What the Bear Stearns Resolution Tells Us About the Fed

The market was shocked yesterday by the terms of the Bear Stearns (BSC) "rescue." It certainly was no bailout for the shareholders or management. There are those who expect government actors to behave like a deer in the headlights. We have the uncomfortable feeling that some pundits actually want our economy to fail and for many average investors to lose their money, their jobs, and their homes. Why? To prove their uber-bearish predictions to be correct? To sell books? To lock in short positions?

Our perspective is quite different, directed at the mainstream of investors. This is not a game between bulls and bears. It is about life chances for the many. We wish that those who are most vocal in criticizing policy would also offer some solutions.

The Reality

The Fed is not playing by the rulebook of the bearish pundits. We have maintained that it is not wise to fight the Fed, and that Bernanke will do whatever it takes to solve the various problems. It is unfortunate that we do not have a stronger President right now, or even better policies would be available. There are proposals in Congress, but progress might be difficult.

Yesterday was a day when there could have been a major systemic failure and a stock market collapse. Instead, timely action stabilized credit markets and counter-party risk. It was no help to Bear Stearns shareholders, but it was good for the U.S. and global economies.

John Mauldin, collecting information and writing in his widely-disseminated thoughts, observes as follows:

As I have been writing, the Fed gets it. Their action today is actually re-assuring. I have been writing for a long time that they would do whatever it takes to keep the system intact. As one of the notes below points out, this was the NY Fed stepping in, not the FOMC. The NY Fed is responsible for market integrity, not monetary policy, and they did their job. And you can count on other actions. They are going to change the rules on how assets can be kept on the books of banks. Mortgage bail-outs? Possibly. The list will grow.

Yes, tax-payers may eventually have to cover a few billion here or there on the Bear action. But the time to worry about moral hazard was two years ago when the various authorities allowed institutions to make subprime loans to people with no jobs and no income and no means to repay and then sold them to institutions all over the world as AAA assets. And we can worry in the near future when we will need to do a complete re-write of the rules to prevent this from happening again.

This is exactly what we have argued for months. The Fed will not be constrained by the "old rules" and will basically do whatever it takes. It is not just about the level of interest rates.

The Logic of Government Action

As we have observed, none of the leading bloggers or media pundits has any real expertise about how government policymakers behave. Here is a key concept:

Government leadership is difficult!

It is frequently the case that the "best" course of action, selected on some rational basis, is very unpopular. This is the current case with the subject of "bailouts." These might be bailouts of investment banks, investors, bad lenders, bad borrowers, and other folks who have screwed up.

A large portion of our society is more interested in punishing those who have made mistakes than they are in looking at the systemic effects. This pervasive sentiment makes it difficult for political leaders to act. Getting the average citizen to see the general interest is a major political challenge, beyond the capability of a lame-duck president.

Once again, John Mauldin has an argument, even drawing upon a theme we had planned for a future article (scratch that!):

But for now, we need to bail the water out the boat and see if we can plug the leaks. Allowing the boat to sink is not an option. And get this. You are in the boat, whether you realize it or not. You and your friends and neighbors and families. Whether you are in Europe or in Asia, you would have been hurt by a failure to act by the Fed. Everything is connected in a globalized world. Without the actions taken by the Fed, the soft depression that many have thought would be the eventual outcome of the huge build-up of debt would in fact become a reality. And more quickly than you could imagine.

Our Take

We are delighted that a sophisticated observer like Mauldin has grasped the fact that the Fed will continue to take imaginative and aggressive actions.

This contrasts sharply with most of the media coverage, which continues to portray everyone in government as stupid, naive, and ineffective.

One of the reasons that people in government choose those jobs over private-sector finance is the desire for power and policy influence. This is something that is little understood by those who took different career paths. We suspect that the hedge fund and media critics of the government and the Fed will be getting a lesson about this in the months to come.

Comments

[User 165042:]

This is absolutely ridiculous. Go study some economic theory and burn your stupid Keynesian books.

Government control, exercised through taxation (theft), inflation (monetary policy) and protection rackets (regulation) is the root cause for market cycles and quote "market failures." As long as government exists, there will be the "invisible hand" of corruption and insupportable, overextended, immoral greed and theft.

"Regulators" do not have performance linked to pay any more than the concept of regulation can be morally supported. When a moral, free market exists alongside this and KNOWS it will be bailed out to a certain extent by regulators at the cost of all others, guess what happens? Traders and trading firms are rational actors whom will respond to incentive....

2008 Mar 18 04:47 AM

[User 165042:]

Almost forgot, I want to make this clear: There is NO immorality to giving loans to people unless they were somehow lied to. Even in that extreme case, it is somewhat on the individual to verify that legal documents are correct.

To suggest that regulators should be involved in restricting the business of free exchange with regards to the time preference of money only makes the suggester a center of moral hazard.

2008 Mar 18 04:52 AM

[megiddo666:]

I agree with the Fed action. Despite the "moral hazard" some may pitch, the greater moral hazard would be the Fed doing nothing.

Of course either way the "doom prophets" would make it seem more terrible. I think some folks are in mantra mode to help the system collapse and then who wins?

Doom prophets are not usually solution sources, since that doesn't sell as well as fear. Same goes for the media, who like the fear mongers since it keeps people watching... or reading. I think the previous commentator would rather see the shorts win as well....

Professional traders and trading firms are what got us into this mess. A different take on Greenspans irrational exuberance....

2008 Mar 18 05:00 AM

[scobbydube:]

The Fed's action might work for a short term, but they are not solving the real problem.. This country and most of it's people are living way beyond their means.. Currently we are penalizing the people who save - these are the people who should be rewarded not the brokers, bankers, and hedge funds who constantly get bailed out.. These guy know the Fed will step in. And JP buying Bear for $2.00 is a big joke..

2008 Mar 18 06:14 AM

[Balsamo:]

Well, Mr Miller
you really seem to have faith in government though i doubt that the Bush administration will be remembered for its "great achievements" in the last 8 years.

The question is not if the fed did or didn't the right thing concerning Bear Stern. It did, but my concern is about its brighter strategy. The fed is acting like some kind of intrepid fireman running from on fire to the other while trying to get grand ma's cat from the tree.
In acting as it does, the fed seems to loose sight of the biggest picture.

I have already posted the following, but as your latest article quoted David Malpass from Bear...euh...JP Morgan (?), here it is.

So went the Malpass quote :
“We think there’s a general underestimate of the power of central banks to stimulate their economies in the short term.
• U.S. recessions have occurred when the Fed tried to stop inflation with high interest rates (1974, 1980, 1982, 1990), a situation the Fed may put off until 2009 or 2010. In contrast, when the Fed has held interest rates down to the inflation rate or below, the result has been strong growth, as in 1977 and 2003.”

I found it amazing.
It just illustrates the common confusion that exists when considering stock markets and the economy. Just take a look at a historical chart of the SP 500.
According to Malpass, recessions occur when the fed tries to stop inflation. Ok. But what tells the market. First quarter 1974 : Nice Bear market rally push the SP from around 60 to more than 100; meanwhile fed action made CPI plunge from 12.2% to around 6%....

And Malpass to continue “strong growth resulted from the fed holding rates down as in 1977”
What tells the market? :The SP just plunged in response to around 80…oh and the CPI jumped to 15%...
1982 : Thanks to Volker, we all entered the longest bull market in history.

By the way, the year 2003 quoted by Malpass is misleading as the fed started to lower rates in march 2001…And started to raise rates in July 04… Remember how the markets reacted to both dates?

Now we can consider what Uncle Bernanke is doing now with more background.
My conclusion is that the fed is fighting the wrong threats with the wrong tools.
Another conclusion is that the fed should carefully define what battle diserved to be fought as he cannot and won't win on all front.

But i agree, preserving the banking system to collapse is a priority, but i don't think that bringing the rates down another 100 bp is a requirement.
Letting the dollar fall further is by no mean a step in restoring confidence, on the contrary. Inflation is the mother of all the ennemies the fed is trying to fight at the moment.

One sure thing history tells us, you cannot save the stock markets by letting the inflation win.

2008 Mar 18 06:33 AM

[the final h...:]

Oh...now i see how it works...the NYFed is different and independent from all the other Feds...so each is an independent empire now.

therefore, JPM will eventually own us all!

AHA! too bad i cant buy JPM stock for the next 500 years.

or maybe i should buy NYFED stock, since they will probably own JPM....

or perhaps the chinese will own NYFED...after all, why bother to do this under the table? we cannot stop anything anyway.

2008 Mar 18 10:08 PM

[Jeff Miller:]

I am delighted to see that several people have taken the time and effort to comment.

I am not surprised that those who choose to write disagree so strongly. It is always difficult to reconsider strongly held opinions. My conclusions about government action come from many years of study and observation. Readers can and will choose whether to find this helpful, or to follow the lead of the many pundits who have no background or understanding government institutions, organizational behavior, or economics.

I get no monetary benefit from allowing my work to appear on Seeking Alpha. My hope is that some readers can look objectively at evidence.

I am less interested in analyzing how this happened than figuring out how to profit from the current circumstances.

I strongly suggest that readers try to understand FOMC motives in order to predict their behavior.

As always, I am happy to engage any well-reasoned comments.

Jeff

2008 Mar 18 11:47 PM