It Wasn't a 'Bailout'

How shall we describe what happened this weekend with Bear Stearns (BSC)? The first big casualty of the credit crisis, yes. Bailout, no.

Bear Stearns was an investment bank that made trades and created markets for a broad range of securities, including extensive use of derivative contracts such as credit default swaps. In a credit default swap, the seller agrees for a fee to absorb the losses if a certain asset specified by the buyer goes into default. As an upper bound on the importance of such positions, one can look at the gross notional value of all derivative contracts. For example, if you've sold a put option under which somebody could force you to buy 1000 shares of IBM at $100 a share if the price falls that low, your notional exposure would be $100,000. According to Bear Stearns 2007 10-K, the notional value of all Bear's derivative contracts as of November 2007 came to $13.40 trillion. That's trillion, with a "t". As in, about the same number as total 2007 U.S. GDP. Now, Bear's actual net liabilities could under no conceivable scenario actually achieve that number-- for example, if that put is exercised, you buy at $95 to fulfill your obligation to sell at $100 so you're actually only out $5,000. But $13.4 trillion is a staggeringly big number, whatever it means.

A second number that I find fascinating is Bear's stock price, which had fallen from $100 a share at the start of this year to $30 on Friday. Under the deal brokered by the Federal Reserve over the weekend, JPMorgan offered to take over Bear for $2 a share, or less than $300 million for the entire company. By comparison, Bears' NYC building alone is thought to be worth $1.5 billion. Hence when I read statements like this one from Elizabeth Spiers it drives me nuts:

Now Bear is being bailed out by the Fed via JPMorgan Chase, which is buying the troubled firm for $2 a share.... The Fed itself is dodging criticism from people who worry that its willingness to play lender of last resort to the embattled brokerage will cause similar institutions to expect that their worst mistakes can be fixed with a Fed bailout.

$2 a share is a "bailout" that "fixes" management's worst mistakes? I rather think instead that it pretty much wipes out the stake held by owners of the company, and is the very least that could possibly be offered as inducement to try to get Bear to agree to the steps necessary to swiftly resolve the huge problems that its illiquidity creates.

No, $2 a share is no bailout, but instead represents a fire sale price. Indeed, as Felix Salmon observes $2 seems to be substantially below that minimum necessary inducement. BSC shares are trading at the moment closer to $6, suggesting owners have reason to expect something better can be obtained than the initial proposal.

True, the Fed did offer a $30 billion non-recourse loan to JPMorgan to sweeten the deal. But what twist of logic would lead us to describe that as a "bailout" of Bear as opposed to an inducement to JPMorgan to help clean up the mess?

Granted, this and the Fed's other recent unconventional measures are exposing the Fed-- and ultimately the U.S. taxpayer-- to additional risk. But knzn offers a good counterpoint-- perhaps the greatest single risk to the U.S. Treasury is the risk of declining tax revenues from a major economic downturn. I do not share knzn's particular fears of deflation in the U.S.-- I am absolutely confident that Bernanke can and will prevent deflation. But lost revenues from an economic downturn are already a reality, and it's only a question of how much more severe that's going to become. Minimizing net loss to the Treasury, receipts and expenditures included, is perhaps one reasonable metric for deciding how big a risk it makes sense for the Fed to assume in this situation.

But I think the really troubling thing about this development is the rapidity with which Bear's capital seems to have disappeared in smoke. It looks to me like the correct language to describe what happened is that of a classic bank run-- Bear's short term creditors said "no mas", and it was impossible to liquidate long-term assets fast enough to cover the gap.

Some are saying that this was ultimately an error by the Fed, in failing to provide interim liquidity to Bear sufficiently quickly. But that we have been marching toward a day like last Friday should have been very clear to everyone for at least a year now. Stability of the system is supposed to be achieved by ensuring that any institution that is borrowing short and lending long holds a sufficient cushion of net equity so as to be able to absorb the losses from short-term liquidation. Whatever the true meaning of the $13.4 trillion notional exposure, that number was "only" $8.74 trillion in 2006. It appears that Bear was unable or unwilling to work itself into a position of lower leverage and higher equity even with one year's advance warning. For which, I say, the owners and managers should and will suffer.

Bear is not going to be last, but it is the model I think for what we'd want to see-- owners of the companies absorb as much of the loss as possible, while the Fed does its best to minimize collateral damage.

But if you're still walking the streets of New York, watch out for falling debris.

Comments

[jaybe_be]

It reminds me of John Pierpont Morgan's 'achievement' during the 'Banker's Panic of 1907' ?

[CarlosSlim]

I agree with knzn.

The greatest single risk to the U.S. Treasury is the risk of declining tax revenues from a major economic downturn.

I wonder why we tax revenues are declining, if as GWB says, the economy is fundamentally strong?

Perhaps GWB's tax cuts are to blame for the declining tax revenues?

Ironic, don't ya think?

[Sournois]

However you slice, paint it, cover it....it was a bailout at the expense of the American tax payer. BSC 'was' a public company that threw it's chips on the table of a free market and after a good run, it lost its game and screwed the pooch. Ben and his boys should have had nothing to do with Bear. What happens when the next one falls? And the one after that? You want to keep these firms afloat as well? You must have already sold all your USD...

[TheLittleGuy]

I would agree that Bear was hit with a bank run. The other economic topic illustrated by the FED action is moral hazard. Now they are really on a slippery slope. Someone at some point had to be the object lesson and it should have been Bear. Wait for the lawsuits to fly next, will the FED deflect those too? Or was the $30 billion to help settle?

[TheLittleGuy]

We had a great illustration of a modern day bank run. This illustration was followed nicely by another modern day example of moral hazard. The FED is on a slippery slope now. Bear should have been the object lesson for the rest of a greedy industry. Companies that go under file for bankruptcy and its assets and liabilities are handled in an orderly fashion. Now, will the FED help with settling the approaching storm of shareholder lawsuits too?

[Purl Gurl]

James Hamilton writes, in part,

"Bear Stearns...The first big casualty of the credit crisis, yes. Bailout, no."

This historical action by the feds was not a bailout of Bear Stearns rather was a bailout of Wall Street, at large. There is really no difference with the feds simply using Bear Stearns as a vehicle to bailout almost all other Wall Street financial institutions.

Bear Sterns is not a "casualty" of this credit crunch. No, Bear Stearns did not shoot itself in the foot, Bear Stearns shot itself in both feet through deceptive business practices. This deception is the clear omission of truth about this company's fundamental strength, or lack of fundamental strength.

While statistical analysis of our economy, of our world economy, serves an important and good service for all, this learning afforded through analysis is of lesser quality when presented data is fabricated. Clearly Bear Sterns engaged in fabrication for quite a period of time before this company could no longer cover up truth.

Certainly controversial, my personal opinion is a good eighty percent of corporate executives, especially those directly involved with Wall Street, are financial criminals yet to be caught and prosecuted. Readers can fairly debate what percentage of Wall Street executives are criminals, but cannot debate this level of securities fraud inflicted upon American families is significantly higher than is expected; financial crime is pervasive across Wall Street, both subtle and overt.

Part of my personal trading strategy is considering all companies to be operated by financial criminals. I presume all company executives to be liars and thieves. Then I proceed to work at proving those executives to be truthful and honest. Quite rare am I able to prove those of Wall Street to not be criminals.

I am not so sure this fed action was a bailout. I do entertain a suspicion this fed action was, in part, an effort to delay revealing truth, while working at correcting problems created by deceptive corporate practices.

Fortunately, truth has a habit of becoming self-evident, in time.


Okpulot Taha
Choctaw Nation

[Britishsteel]

purl gurl is absolutely right! And the fed aided and abetted this scam by NOTdoing their job in enforcing the laws that do exist. Everyone says their oughta be a law against this . Well guess what ? Their is But laws are useless unless they are enforced!

[James Cullen]

Dead on - who really thinks that wiping out the equity holders in a company constitutes a bailout?

[Vikram]

Bear was sacrificed so that a financial system collpase could be avoided. It was made an example of. If the Fed had opened their window to IBs a week ago, Bear would still be around.

Also the notional value of CDS has very little to do with leverage. In most cases each position has a hedge. For example, your $100 put on IBM might be hedged with an other side put on the Technology Spider (XLK). The notional amounts will still add up but the risk is hedged.

The leverage comes from the securities Bear held in its own books. They were heavily levered (30:1 ?) so a 3% fall in the values of the security would wipe out their equity. IBs use this leverage to benefit from the interest rate arbitrage; they borrow at a lower rate and invest at a higher rate.

When the value of the mortgage bonds started falling, Bear got margin calls, which triggered a bank run. Bear could not satisfy the cash requirement since it could not liquidate its securities fast enough at a fair price.

This can happen to any bank; the role of rumors in this case is really sad. The wealth of a lot of hard working people was wiped out.

[Jack inMaryland]

Mr Hamilton: Thank you for this commentary. Would you also say what you think of Jim (Investment Biker) Rogers' view that BSC wasn't allowed to go bankrupt because that would have meant that billions in bonuses delivered this year would have to be returned?

[SS]

One thing that people don't mention is that while the equity holders took it on the chin the BS bondholders did get a bail out with this transaction. I really can't see how the FED didn't end up at the bottom of the slippery slope with those stakeholders.

[Rhodomontade]

The Federal Reserve is an insidious banking cartel. Repeal the Federal Reserve Act, break the grip of the money trusts, and return the power to issue currency to a Congress of the people.

[sammyg123]

Excellent. Get your tin hats out everyone. It's not an economic crisis....it's a conspiracy. Insert spooky music here.

[Britishsteel]

Its not a conspiracy, the conspiracy is that anyone who is against the federal reserve. the war in Iraq and anything else that runs counter to the dumbing down of America is marginalized and made to seem like your a nutjob or unpatriotic if that is your view! If Americans would just think for themselves instead of beliveing every government number that comes out and the the page 6 gossip propaganda that is force fed every day to the masses we would have a much better and stronger country. Have you noticed how every Busines channel now has the the push up bras ,and miniskirt anchor woman who are complete ditz's! But they sure are eye candy, but what does that have to do with REAL REPORTING!
And as far as Bear being sacrificed ? It was not Bear that was sacrificed it was the shareholders and the employees who got screwed and also the American taxpayer. What should be done is that the laws that are on the books need to be ENFORCED. Who was supposed to be overseeing the underwriting and enforcing safe lending practices? Barney Franks? Jail him 25 years to life for wiping out and destroying people's lives? Ben Bernake same thing. As long as we as Americans do not demand the same standards be upheld and adhered to that we as individuals face from the criminal justice system and our employers then we give our "government "the right to screw us every time!
ASK YOURSELF IS GOVERNMENT HERE TO SERVE THE PEOPLE OR ARE PEOPLE HERE TO SERVE THE GOVERNMENT.

DEMOCRACY IS OUR CHOSEN SYSTEM NOT SOCIALISM!
SO STAND UP AMERICA AND DEMAND EQUALITY AND JUSTICE FOR ALL! It applies to the very Rich as well as the Poor.

[nukldrager]

Panic of 1907... "United States Secretary of the Treasury George B. Cortelyou earmarked $35 million of Federal money to quell the storm. Complete ruin of the national economy was averted when J.P. Morgan stepped in to meet the crisis. Morgan organized a team of bank and trust executives. The team redirected money between banks, secured further international lines of credit, and bought plummeting stocks of healthy corporations. Within a few weeks the panic passed, with only minimal effects on the country." from Wikipedia re jaybe's comment... History repeats itself literally?

[drmalaka]

Keep living in your dream land that this was not a bailout. The US taxpayer is footing the bill for this in the form of $30 billion in loans to cover Bear's potential losses.

Bear Stearns did not get bailed out but tons of other people did. What about preferred stock holders and bond holders? How come they get their money back while the taxpayer foots the other bill? What about the counterparties that Bear did business with, they got their risk guaranteed by the taxpayer? What about the rest of the banks that are being propped up now by the Fed and their scumbag partners keep taking billions in bonuses?

This is an entire bailout of the banking industry by the US taxpayer. To save these low life thieves every single American taxpayer is now on the hook for this debt.

The bottom line is that all these banks' actions are being covered by the taxpayers again. We have lowered interest rates explicitly to save the banks. The net result is that prices are skyrocketing for all our expenses. The banks live and the individual pays for it in higher prices.

Symantics as usual, sure Bear was not bailed out, the entire banking industry was bailed out. And everyone reading this, you are the ones paying for it.

Should we start taking bets on the next bubble these douche bags will be involved in. The government needs to sieze the bank accounts of all the bankers who were involved with this fiasco and recapture that money for the American taxpayer. Instead these criminals have lost there jobs and have to spend their entire days doing nothing but hanging in their Hamptons houses and driving their Mercedes around.

[atlasapple]

to expand on drmalaka's right on post:

The flame out of Bear Stearns, while it wasn’t a bailout of shareholders, was a bailout of Bear Stearns creditors and counter-parties.

The current crisis is the direct result of the moral hazard created with the bailout of Long Term Capital Management (LTCM), in 1998 (more details below the fold). As with Bear Stearns, the shareholders of LTCM were NOT bailed out, but the counter-parties and creditors were bailed out. Thus, the Fed sent a message that if you lend recklessly to a hedge fund or investment bank, don’t worry, the FED will guarantee private contracts, as long as the lending is reckless enough to put the entire economy at risk.

The saying, “too big to fail”, directly and inexorably leads to the kind of reckless lending that crushed Bear Stearns and still threatens the US economic and monetary supremacy.

Who would lend billions of dollars to Bear Stearns unless they know, via the actions in 1998, that Bear Stearns debt would be backed by the faith and credit of the Federal Reserve? Rather then squelch the reckless lending that allowed for the current crunch, the Bear Stearns creditor bailout reinforces the LTCM lesson that as long as you lend to large enough institutions you need not worry about default and counter-party risk.
The problem today is that there isn’t enough money to bail out the entire system as LTCM was bailed out in 1998. In 1998, LTCM was the only over leveraged firm threatening the economy, now virtually all investment banks are over leveraged (and banks as well given Glass-Steagall;s 1999 repeal).

Had the FED and Wall Street allowed LTCM to fail, causing counter-parties a lot of financial pain, perhaps Bear Stearns would not have been allowed to borrow 3000% of their equity. Homeowners buying houses with zero equity is understandable as they are laypersons, Wall Street over leveraged precisely because of the backing of the FED as implied by their behavior in 1998. Just as Wall Street misjudged the severity of home mortgage defaults they are still misjudging the severity of their own over-leveraging.

Grab you hats, this roller coaster is still on the way down.

[Britishsteel]

TRhisd all being engineered and if you All read Greenspans book and his comments on the savings and loan crisis , you would understand what I mean its simple really, They enginereed this bubble by not regulating and enforcing the laws THAT ALREADY EXIST and now that they cannot squeeze any more cash out cause the jig is up , they are forcing the liquidation of these lenders and banks and they are being bought up for pennies on the dollars So once again they make more cash and cut out the competition. History always repeats itself. Hedge funds are now being forced to adhere to the 4-1 ratio of leverage and that means no more need for hedge funds cause they cannot perform in that enviorment