Vincent Reinhart on Bear Stearns
By Arnold Kling
the form of the Bear Stearns resolution actually invited another form of speculative attack. The official playbook appeared to protect creditors fully and to wipe out shareholders. This expectation made it profitable to identify the next financial firm to be resolved and then to sell its stock short and use the proceeds to purchase its unsecured debt. If the candidate firm was identified correctly, the debt would appreciate in value and its stock collapse. The basic message is that repaying unsecured creditors at par creates an opportunity for capital gain. When the government creates an expectation that it will intervene in this way, market participants bring forward the pressures officials fear in a classic speculative attack.
This is worse than moral hazard. This is bailout arbitrage. I had not thought of this possibility before. I wish that Reinhart would write an article that focuses on this. It is too important an idea to be buried as one paragraph in the middle of a longer article.
One point that he does not mention is that this sort of speculative attack will wipe out the firm’s capital, which forces the regulator’s hand.