By -
The rescue of Bear Stearns & AIG
Support of Critical Institutions: Bear Stearns and AIG


In March 2008, a Fed loan facilitated the takeover of the failing broker
-dealer, Bear Stearns, by the bank JP Morgan Chase. In October 2008, the Fed intervened to prevent the failure of the nation's largest insurance company, AIG
AIG : In September 2008, AIG—a multinational insurance and financial
services firm—faced serious liquidity problems that threatened its survival. Many losses came from the insurance it sold on bad mortgage-related securities.

Because AIG was interconnected with many other parts of the global financial system, its failure would have had a massive effect on other financial firms and markets.

However, AIG also owned sizable assets that could be used as collateral. To prevent its collapse, the Federal Reserve loaned AIG $85 billion, using AIG assets as collateral. Later, the Treasury provided additional assistance.

The rescue of AIG prevented even greater shocks to the global financial system and global economy.

Over time, AIG stabilized. It has repaid the Fed with interest and has made progress in reducing Treasury's stake in the company.

The problems at Lehman, AIG, and other companies highlighted the need for new tools to deal with systemically critical financial institutions on the verge of failure.



What's the timeline of important events from the beginning of 2008 to
the end of the crisis?




Why did the Fed bailout AIG and
 how was it carried out?



AIG’s bailout was obviously consistent with this “Big Bank Theory” because the US government is afraid the collapse of AIG would cause an economic catastrophe that can affect not just the local economy but perhaps the global markets as well.
The particular risks that brought the company to the brink of bankruptcy seem to lie not with its core insurance businesses but with its derivatives-trading subsidiary AIG Financial Products. AIG FP, as it's called, merits a mere paragraph in the nine-page description of the company's businesses in its most recent annual report. But it's a huge player in the new and mysterious business of credit-default swaps: derivative securities that allow banks, hedge funds and other financial players to insure against loans gone bad.

As a result, the US Federal Reserve (FED) said  it had issued a $ 8.5bn emergency loan to AIG for a 79.9% stake with the aim of assisting the insurance company. This is to escape from bankruptcy which could seriously damage the economy. It seems that the US government is going the right way.



What is the moral hazard risk people talked about after the Fed's rescues of several financial institutions?


 
Moral hazard, a term first used by the insurance industry, captures the unfortunate paradox of efforts to mitigate the adverse consequences of risk: They may encourage the very behaviors they’re intended to prevent. For example, individuals insured against automobile theft may be less vigilant about locking their cars because losses due to carelessness are partly borne by the insurance company.

Moral hazard occurs whenever an institution like the Fed cushions the adverse impact of events. More to the point, lessening the consequences of risky financial behavior encourages greater carelessness about risk down the road as investors come to count on benign intervention. Moral hazard must be weighed carefully in responding to financial crises.

In the cases of Bear Stearns and AIG, some argue that the greater good would have been served had the Fed stood back and allowed the firms to fail, immediately taking all management, shareholders and creditors down with them. This course would avoid moral hazard entirely—and satisfy the general public’s desire for seeing Wall Street highfliers brought low.


The Fed, however, must be ever vigilant in its mission. The Federal Reserve Act explicitly and implicitly sets out several mandates to guide Fed actions. The most important are
• Full employment and sustainable economic growth       
• Price stability
• Banking and financial system stability.

By intervening in a financial crisis, the Fed doesn’t allow markets to play their natural role of judge, jury and executioner. This raises the specter of setting a dangerous precedent that could prompt private-sector entities to take additional risk, assuming the Fed will cushion the impact of reckless decision making. So, when intervention is the only option, the Fed has the duty to minimize micro moral hazard—that is, the benefit to any specific firm or industry.

Minimizing micro moral hazard starts with imposing tough terms—generally the orderly closure of the troubled firms that benefit from intervention. The Fed didn’t just shovel money at Bear Stearns’ and AIG’s problems.

It demanded collateral for the loans and charged interest—in AIG’s case, at high rates.


Minimizing micro moral hazard means keeping information about the targets, timing and terms of any potential intervention as vague as possible, a tactic sometimes called “constructive ambiguity.”



Minimizing micro moral hazard also means aiding selected firms only as a last resort. Federal authorities found alternative solutions short of direct intervention for some financial giants. The Fed expedited the reclassification of investment banks Goldman Sachs and Morgan Stanley to bank holding companies. Private-sector buyers acquired Merrill Lynch, Washington Mutual and Wachovia.
When direct intervention does take place, the Fed’s duty goes beyond minimizing micro moral hazard. The central bank has the equally important responsibility to maximize macro moral hazard—a somewhat counterintuitive term that captures the greater good of preventing unnecessary damage to financial markets and the economy. Maximizing macro moral hazard recognizes the Fed’s obligation to reduce the risks of recession and price instability and the risks stemming from an unstable banking and financial system. By fostering a more stable macroeconomic environment, the Fed’s policy actions reduce the private sector’s pain from bad decision making.        



The outright, uncontrolled collapse of Bear Stearns or AIG could have harmed millions of households and companies as financial market troubles brutalized retirement accounts, paralyzed the flow of capital, and ultimately led to layoffs, stunted consumption and a severe recession. The goal of Fed intervention is to prevent, or at least forestall, such macroeconomic spillovers.






The best case for the bailout seems to be that nobody has the faintest idea what the consequences of AIG's failure for financial markets would be, but the fear was that it could lead to total chaos. The biggest fears had to do with the credit-default swaps, which AIG appears to have sold in large quantities to practically every financial institution of significance on the planet. RBC Capital Markets analyst Hank Calenti estimated Tuesday that AIG's failure would cost its swap counterparties $180 billion.  


The decision of the central banks (especially the Fed) to reach out to help is difficult because if the central bank immediately help and without limit by injecting liquidity as they do, moral hazard might be happened. The problem is the belief of the market that the central bank will reach out to help when economy is depressed. So calm and more risky investment. Bubbles lead to severe over control. In addition, if the central bank cuts its policy interest rate aggressively, as the market demands. It can cause high inflation problems in the next phase. If the central bank do nothing  about the problem, the financial crisis might spread into the real economy through the decline of the wealth effect,  

Comments

Post a Comment