded is remarkable. Bear Stearns went to the Securities and Exchange Commission on 13 March, stating that it was preparing to file for bankruptcy. On the very same day, JP Morgan announced that it was lending some US$ 30 billion to Bear for a month, underpinned by the Fed. By Sunday 16th, JP Morgan had made an offer of US$ 2 a share which valued Bear at a derisory US$ 236 million. On Monday 17th, JP Morgan staff were installed at Bear and effectively took control of operations.
Although Bear does not have retail depositors, the company is at the centre of a myriad of major international deals and positions. Simply unravelling these positions would be a prolonged and convoluted process which would also draw other US institutions into the mire. The Fed did not want the contagion to spread to other banks.
There is also widespread concern that the demise of Bear was brought about by the concerted efforts of a group of 'short sellers', that is, the practice of betting that the price of a share will drop. If enough people do this, market sentiment is swayed, and it becomes a self fulfilling prophecy.
It must not be assumed that integrating Bear into JP Morgan will be an easy task, as the two organisations are quite dissimilar.
As part of the rescue operation the Fed lent some US$29million as part of the emergency action.
It was felt that when the Asian markets opened after the weekend, Bear's position would be untenable and a major crisis of confidence in other US banking institutions would quickly follow.
The Fed also took action to boost the standing of Lehman Brothers who were the object of negative market rumours. They apparently telephoned numerous US and international banks stating that Lehman was solvent and enjoyed the Fed's confidence. Despite a price fall of 20% on 17 March, Lehman shares rose by 45% on Tuesday when it issued a company report.
It should not be assumed that the Fed will support any US financial institution. Only the major players enjoy this special privilege.
Carlyle Capital is listed on the NYSE Euronext exchange at Amsterdam, although it is managed from New York. It administers US$ 81 billion of investments and has real estates deals to the value of US$ 229 billion.
The fund achieved the dubious distinction of leveraging its equity in excess of 32 times, and used this debt to finance the purchase of residential mortgage backed securities. These were issued by Freddie Mac and Fannie Mae.
It is these very same securities, with treble A ratings, which have percolated through the international banking system. The downgrading of these securities triggered the current credit crisis.
By 14 March 2008, Carlyle had defaulted on debt repayments. Many of its major creditors had recently received soft loans from the Fed. Their sudden financial strength gave them the confidence to play hardball with Carlyle and foreclose on the collateral. The banks acquired Carlyle's assets on the cheap. They would further benefit by exchanging these tainted securities for pristine US Treasury Bonds under a swap scheme announced by the Fed. This is an unexpected and thoroughly undesirable consequence of the Fed's actions to support the major players.
On the other side of the Atlantic, the Northern Rock saga continues to unfold.
Northern Rock has announced its future plans for the period up to 2011. As expected, the priorities of the UK Treasury have dictated the strategy, which is based on the premise of repaying GBP 30 billion of public funding.
As usual the term 'nationalisation' is not used and is replaced by the euphemism of 'temporary public ownership'.
Firstly, In order to repay the GBP 30 billion, the bank will endeavour to reduce its asset base by one half and severely reign in the level of new mortgage advances. What this means in practice is that half of Northern Rock's mortgage holders will need to redeem their mortgage and take out a new mortgage with another lender. The scale of this proposal is staggering. Northern Rock has some GBP 110 billion in mortgage advances and had achieved a 20% market share for all new mortgages in 2007.
This objective can only be achieved if other banks or building societies are able and willing to offer re-mortgages to Northern Rock customers. At present, all indicators point in the opposite direction. Mortgage lenders are cancelling offers to borrowers and requiring new borrowers to increase their deposits to 10% or more. A Northern Rock customer, who enjoyed a mortgage advance of 125%, will find it both difficult and unattractive to migrate to a 90% mortgage.
Secondly, Northern Rock aspires to become a savings bank. This means that the previous policy of aggressive expansion, based on short term funds from the wholesale market, will be substituted by long term deposits from retail customers. In other words, borrowing from other banks will be replaced by deposits from private customers. The latter group are mainly middle aged people saving for their retirement.
While Northern Rock remains nationalised, and continues to offer attractive rates for savers, this aim can be achieved. Other banks will bleat about unfair competition, and the EU could be an irritation. However, if and when the bank is deemed ready for return to the private sector, there could be an immediate and devastating outflow of funds which would have echoes of the run on the bank in August 2007 which prompted the original crisis.
In recent years, London has clearly overtaken New York as the leading global financial centre. Although Tony Blair and Gordon Brown have claimed credit for this, the reality is that the moderate degree of regulation of UK markets encouraged international capital and financial players to locate there. The City of London made these newcomers welcome, and also embraced innovation and change in its financial products and working methods. London has become the capital city of world finance, and also a favoured playground for the rich and famous.
The extended sage of Northern Rock, which started in August 2007 and which will run until the bank is returned to the private sector, has dogged the international reputation of London. The UK authorities have demonstrated their inability to handle a crisis.
The swift and brave action of the Fed in dealing with Bear Stearns has astounded international financial markets and demonstrated the determination of the US to mitigate the fallout from the credit crunch.
The credit crunch originated in the US, and the Fed has acted decisively. No major US bank or financial institution will fail. The contagion spread to the UK and the UK authorities dithered for 6 months. At the end of that time, they were intellectually bankrupt and resorted to the classic Old Labour or socialist remedy of nationalisation.
The irony of the comparison between the two crises is that a similar solution was available in the UK. Before the crisis broke, Lloyds TSB wished to acquire Northern Rock with the benefit of some GBP 30 billion of guarantees from the Bank of England. At the time, the Governor of the Bank of England preferred to lecture on the dangers of moral hazard associated with bailing out banks.
Unease about the competence of the Bank of England has been heightened by the Bear Sterns affair. There is a noticeable lack of confidence in the ability of either the UK government or the Bank of England to prevent a repetition of the Northern Rock disaster. For this reason, black rumours will continue to circulate about other UK banks. It is clear that the crisis is far from over, and the Bank of England will again be put to the test.
Copyright - Leslie Hardy, 26 March 2008
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