Twofish's Blog

March 17, 2008

Things fall apart….

Filed under: china, new york city — twofish @ 4:47 am

This has been an exhausting week news-wise. You have the resignation of the governor of New York, Tibet is on fire, and then you now have the purchase of Bear-Stearns by JP Morgan. And then next week is the Taiwan presidental elections. I’m trying to remain as calm as I can through these events. I’ve been cursed with having to live an interesting life in interesting times.

I really don’t have that much to say about the Tibet situation. You can find your standard predictable flame war all over the internet,
and I try to avoid making points that have been made in other places. Also usually I end up being something of the voice of reason, and you sometimes just need to have people get tired of screaming at each other before you can say something sensible, and I’m just too exhausted to scream.

About Taiwan. I make no predictions about who will win. I made the mistake in 2004 of going to sleep sure that Lien Chan would win, and then being surprised in the morning when he didn’t. If Frank Hsieh wins, it will be one of the biggest surprising political upsets in politics, but big surprising political upsets do happen. About Bear-Stearns, I do have some things to say that are different.
As I mentioned in Brad Setser’s blog, this really isn’t a bailout, rather its a reaction to the fact that Chapter 11 bankruptcy law
doesn’t work for large financial institutions. The main economic purpose of Chapter 11 is to save as much as can be saved from
companies in trouble, so the first thing that a bankruptcy judge will do is to freeze debt collection and give companies even working capital so that they can keep running while everyone figures out what to do, and this can take several months.

This works well for most companies, but it works very, very badly for financial companies. The problem is that finance is a fast moving web in which people owe each other money. If you freeze one part of the web, then everything falls apart very, very quickly. Taking weeks or months to sort things out works if you are making pencils, but in finance where everything takes place in minutes or seconds, you just don’t have the time. Also if you are running a pencil factory, you still have a factory and pencils and workers and they aren’t going anywhere. In finance, all you have is trust, and trust takes years, even decades to build, and trust can disappear in an instant.

So what is happening is that the Federal Reserve is basically taking the role that would be played by bankruptcy court, it gave
Bear-Stearns an emergency blood transfusion that could get it to the emergency room. This is quite unique and it is something that was done in the case of Long Term Capital Management. It’s really breaking new ground here, and what happens will be studied as a guide for what happens the next time this happens (which I hope will be a long, long time from now, but who knows).

One group that comes out of this looking really bad is CITIC Securities. JP Morgan ended up paying $270 million for all of Bear Stearns and total control, whereas CITIC was about to pay $1 billion for six percent with no management control. It’s fortunate that the Chinese securities regulators failed to approve the deal otherwise, CITIC would have ended up burning $5 billion.

I think the one common thing that Spitzer, Tibet, and Bear-Stearns have in common is that it shows how quickly things can fall apart.

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