From the desktop of Brad DeLong, a very good synthesis of the evolving state of Federal Reserve policy:
We now have two precedents. If the Federal Reserve judges that a major financial institution:
- is too big to fail in that its failure will generate systemic risk
- has followed portfolio strategies that have produced inappropriate and excessive leverage
- requires immediate action
then the Federal Reserve will intervene to structure and support a deal that leaves principals and investors in the offending systemic risk-creating institution with effectively zero entity. Counterparties will be rescued. Principals and investors will not--even if normal more lengthy legal and bargaining processes would give principals and investors a share of the equity value on the table.
This is not the arms-length equal-treatment impersonal-rule-of-law ideal to which a government should aspire. This does, however, seem to get the incentives about right.
Charlie Kindleberger once wrote, in Manias, Panics, and Crashes, that the key to avoiding both depression and moral hazard was for the lender-of-last-resort to always show up in a crisis but for its appearance to always be doubted until the very last moment. These two precedents suggest that the Federal Reserve is evolving a case-law-of-twenty-first-financial-crisis that is somewhat different: in a crisis the lender-of-last-resort will always show up, but investors and principals in individual institutions that need to be specially rescued will discover that the lender of last resort is not their friend.
It is the "too big to fail" characterization of an institution that precludes the ideal arms-length equal-treatment impersonal-rule-of-law conduct of monetary policy. Given that characterization, however, the Fed's evolving policy goes directly after moral hazard in two places. First, by (very nearly) wiping out the value of the equity, the Fed sends the strongest message it can to these institutions that you don't want the Fed to have to get involved. Second, by moving control of the financial decisions away from the insiders who now hold little equity, the Fed sets up reasonable conditions for more prudent behavior after it leaves the scene.
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Fed
Are you serious? The Fed's TBTF policy stands. A policy it denies having. It's all right. The dollar is finished. The Fed's message: the politically favored will be bailed out.
If Bear Stearns had its man at Treasury, Bear would still be with us. The rule of law does not exist. I disagree with DeLong. My solution: repeal the Federal Reserve Act and let the chips fall where they may.
The current message: make sure the Fed and Treasury are liberally sprinkled with your alumni, like Paulson and Steel.
Citi's hedge fund failures and stock offering solution
Yesterday's actions by Citi would seem to confirm DeLong's analysis of the new Fed.
Citi principals and shareholders will dilute their own stock voluntarily before facing the firing squad -- the Bear Stearns scenario.
Update
Looks like Citigroup is in a heap of trouble, but trying to put lipstick on the pig. They upped the offering from $3 billion to $4.5 billion. Fed cut rates again, jobs numbers look to be terrible, and they specifically mentioned continuing weakness in the financial sector.
half a penny
"Counterparties will be rescued. Principals and investors will not--even if normal more lengthy legal and bargaining processes would give principals and investors a share of the equity value on the table."
Overall, DeLong gives a nice summary. However, I'd like to see a more nuanced approach to the principal and investor position: principals and investors who relatively recently invested in equity will not be protected, but principals and investors with older and lower cost basis will be protected (if you had invested in Bear Stears around year 1985-1986 and left it alone, you would not be wiped out. If you graduated from college in the year 2000s and sunk a bunch of capital into Bear, you'd be cringing).
I think this nuance is important. Young people (20s to 30s) have less say and control (compared to people in 40s, 50s, 60s) in an orgz the size of Bear, and thus less ability to manage orgz risk.
There may need to be litigation in the situation. Older managers who mislead employees, or who implicitly coerced employees to buy stock through company stock purchase plans, may needed to be spanked. I suppose it depends on how this all ends.
Why should young people have less say and control?
You're saying that if I'm 25 years old and hold 50,000 shares of Citi I bought last year that I should be screwed more than the 50 year old who has 200 shares purchased 10 years ago?
Every share of stock has to be treated equally, regardless of age/race/gender of holder. Anything else would be illegal discrimination.
Everyone assumes the same risk when purchasing an equity. Some are not more equal than others.
some young people shouldn't
regarding people in 20s:
how many have the authorization to hire and fire?
how many allocate capital within the organization?
how many have decision-making authority on risk-mgt policies?
so young people (relative to older people) may not be in the same position to influence the value of the equity. this is what i was trying to say.
"You're saying that if I'm 25 years old and hold 50,000 shares of Citi I bought last year that I should be screwed more than the 50 year old who has 200 shares purchased 10 years ago?"
"screwed" depends on many other factors. Your statement is a little too simplistic. Generally, a young person has more time to recover from disastrous managers than a 50 year old; thus, a young person may be less screwed than an old person.
Moral Hazard
What you're saying -- that we should protection the very decision makers who created the mess (the CEO and higher level execs at the company) vs. the average stockholder -- is pretty much what happens today. They get the multi million dollar parachutes while the stock sinks.
But is it right to reward the people who implemented poor risk management policies -- you know, the ones who decided that leveraging money by a factor of 30 or 40 was a terrific idea?
That's just nuts, and is the biggest moral hazard out there right now.
Huge disincentive to investing and saving
A policy of hitting younger people harder for the mistakes of the older generation would not only cause riots in the street, but also is a huge disincentive to saving for young people. If I were 20 and this were the policy I wouldn't bother to save any money. Nada.
This is a generation that's already looking forward to having lower real wages, changing jobs every 5 years, no defined pension plans (save on your own for retirement), no social security, possibly no Medicare, and huge taxation to pay for the debt left by the baby boom generation.
Now you think it's a good idea to punish them for investing too?
No wonder they're all leaving the country.
lenders
Note that, although equity investors got killed, debt investors were entirely bailed out. So the incentive remains to lend blindly, without any consideration of risk, to any "too big to fail" institution.
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