Saturday, March 15, 2008

Redefining Market Failures: Bear Stearns and the Class Element in Market Discipline

We have been told that " The Federal Reserve took the extraordinary step yesterday of providing emergency funding to one of Wall Street's venerable firms, Bear Stearns, after it ran out of cash to repay its lenders." Neil Irwin and Tomoeh Murakami Tse, Fred Comes to the Rescue as Wall Street Giant Slips, The Washington, March 15, 2008. Government intervention was both extraordinary and necessary, we were told, to prevent a collapse of the economy.
"The Fed's action, arranged in a series of pre-dawn deliberations yesterday, is one of the most significant government efforts to save a private firm in modern times. The nearest parallels are the New York Fed-engineered buyout of the hedge fund Long-Term Capital Management in 1998 and the bailout of Continental Illinois Bank in 1984."
Neil Irwin and Tomoeh Murakami Tse, Fred Comes to the Rescue as Wall Street Giant Slips, The Washington, March 15, 2008.

But while we are all breathing a sigh of relief at the heroic action of the great leaders of our public and private sector, now may be an excellent time to reflect on the lessons of this affair--one that will likely be repeated as the United States lurches toward its Presidential election in November 2008. The first lesson is the most well known--it is better to borrow enough to become a threat to the lending system than to do otherwise. Bear Stearns reminds us that swine are rewarded and nice little well behaved creatures are devoured. It is better to be a swine than not. "Critics characterized the Fed's move as a bailout that inappropriately intrudes on the free market and could lead banks to keep taking risks like those that imperiled Bear Stearns. Other analysts said the action was necessary, given the precarious state of world financial markets." Neil Irwin and Tomoeh Murakami Tse, Fred Comes to the Rescue as Wall Street Giant Slips, The Washington, March 15, 2008.

But more important, perhaps, is a lesson about the class ramifications of this market system. First, not all market participants are treated equally in the market. Markets are a long way from being the perfect vehicle for the discipline of economic activity. More importantly, as economic institutions become more powerful, their public institutional aspects become more important as well. Bear Stearns cannot be permitted to fail because, in essence, it serves a public function--maintaining state policy on finance and the framework on the market through which such public policy is effectuated. In a sense, then, the critique of developing states is vindicated to some extent here. Because Bear Stearns serves a public function, it ought to be burdened, to that extent at least, with the obligations of states--accountability, observation of human rights and other norms. There is an inconsistency here, then, between the actions of the United States in the international arena, and its actions in saving Bear Stearns. See Larry Caá Backer,

More ironic, though, are the class implications of the bailout. Markets are supposed to reward success and punish failure. The success-failure matrix is meant to provide a great incentive in a value maximizing market environment both to do well, and to replace those people or conditions that do not. Yet, in the face of the long simmering failures at Bear Stearns, there is little indication that the directors (yes, I said directors) or officers have sought or offered to resign. Incompetence is its own reward and failure is the mark of experience at the highest levels of the labor markets. Those who most sanctimoniously speak to the evils of inefficiency in labor, who with such eagerness trim the "fat" or "non-productive" elements of their workforces, who terminate those who do not meet expectations, seem immune to the same market forces. It is difficult to reconcile the mythologies of the market with the mummification of leadership at Bear Stearns long after it became clear that their operations through hedge funds in the mortgage market had essentially collapsed last summer. See Matthew Goldstein, Bear Stearn's Subprime Bath, BusinessWeek, June 12, 2007.

Yet, the investors and consumers who so welcome labor efficiency in a firm at the lower reaches ought to value that impulse more at the highest levels of the labor totem pole. Thus, as a Bear Stearns investor, I might not have sold my shares because of the federal government bailout, but might have been tempted to do the same on the news that the incompetence of management in that crisis has been rewarded with job security. And I am not alone. "Teetering on the brink of collapse from a lack of cash, Bear Stearns got emergency funding on Friday from the US Federal Reserve and JPMorgan in the largest government bailout of a US securities firm. The move failed to avert a crisis of confidence among Bear Stearns' customers and shareholders, who drove the stock down a record 47 percent." JP Morgan May Buy Bear Stearns, Taipei Times, March 16, 2008.

It seems that the socialist model of employment applies at the highest levels of labor, but a more ruthlessly efficient model applies t everyone else. This sort of labor and market cronyism almost brought down the Malaysian government. It was at the heart of the crisis of the nomenclatura based controlled economies of the Soviet era, its worthlessness was attacked even by such unlikely leaders as Deng Xioaping. That sort of dissipation in the American system produces decadence and a failure of leadership that will be felt in future generations.

The only bright news on the horizon is the workings of the market mechanism at the macro level. "Bear Stearns Cos' 85 years as an independent Wall Street firm may be coming to an end as JPMorgan Chase & Co considers buying the crippled company." JP Morgan May Buy Bear Stearns, Taipei Times, March 16, 2008. Perhaps the new owners will engage in the sort of housekeeping that is necessary. This result is more likely given the betting among members of the financial community. "Options traders increased bets that Bear Stearns will collapse. Implied volatility, a measure of contract prices, surged past 300 for the New York-based securities firm. That's a level Ambac and Thornburg Mortgage Inc. reached this year as investors sold stock on concern the companies may fail." Elizabeth Stanton, U.S. Stocks Drop for a Third Week as Bear Stearns Gets Financing,, March 15, 2008.

Sadly, the transaction costs of efficient labor markets at this level is high. Golden parachutes and other preference and contingency payments are likely to be high and able to support attacks based on breaches of a board of directors' fiduciary duty. See Larry Catá Backer, Disney/Ovitz: The Delaware Supreme Court Augments Its Complication of Fiduciary Duty, Disney, Law at the End of the Day, June 10, 2006.

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