Bulls, Bears, and Bear Stearns

Schwarcz: elucidating the hazards of herd behavior.


Jim Wallace

This past spring, with securities firm Bear Stearns floundering, the federal government orchestrated a deal to allow investment bank JPMorgan Chase to buy the company out, thereby staving off a larger crash in the financial markets. At least part of Bear Stearns' trouble stemmed from the downturn in the housing market. As home prices dropped, homeowners who'd taken on debt to purchase their homes lost equity and began to default on their loans, leaving firms that had invested heavily in mortgage-based securities with little recourse.

Before joining the Duke faculty, Steven Schwarcz, Stanley A. Star Professor of law and business, spent more than twenty years working as a lawyer in New York City, where he represented some of the world's leading banks and financial institutions and helped to pioneer the field of asset securitization.

In a lecture you gave this past spring, you drew a comparison between the subprime mortgage crisis and the Great Depression.

There is a superficial analogy there, certainly. During the Great Depression people were taking out loans and investing the money in stocks. Everyone assumed the stock market would continue to go up. At the beginning of the Depression, the prices of the stock didn't go down that much, frankly. But people panicked because they were leveraged up. They had all this stock, and it was all paid for on borrowed money. And now the stock was worth less than the amount they borrowed to pay for it. So they defaulted on the loans.

That's just like with homes. In the [modern] housing market, many people look at homes like investments. Home prices went down, not that dramatically, but the key point is that the prices of homes went down below the amount people actually owe to pay for the purchase.

So they couldn't make the mortgage payments?

In some cases, people probably couldn't pay their mortgage loans. I suspect that in many cases people saw that they had lost equity in their homes and just said, "I'm not going to pay for this. I'll just default on the loan, let them try to come after me."

What was it that happened that made the prices go down that first little bit? Was that a natural shift?

There are different views of that. One view of that is that there was a housing bubble. Market prices tend to go in bubbles. The dot-com thing was a bubble. There are classic bubbles. For example, the seventeenth-century tulip craze in Holland, where the prices of tulip bulbs went just ballistic. Bubbles are not necessarily irrational. They're almost like just an incident of market behavior. But the bubble bursting is one thing that happened.

Part of the problem could also be that the Federal Reserve made housing money so cheap, mortgage money so cheap, that housing costs were artificially inflated. You had so many people borrowing money and buying that demand for a house sort of exceeded the supply. When the rate started to increase, then the amount of money reduced, and you didn't have as many buyers—they couldn't afford it—and so the demand went down and the prices of homes went down. And that in turn started triggering the defaults.

You mentioned the Federal Reserve "making" housing money cheap. Where was the money coming from?

One of the main sources for liquidity in the mortgage market is securitization. Essentially you have a bank, a mortgage broker, or some institution that makes mortgage loans. Now consider that you are a financial institution, and you have a certain amount of money that you have access to, let's say a million dollars to make mortgage loans. Once you've lent the money, you have no money you have access to. But if the loans you've made can now be sold off in a way that enables you to get a million dollars back, you can now make a million dollars more in loans. So you sell them to investors as mortgage-backed securities.

One of the theories about why everything crashed is that when you have securitization, then the person originating the loan—and then selling it off—will not take the steps to make sure that the loan standards are really high quality. It's called moral hazard in economics. Before this happened, the markets were beginning to adjust so that there was responsibility that was beginning to be imposed on the mortgage brokers.

In what ways?

Where there's a default of the mortgagor within three months, then the mortgage will be put back to the broker, for example. The problem was that some of these mortgage brokers were fly-by-night outfits. But the real failure, I think, was of the investors, the ultimate buyers of the mortgage-backed securities, to monitor the system properly.

Why didn't they see this coming?

Well, there are two groups. There are the rating agencies, which are coming in for a lot of abuse. And there are the investors. One reason I think investors blew it is because things are so damn complex. I have an article I'm working on called "Complexity as a Catalyst of Market Failure."

A prospectus can run hundreds of pages, just on one investment. If you're an analyst at a company, and your job is to invest in big portfolios of asset-backed securities, are you going to read 300 to 400 pages of complex data and try to understand it, or are you going to see it's rated AAA by Standard and Poor's and Moody's and go ahead and invest in it? There's a sort of herd behavior. Everyone else is doing it. This is why people invested in Enron. A lot of people knew Enron was a bit of a house of cards, but everyone was investing in it, and if you didn't invest in it, the question was, why? And if you did, and it failed, then everyone is equally responsible. There's a sense of complacency.

One of your research interests is the idea of systemic failure. Can you describe what that is?

I define it to mean that you have some sort of shock to the financial system, be it a failure of a major bank or hedge fund or major market, that then triggers a ripple effect or a domino effect where a big segment of the market will collapse.

Have we seen that domino effect in the recent case of Bear Stearns?

We are seeing it now. The major systemic effect is the drying up of the credit markets. People can't get credit very easily. There is an effect on the so-called "real economy," which means how you and I live.

Of course the government did arrange for JPMorgan to buy out Bear Stearns.

It wasn't that people were interested in saving Bear Stearns, per se. It's that Bear Stearns had all of these contracts with hundreds of other major institutions. So if you had Bear Stearns default on these, then the other institutions would not be able to get paid, and they would default. That's what happened in the Great Depression with banks. Banks were not getting paid, so they could not pay the investors in banks—the depositors—and depositors then started freaking out and running on the banks. It's a very finely intertwined system.

Are there things the government should do to avoid a systemic collapse?

I think that the government should at least consider setting up a mechanism so that when you have the beginnings of a market failure, it could come in and at least consider whether it will provide some sort of liquidity. Especially if it's truly an irrational market failure, like a collapse like we have now, where the mortgage-backed securities have dropped far below their actual value and people are scared to invest in the markets.

The government could overcome moral hazard by following a policy of constructive ambiguity—exercising the right, but not the obligation, to purchase securities. To further mitigate moral hazard and to avoid shifting the costs to taxpayers, it should purchase securities only at a deep enough discount to ensure ultimate repayment of its investments, ideally at a profit, while stabilizing market prices below the levels paid by speculating investors.

Why is it that the market doesn't correct itself when the price gets too low?

Part of the answer is that same herd behavior, where individuals do not want to jeopardize their reputations and jobs by causing their firms to invest at a time when other investors have abandoned the market. In this case, an investor of last resort could act to correct the market failure.

At the point that Bear Stearns looked like it was going to fail, was there another option besides helping another company buy it out?

That's more of a macroeconomic issue. I suspect that there was, but the issue was one of timing. I think Bear Stearns said, we're going to file bankruptcy tomorrow, and so the government really, for better or for worse, decided to find a buyer for it. The unfortunate part is that they created a lot of moral hazard by guaranteeing JPMorgan as buyer. You're telling institutions that the government's not going to let them fail, which encourages them to act recklessly. You're also shifting taxpayer money to JPMorgan, which is making a huge profit, and for whom there is really no downside because of the government indemnity. It would have been good if there actually had been people out there who would have purchased Bear Stearns at a market price. Given sufficient time and information, that maybe could have happened.

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