An Investment Banker's Take On Life: On Judgment Calls, Moral Hazard and Catch-22

[Raven commented yesterday in my post on Bear Stearns that she feels the Fed is doing an awful job in keeping the economy stable, and asked if I could write down some of my thoughts on the matter. Instead of continuing that thread under "Comments", I thought I should instead put my thoughts in a post like this, so space will not be a constraint.]

Judgment call. That's the demon that the top honchos of at least three institutions--the Fed, Bear Stearns and JPMorgan Chase--had to wrestle with over that fateful weekend when the future of an 85-year-old institution was hanging on the balance. I'm sure each of them received the best analysis and advice, given whatever constraints there may have been at the time, from the best minds within their respective organizations. But at the end of the day, each of them had to make the judgment call which is now water under the bridge and part of the yet unfinished history of the worst financial crisis to have hit in the last 50 years.

If I have given undue emphasis to that decision point, short of romanticizing the act itself, it's because I wanted to call your attention to the fact that executive decisions especially of a "life-and-death" nature are gut-wrenching and involve, for the most part, a leap of faith for those aspects of the problem which cannot be subjected to even rough quantification.

Metaphorical kitchen sinks have been thrown by angry critics at US Fed Chairman Ben S. Bernanke and Bear Stearns CEO Alan Schwartz for their decisions which made the buyout deal possible. For Mr. Bernanke, that kitchen sink is called "moral hazard", while for Mr. Schwartz, it could be a lawsuit from shareholders. Many are saying $2 is a steal for JPMorgan Chase given that the Bear Stearns midtown Manhattan headquarters by itself is already worth more than $1.0 billion.

For this post, however, let's just focus on the Fed action and start with some basics. I'd like to quote the Investopedia on the official role of the Fed, so we can use this explanation to view its actions in proper perspective:

The Fed is the gatekeeper of the U.S. economy. It is the bank of the U.S. government and, as such, it regulates the nation's financial institutions. The Fed watches over the world's largest economy and is, therefore, one of the most powerful organizations on earth.

* * *

The Fed dictates economic and monetary policies that have profound impacts on individuals in the U.S. and around the world.

It is an awesome (and, if I may add, humbling) responsibility, no doubt, because what the Fed does or does not do affects not only the US economy but the world economy at large. We can, therefore, rest assured that the official decisions taken by the Fed are all well-considered and well-analyzed, and represent the collective wisdom of very senior academic and applied economists.

I need to underscore the word "wisdom" in that last statement because there's a dirty little secret in some types of decisions, a catch, if I may call it as such. Fortunately, Joseph Heller has a term for it--"Catch-22", which he made the title of his bestselling novel, with a movie tie-in.

Catch-22 refers to "a false dilemma, where no real choice exists," according to the Wikipedia. When I use the term in everyday conversation, I mean a damned-if-you-do-damned-if-you-don't situation--very much like the one the Fed had face since the subprime mortgage crisis blew up in mid-2007. That's the unenviable position Mr.Bernanke has found himself in.

Take, for instance, this write-up by Edmund Andrews which the New York Times published on September 14, 2007, before a crucial FOMC meeting:

In practice, the line between rescuing financial markets and rescuing the overall economy is far from clear. Mr. Bernanke faces big risks, either by acting prematurely and giving investors the impression the Fed will shield them from risk or by acting too slowly and allowing a recession to set in.

Expressed differently, at that moment in time last year, Mr. Bernanke was torn between committing "moral hazard" (i.e., acting prematurely) and upholding the Fed's non-intrusive and market-driven regulatory policy (i.e., acting too slowly). Now comes the $64 question--Between moral hazard and a market meltdown as choices, which would you choose if you were Mr. Bernanke? As both are unpleasant non-choices that will both produce so-called collateral damage, the decision boils down to which will have the least unpleasant effect.

That's precisely the same menu he was served again during the Bear Stearns affair and, I imagine, the one he'll have over and over again all throughout this crisis, which has yet to run its full course. The buyout deal left a very bad taste in the mouth of many, most especially among the shareholders, officers and staff of Bear Stearns who were at the receiving end of that deal. A deluge of lawsuits might hound this deal, as a result.

But then, like in a chess game, even an important piece like the Queen may have to be sacrificed in a set play called "Queen's gambit" as part of a strategy to ultimately achieve victory. Financial bloggers like myself are sometimes guilty of trivializing the Fed's actions when we indulge in so-called Monday morning quarterbacking (like so many have done on the JPMorgan Chase $2-bailout of Bear Stearns and the recent 75-basis-point interest rate cut).

Just because we disagree with the Fed doesn't mean that the Fed is wrong. For instance, I had to eat my humble pie when the Dow Jones industrial average rose by 420 points on Tuesday (reason: I wrote in my previous post that the rate cut won't be enough to "calm an angry sea" after the market became more jittery with the precipitous fall of Bear Stearns). Oh, well...win some, lose some, although it's not over yet (there was big market correction yesterday) and I could still be vindicated for my contrarian view.