Cover Page The following handle holds various files of this Leiden University dissertation: http://hdl.handle.net/1887/59480 Author: Bartenberger, M. Title: Political pragmatism and principles in times of crisis : the role of pragmatist political crisis management during the U.S. financial crisis Issue Date: 2017-12-13 5 The Rescue of the Investment Bank Bear Stearns The first decision I will analyze in greater depth is the rescue of the investment bank Bear Stearns. The question here is a simple one: Why did president Bush and his administration rescue the investment bank Bear Stearns even though it clearly violated their free market principles? On February 8, 2008, only weeks before the rescue of Bear Stearns, Bush emphasized these economic principles in a public speech at the Conservative Political Action Conference: “Our views are grounded in timeless truths. [...] We believe that the most reliable guide for our country is the collective wisdom of ordinary citizens. […] We believe in personal responsibility. […] We applied our philosophy on issues relating to economic prosperity” (Bush 2008d). A former CEO of the investment bank Goldman Sachs, Henry Paulson shared Bush's philosophy, calling himself “an advocate of free markets” (Paulson 2010, 438). But Paulson also noted: “The interventions we undertook I would have found abhorrent at any other time. I make no apology for them, however. As first responders to an unprecedented crisis […] we had little choice” (Paulson 2010, 438). It is this fallibilist change from a position that favored free markets and skepticism about government interventions to a decision to support a private investment bank with public money that is at the center of my interest here. But before I proceed with this analysis I will briefly introduce the case. In March 2008, Bear Stearns was the smallest of the five big investment banks on Wall Street. Two of Bear Stearns' hedge funds had already failed in summer 2007 because of their strong investments in collateralized debt obligations (CDOs) that were linked to subprime mortgages. In March 2008 Bear Stearns still held many investments in the housing market (Bland 2007; Creswell and Bajaj 2007). On March 10, the rating agency Moody's downgraded 15 mortgage backed securities issued by Bear Stearns, leading to a run on the firm (Financial Crisis Inquiry Commission 2011, 286). Counterparties “refused to believe that the firm was solvent and refused to continue to extend credit” (Kolb 2011, 95). Additionally, counterparties demanded more securities from Bear Stearns (margin calls) which quickly decreased the financial liquidity of Bear Stearns (Financial Crisis Inquiry Commission 2011, 288). While on the morning of March 10 Bear Stearns' liquidity pool had been around $18 billion it was down to $12.5 billion by the end of the day (Blinder 2013, 103; Financial Crisis Inquiry Commission 2011, 286). On the morning of March 13, Alan Schwartz, CEO of Bear Stearns, called Timothy Geithner at the 121 New York Federal Reserve and Bob Steele at the United States Treasury, telling them that his company faced serious liquidity problems (Kelly 2009, 17; Paulson 2010, 93). Treasury Secretary Paulson subsequently called president Bush to inform him about the situation (Bush 2010, 452; Paulson 2010, 96). During the day of March 13, the liquidity reserves of Bear Stearns further declined to $2 billion, leading to a conference call between representatives from Bear Stearns and its regulator, the Securities and Exchange Commission (SEC), at 7:30 p.m. (Financial Crisis Inquiry Commission 2011, 289). During this conference call Bear Stearns stated that it would have to file for bankruptcy on the following day, a message that was also delivered to New York Fed director Geithner and Treasury Secretary Paulson (Geithner 2014, 149; Paulson 2010, 97). Overnight a team from the New York Federal Reserve analyzed the situation and assessed possible consequences of a bankruptcy of Bear Stearns (Sidel et al. 2008). During a conference call on early Friday morning, March 14, 2008, members of the Federal Reserve Bank (led by chairman Ben Bernanke and New York director Timothy Geithner), the U.S. Treasury (led by Secretary Henry Paulson) and the SEC assessed the situation. The short amount of time made it impossible to find a buyer for Bear Stearns or to build a consortium of other financial institutions that would lend to the investment bank (Kelly 2009, 63).58 Anticipating severe consequences for financial markets and the general economy in case of a Bear Stearns bankruptcy Timothy Geithner proposed that the Federal Reserve could lend money to Bear Stearns via the bank JPMorgan (Geithner 2014, 152; Kelly 2009, 66). After Treasury Secretary Paulson had agreed to protect the Federal Reserve Bank from any losses of the loan (Paulson 2010, 101), Fed chairman Ben Bernanke supported the idea and assembled the available Fed governors to approve the loan (Sidel et al. 2008). With the indirect $12.9 billion loan by the Federal Reserve Bank via JPMorgan on Friday morning, Bear Stearns made it through the day (Federal Reserve Bank 2008a) but the rating agencies continued to downgrade the investment bank and the stock of Bear Stearns had fallen by 47% by the end of the day (Financial Crisis Inquiry Commission 2011, 289). For the government, this was a clear sign that trust in Bear Stearns had not been restored by the indirect loan. While initially the loan was supposed to be available for up to 28 days, Geithner and Paulson now pushed Bear Stearns to find a buyer over the weekend (Kelly 2009, 100). JPMorgan signaled interest to buy Bear Stearns and began to work on a deal with the investment bank over the weekend. On Sunday, however, 58 The template of a consortium solution was based on the case of the hedge fund Long Term Capital Management, which was bailed out by a consortium of banks and other financial institutions in 1998 (Blinder 2013, 113). 122 JPMorgan told Geithner and Paulson that it would not be able to takeover Bear Stearns without additional financial support (Financial Crisis Inquiry Commission 2011, 289; Paulson 2010, 109). With the backing of president Bush and Treasury Secretary Paulson, Bernanke and Geithner decided to invoke the emergency clause of the Federal Reserve Bank, section 13(3) of the Federal Reserve Act, that authorizes the central bank to lend to any institution under “unusual and exigent circumstances” (Federal Reserve Bank 2013). Under this provision the Fed purchased $30 billion of Bear Stearns assets with the special condition that JPMorgan would cover the first $1 billion of eventual losses from these assets (Financial Crisis Inquiry Commission 2011, 290). Enabled by the support from the Federal Reserve Bank, JPMorgan and Bear Stearns announced on Sunday that JPMorgan would takeover Bear Stearns, paying $2 per share (Kelly 2009, 219). The takeover by JPMorgan prevented a bankruptcy of Bear Stearns and the financial markets calmed down in the weeks that followed (Blinder 2013, 114). The following timeline summarizes the events of this case. Figure 5: Timeline of the Bear Stearns Case Figure 4: Timeline of the Bear Stearns Case Commentaries have noted the unusual character of the steps taken by the government in order to save Bear Stearns. The Wall Street Journal concluded that the Bush administration “more or less threw its rule book out the window” (Sidel et al. 2008). And the New York Times quoted an economic historian saying “Traditionally regulators have helped commercial banks in financial 123 panics, but not investment banks, which do not hold customer deposits. […] I don’t remember a Fed action aimed at a noncommercial bank” (Landon 2008b). The following analysis will show how the actions by the government were not only unprecedented but can also be regarded as an example of pragmatist political crisis management. 5.1 Decision Making The following sections will concentrate on two core aspects of political crisis management and will analyze the Bear Stearns rescue along these two dimensions: decision making and meaning making. 5.1.1 The Fallibilism of George W. Bush and Henry Paulson Specifications of Pragmatist Political Crisis Management: Readiness to change existing beliefs and decisions; Avoidance of unrevisable decisions Fallibilism, as we have seen in the preceding chapters, is one of the building blocks of pragmatism. As understood by pragmatism, fallibilism is an approach that is “anti-dogmatic and anti- ideological” (Bernstein 2005, 51) and rejects absolutes and “moral certainties” (Bernstein 2005, 42). Pragmatist fallibilism argues for the revision of existing beliefs and habits when confronted with reasonable doubt. In the case of the Bear Stearns rescue, fallibilist behavior could be witnessed in two of the main actors: president George W. Bush and Treasury Secretary Henry Paulson. I have chosen Bush and Paulson to elaborate this fallibilist behavior because they have shown the strongest adherence to free market principles.59 Thus they can serve as prime examples for fallibilism. If we consider the pre-crisis mindset of Bush and Paulson, who advocated for free markets and were skeptical about government interventions, a government-backed bailout of Bear Stearns seemed highly unlikely. But as we will see in this section in deciding to save the investment bank Bear Stearns Bush and Paulson were able to overcome these existing beliefs that were grounded in free-market ideology. As I will argue, overcoming these existing beliefs and strong principles qualifies as pragmatist fallibilism. 59 Ben Bernanke and Timothy Geithner are also interesting but less pronounced examples in this regard (for Bernanke see Andrews 2008b). 124 Departing from the Doctrine of Moral Hazard I will start the analysis by briefly explaining the main ideological principle from which Bush and Paulson departed: the doctrine of moral hazard. As Bush remembers in his memoirs when he first heard about the liquidity troubles at Bear Stearns: “My first instinct was not to save Bear.