The Federal Reserve-orchestrated fire sale of Bear Stearns to JPMorgan Chase has forced the market to come face to face with the prospect of massive government bank bailouts, and of what it could mean to taxpayers.
This stunning deal raises the questions of whether it is right for the government to help out a major financial institution that made risky mistakes during the mortgage market boom or whether, on the other hand, Bear Stearns is too big for the Fed to let fail.
To be sure, as news of Bear Stearns' stunning downfall became known, fears of a global financial crisis began to grow.
With its unraveling in full motion, the venerable brokerage house was sold to JPMorgan on March 15 for $2 a share in stock, or roughly $236 million. The Fed, in an effort to complete the deal, extended a $30 billion credit line to JPMorgan.
According to reports, the cash position at Bear had shrunk to $2 billion on March 13, a massive drop-off from the $18 billion that had been reported by Standard & Poor's earlier that week.
"This underscores how close Bear came to the brink of bankruptcy," Kathleen Shanley, an analyst at Gimme Credit, wrote in a research note on March 18.
The Fed's decision to act as lender of last resort in the agreement has left some market participants wondering whether it sets a new and potentially unwanted precedent.
"The taxpayer bailouts have already been coming with the subprime rescue packages," said Pete Sepp, a spokesman for the nonpartisan National Taxpayers Union, which advocates for lower taxes and a more accountable government. "If entire institutions start to falter or fail, the flood of legislation will be unbelievable."
Sepp added, "Many analysts would say we worry too much about a taxpayer bailout, but we're paid to worry here. And we are worried."
As with the troubled Countrywide Financial Corp. - which was bought by Bank of America in January for approximately $4 billion in stocks - it was not surprising that observers inside and outside of the market immediately began debating the merits of a Bear Stearns bailout. But what if neither deal actually constituted a bailout?
"As long as taxpayers take no loss, then the Fed's actions do not, in my opinion, constitute a bailout as all the losses in these two situations will be borne by stockholders, as should be the case," said Bert Ely, a free-market-oriented public policy consultant who advises on issues related to financial institutions and monetary policy.
While Ely noted the Fed's "assumed credit risk" by issuing a discount-window loan to JPMorgan in the Bear Stearns deal, he said, "Hopefully the collateral haircut the Fed has imposed will protect the Fed, and therefore taxpayers, from any loss." In this scenario, the costs would instead be imposed on the shareholders.
"Presumably, Bear will soon be acquired, or shrunk sufficiently that it no longer is of any consequence systemically," Ely said.
This potential systemic risk from a Bear Stearns collapse is why the Fed moved when it did, according to Elisa Parisi, an economic analyst for RGE Monitor. Specifically, the risk of a big credit-default-swap counterparty de-faulting had grown too high.
"Clearly the Fed is acting with the intent to stem systemic risk," Parisi said. "In terms of risk to the real economy, Bear Stearns is not the biggest player either for households or for corporate. So they're clearly worried about systemic risk in the credit derivatives market."
Thus, according to one argument, it wasn't that Bear was too big to fail, but that it was too interconnected with the financial markets to be allowed to file for Chapter 11 bankruptcy. As one source noted, a large number of investors in the firm were not venture capitalists, but rather pension funds that could have gone broke along with the bank.
Other market participants, however, still believe that the reason to save Bear from bankruptcy is simply its significant position in the market. It's an argument that Sepp doesn't buy.
"The trouble with the too-big-to-fail' argument assumes that the biggest of the too big to fail is the federal government, and that's the problem," he said. "The federal government is certainly not too big to fail. If the United States were to take on $500 billion or a trillion dollars in bad bank assets, that would send our Treasury bills and bonds probably into the cellar. People who think Argentina can't happen here should always keep that in the back of their minds."
Although the deal with JPMorgan appeared to happen at breakneck speed, Bear Stearns' demise, of course, did not happen suddenly. The first major sign of trouble came last June when two of its hedge funds, once valued as high as $16 billion, went broke after having invested heavily in subprime mortgages.
"It was clear from the beginning that these institutions have grown so highly leveraged, meaning they rely on short-term funding, warehousing and securitization," Parisi said. "The risk is clearly that as soon as investors are unwilling to lend to these highly leveraged institutions any further there will be basically a Northern Rock situation."
According to one market participant who spoke on condition of anonymity, the entire risk management culture has changed. Whereas before Bear Stearns wouldn't take positions beyond a notional amount, the concept of taking on billions in CDOs or Alt-As took hold, he said.
Bear's flaw became relying on short-term funding, which is the most convenient. Bear basically had a one-
to-one correspondence between its cash on hand and the percentage of its short-term debt, according to the source.
"What happened was, people got scared of doing business with them," he said. "People would rather have the cash than have the collateral in this volatile market."
A Bailout or Not?
Whether or not you consider the deal to save Bear Stearns a bailout - and judging by the headlines and commentary over the past week, some continue to insist that it is - the debate about how far the Fed should go to save troubled financial institutions will be ongoing.
Ultimately, Parisi doesn't think the discussion should be about the merits of a bailout, but whether all the Fed's actions - such as dropping the interest rate by three-quarters of a percentage point on March 18 - is actually helping repair the market.
"The more important question I think is if the Fed's action actually solves the problems these institutions are facing, like Bear Stearns," she said. "Injecting more liquidity helps pay off existing debt, but it's not new equity that will shield you from further write-downs in CDOs and CLOs, and it doesn't help to prevent housing prices from falling further or prevent borrowers from defaulting on their mortgages. It's a liquidity injection, but it does not solve the underlying solvency problem."
Sepp and the National Taxpayers Union will continue to argue for proactive steps that can be taken "to make sure the correction is not excessive and a part of the healthy cycle of the economy." He points to a past economic crisis as a warning bell for how the current one should be handled.
"The S&L crisis didn't turn out to be as bad as people were predicting maybe around 1990 or so, but it turned out to be a lot worse than they were predicting two years before that," he said. "I think the lesson we're taking from this is to get the marker out there with Congress and the White House to let them know we're not going to accept a bailout."
He added, "There are bubbles in our economy, especially in the financial servicers sector. Everyone knows you can't keep a bubble blown up forever."
But Ely, the policy consultant, believes the Fed must deal with the dire circumstances at hand, regardless of how we got here in the first place.
"While I am not excited that numerous public-policy failures have created the mortgage mess, the mess now exists, with the consequence that the Fed, as an arm of the federal government, is taking the steps necessary to maintain the functioning of the financial markets," he said. "While not reckless, it is unfortunate that numerous public-policy failures have brought us to this sad state of affairs - unfortunately, there is no alternative at this time. The only impact of these actions, and it is a positive impact, is to facilitate the ongoing and inevitable unwinding of the overleveraging of U.S. homes and those who invested in the debt funding that is overleveraging."
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