Let's Get Real About Bear Stearns

Reams of articles and comments have appeared over the past few days on the Bear Stearns (BSC) debacle. A particularly interesting viewpoint has just been penned by my business partner John Mauldin in his Outside The Box newsletter. I realize that a large number of my readers also subscribe to John’s newsletters, but nevertheless, I thought it appropriate to republish his article for the sake of those not receiving his newsletters directly.

I already have a slew of e-mails from people upset about what they see as a bailout of a big bank, decrying the lack of ‘moral hazard’. And I can understand the sentiment, as it appears that tax-payer money may have been used to bail out a big Wall Street bank that acted recklessly in the subprime mortgage markets.

But that is not what has happened. This is not a bailout. The shareholders at Bear have been essentially wiped out. Note that a third of the shares of Bear were owned by Bear employees. Many of them have seen a lifetime of work and savings wiped out, and their jobs may be at risk, even if they had no connection with the actual events which caused the crisis at Bear. Don’t tell them there was no moral hazard.

For all intents and purposes, Bear would have been bankrupt this morning. The $2 a share offer is simply to keep Bear from having to declare bankruptcy which would mean a long, drawn out process and would have precipitated a crisis of unimaginable proportions. Cue the lawyers.

As I understand this morning, JP Morgan will take a $6 billion write down, which is essentially what they are paying for Bear. The Fed is taking $30 billion dollars in a variety of assets. They may ultimately take a loss of a few billion dollars over time, although they may actually make a profit. When you look at the assets, much of it is in paper that will likely get close to par over time, and the good paper will pay premiums mitigating the potential loss. The problem is no one is prepared to take that risk today.

If it was 2005, Bear would have been allowed to collapse, as the system back then could deal with it, as it did with REFCO. But it is not 2005. We are in a credit crisis, a perfect storm, which is of unprecedented proportions. If Bear had not been put into sounds hands and provided solvency and liquidity, the credit markets would simply have frozen this morning. As in ground to a halt. Hit the wall. The end of the world, impossible to fathom how to get out of it type of event.

The stock market would have crashed by 20% or more, maybe a lot more. It would have made Black Monday in 1987 look like a picnic. We would have seen tens of trillions of dollars wiped out in equity holdings all over the world.

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. It should be pointed out that 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.

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.

As I have repeatedly said, recessions are part of the business cycle. There is nothing we can do to prevent them. But depressions are caused by massive policy mistakes on the part of central banks and governments. And it would have been a massive failure indeed to let Bear collapse. I should note that this was not just a Fed action. Both President Bush and Secretary Paulson signed off on this.

The Fed risking a few billion here and there to keep the boat afloat is the best trade possible today. Their action saved trillions in losses for investors all over the world. It is a relatively small price. If you want to be outraged, think about the multiple billions in subsidies for ethanol and the hundreds of billions of so-called earmarks over the past few years to build bridges to nowhere. And think of the billions in lost tax revenue that would result from the ensuing crisis. I repeat, this was a good trade from almost any perspective, unless you are from the hair-shirt, cut-your-nose-off-to-spite-your-face camp of economics.

The Fed is to be applauded for taking the actions they did. And they may have to do it again, as there are rumors that another major investment bank is on the ropes. I hope that is not the case, and will not add to the rumors in print, but I am glad the Fed is there if we need them.

It is precisely because the Fed is willing to take such actions that I am modestly optimistic that we will ‘only’ go through a rather longish recession and slow recovery and not the soft depression that would happen otherwise.

I got a very sad letter today from a lady whose husband is in the construction business an hour from Atlanta. He has had no work for four months and they are rapidly going through their savings. The jobs he can get require them to spend more in gas to drive to than he would make. He is sadly part of the construction industry which everyone knows is taking a major hit.

But without the Fed action, that story would have multiplied many times over, as the contagion of the debt crisis would have spread to sectors of the economy that so far have seen only a relatively small impact. Unemployment would have sky-rocketed over the next year and many more families would have been devastated like the family above. It would have touched every corner of the US and the globe.

Bailing out the big guys? No, the Fed does not care about the big guys, and only mildly pays attention to the stock market, despite what conspiracy theorists think. In the last few years, I have had the privilege of meeting at length with a number of Fed economists and those who have their ear. They are far more focused on the economy, their mandates for stable inflation and keeping unemployment as possible.

No one who owned Bear stock was protected. This was to protect the small guys who don’t even realize they were at risk. To decry this deal means you just don’t get how dire a mess we were almost in. It is all well and good to be rich or a theoretical purist and talk about how the Fed should let the system collapse so that we can have a ‘cathartic’ pricing event. Or that the Fed should just leave well enough alone. But the pain to the little guy in the streets who did nothing wrong would simply be too much. The Fed and other regulatory authorities leaving well enough alone is part of the reason we are where we are. First, get the water out of the boat and fix the leaks, and then make sure we never get here again.

And yes, I know there are lots of implications for the dollar, commodities, markets, interest rates, etc.

I know my position today will be somewhat controversial (a small understatement) to many readers, but I have never let fear of being controversial deter me from giving you my thoughts and calls as I see them.

As I write about 2 pm central time, the Dow is flat on a wild up and down ride. I do not see this as a bottom. The Fed move keeps the system together, but it does not do anything to stave off a fall in consumer spending, a fall in home prices, the increased difficulty to get consumers loans, falling construction, etc. which is what normally happens in a recession (unlike the last time when consumers could borrow to maintain spending).

I believe earnings are going to continue to disappoint in a broad swath of companies, which will ultimately translate into lower stock market prices. Be careful out there. There are good trades and deals available, just not in traditional stock market index funds, in my opinion, which I should point out could be quite wrong.”

Source: John Mauldin’s Outside The Box, March 17, 2008.

Comments

[Jeff Pittsburgh]

Great article!

[Mbuna]

Bah! The executives at Bear Stearns are rewarded for their dishonesty and recklessness by getting to keep all their earnings and bonuses instead of having to hire defense attorneys as they should have. This article is typical one sided BS that conveniently omits facts in order to bolster it's argument. The real point of this article is that the law should not apply to Wall St. executives and that they are supposed to be free of responsibility for their actions.

[buffalogordon]

I agree with the author. Bear was NOT bailed out - they were swiftly liquidated and backstopped by the Fed to keep global credit flowing. Bear was widely known to be a loner on the street - they had no friends. Therefore, instead of the other investment banks helping Bear stay afloat through the turmoil, they were swiftly taken down on a rumour. No trust. Extraordinary times call for extraordinary measures. As much heat as Bernanke takes, I think his scholarship with regard to understanding the machinations of the Great Depression helped here.

[User 165317]

Mbuna said it correctly. What the government is doing is devaluing our life savings that my wife and I diligently saved for
over 35 years so we wouldn't have to worry about surviving in retirement. Now, our own government is intentionally destroying the value of the dollar and they are worth less every day that passes. Sometimes the market needs a whack in the head with a 2X4 to cleanse itself of the junk that's contained within. I have always thought politicians were low on the totem pole of character but now I know that they're right on the very bottom (and GWB is buried in the ground beneath the bottom rung)
and you think it's a good idea.
You're full of it!

[rew]

As long as Wall Street was making money hand over fist creating the derivatives that led to the current crisis, Washington and the Fed were content to let these makers of financial destruction proceed without hindrance. Now that things look grim, we have to spend the taxpayer's money to save the day. Clearly, in addition to re-instating some of the more reasonable regulations of financial markets so hastily discarded in the last 15 years, we need to impose a tax on Wall Street profits to fund a rainy-day emergency pool to finance these inevitable bailouts.

[User 165469]

Bankers and Wall Street have been laughingly referring to Bernanke as "Kristen" because he is their high priced whore. Did you really write "This is not a bailout" and "Yes, tax-payers may eventually have to cover a few billion here or there on the Bear action" just a few lines apart (where did you go to school?)

You want a rescue? Fine, we want a payback to the taxpayers in terms of future gains. These executives reaped huge benefits all the way up - and you want us all to pay them on the way down so they can repeat the cycle again. It is grossly unfair... and you know it.

[Rabbito]

who thinks it is a good idea to short BSC at these levels, as of this post it is $6.20

[venividivici]

I can't believe where you are coming from. The Fed's role in this financial disaster is nothing to be pround of. They sat on their hands for years while Wall Street built a skyscraper out of playing cards and paid themselves over 100 billion dollars in bonuses. Now it's all going very pear shaped not one cent of those bonuses is coming back. Their actions have left the world's financial system teetering on the brink of a precipice and Bernanke has to keep pulling rabbits out of his hat to pull it back. Just how many rabbits has he got left?
If the Fed had exercised any sort of proper oversight, this would have been nipped in the bud long ago.

[HingeFire]

It is interesting to note that the financial press has not touched on one of the more pertinent reasons why the executives at Bear Stearns decided to take the low bid offer rather than to enter reorganization. Under bankruptcy, the executives would most likely be required to pay back the millions in 2007 year-end bonuses that they recieved in the past 120 days.

Things you can buy for two bucks
hingefire.blogspot.com/2008/03/things-yo...

[Just a Hick]

Prieur,

This is the soundest piece of reasoning I have read on the Fed Bailout of BSC. I love reading your articles on SA,please keep contributing.