The Meltdown Put – Wall Street’s New Moral Hazard
The Bear Stearns failure followed by the Lehman failure have created a new kind of moral hazard for Wall Street, something I’ve started calling The Meltdown Put.
A “put” is a kind of option that works very simply. Two people form a contract, a seller and a buyer. The seller writes the contract and agrees that if a stock or security drops below a certain price, they will buy that security from the buyer at that price. So if I buy a put option for a stock at $10 and the stock drops to $9, then I can still sell my stock at $10.
When Bear Stearns failed, the government stepped in and arranged a bailout that eventually valued Bear at $10 per share. Had the government not appeared, then Bear would likely have filed for bankruptcy just like Lehman. Shareholders would have received $0 per share.
Like Bear Stearns, Lehman sits on a lot of messy banking contracts, repos, and all kinds of other stuff. But unlike Bear, Lehman lacks the kind of complexity and depth of Bear’s arrangements for a variety of reasons (including the Fed’s new lending window for banks). A failure of Bear would have been awful. A failure at Lehman is bad, but not the end of the world. The Federal Government, tired of bailing out banks, has conspicuously ignored all pleas to help Lehman.
This is what I am now calling a Meltdown Put. It works like this: if you’re doing something risky, do it in such a way that a failure of your project results in complete financial Armageddon. While counter intuitive, you will actually protect shareholder value and backstop their losses by forcing the Federal Government to bail you out. On the other hand, a more conservative approach will give the government less reason to care, and your shareholders end up absorbing your losses.
Essentially, the government now has an implied put contract on all banks. If a bank risks ending the world, they’ll get bailed out. If not, they’ll get ignored. It’s not completely like a real put, but close enough.
The market rewards risk, and the Meltdown Put is the ultimate reward and the ultimate moral hazard. The shareholders of any company with their finger on a financial nuclear bomb will be better off than those of a more conservative company. The outcome from this can’t possibly be good.
I seem to recall vague rumblings from Bernanke’s direction on this very issue. Isn’t the Fed looking at concrete ways to avoid being put into this sort of situation in the future?
I just read about another moral hazard that seems obvious now, but I had never thought about before. When a consumer is picking a savings account, they will naturally pick one with the highest interest. Since savings accounts are FDIC insured there is no risk to the consumer in picking a higher yielding account, but in order to offer these higher rates the bank is forced to take on higher risks. With the ease of opening an online savings account these days (E*Trade, HSBC Direct, ING Direct, etc.) there are consumers that are rate shopping and increasing pressure on banks to offer these high rates.
I get the feeling unless Paulson sees another “Bear” balance sheet he’s going to let them fail. I didn’t see numbers on how wound up Bear was in derivatives until this article yesterday….
[quote: http://cnnmoney.mobi/money/business/company/detail/92809/2 ] Barry Ritholtz, CEO of Fusion IQ, said that Bear Stearns’ holdings also posed a greater risk to the nation’s financial institution than did Lehman’s. He said Bear Stearns had $9 trillion worth of financial instruments known as derivatives, much of it shared with other financial institutions such as its eventual buyer, JPMorgan Chase. He said Lehman had about a tenth that much exposure. “Lehman was only incompetent enough to blow up and destroy themselves, where as Bear’s degree of incompetence was enough to threaten the entire financial system,” Ritholtz said.[/quote]
Out of this I suspect we get new “well capitalized” rules and I say rules as I hope the financial industry will learn a lesson and self govern rather than have some new convoluted leverage law that the next generation of finance lawyers will look for a way around.
[...] AIG bailout is another example of what I’ve started calling a Meltdown Put. Their capacity for shredding the global financial markets has earned their shareholders $2 a [...]