Warren Buffett Is Wrong on Fed Intervention in Bear Stearns

Just a couple of days ago, the financial media rejoiced over a prediction made by the Omaha oracle, Warren Buffett that “the worst of the crisis in Wall Street is over,” disseminating this declaration across the world in the hopes that it could continue to fuel what will go down as one of the most foolish stock market rallies in history. However, in all the articles I read that covered his declaration (and there were many), I couldn’t find one that actually discussed in detail any of the reasons why Mr. Buffett believes that recent actions taken by the U.S. Federal Reserve are sustainable. It seemed that most journalists were quite content with applying the logic of “if Mr. Buffett said it, it must be true.”

Mr. Buffett’s declarations of the fallout that likely would have ensued had the U.S. Federal Reserve not bailed out Bear Stearns could have been lifted almost verbatim from my bulletin I sent to subscribers over a month ago. If Bear Stearns had gone bankrupt, other Wall Street firms and banks would have failed within a matter of days and the Dow would easily have shed another 1,000 points also in a matter of days. But here’s where I believe Mr. Buffett is wrong. At his annual meeting of his Berkshire Hathaway company, he stated, “I think the Fed did the right thing in stepping in on Bear Stearns.” So why do I think he’s wrong if I think Bear’s collapse would have created much sharper pain in the U.S. stock markets and the collapse of other financial institutions?

To begin, The U.S. Federal Reserve’s complicity in dismantling the Glass Steagall Act, their refusal to encourage Congress to regulate derivative markets, and their debasement of the dollar all have directly contributed to the debacle that created Bear Stearns’ collapse (I know that is a very simple argument, but it would literally take me 100 pages to explain all the intricacies of how the Federal Reserve very cleverly creates the problems that affect the financial world while claiming ignorance of their hand being firmly in the worldwide financial pot). In essence for Mr. Buffett to declare that the Fed “did the right thing” would be analogous to me praising a country for sending minesweepers into a local village to clear 300,000 landmines that they had planted in their fields. But this is where the analogy ends.

Clearing the 300,000 landmines is a positive act that will vastly improve the health of the local village and no doubt prevent many future deaths. The Fed’s action to bailout Bear Stearns is analogous to planting armed soldiers at the perimeter of the fields and not allowing anyone to enter instead of clearing the fields of the mines. On the surface, everything appears fine because there will be no further deaths even though the problem has not been solved. Eventually, when the soldiers leave and the villagers necessarily re-enter the fields to reach the local markets to buy water and food, villagers will re-discover that the problems never went away and villagers will die. Eventually, time will prove the end result of the Federal Reserve’s actions to bailout Bear Stearns to be much more similar to this scenario. The Fed’s actions have produced the appearances that everything is okay without doing anything to solve the problems.

So let’s explore if there is any justification to Mr. Buffet’s statement that the “Feds did the right thing” and that “the worst of the crisis in Wall Street is over.” In essence, JP Morgan threw a lifeline to Bear Stearns that would not have happened without the blessings of the U.S. Federal Reserve as JP Morgan was ready to walk away from the deal and Bear Stearns was set to collapse the following Monday. Enter the U.S. Federal Reserve with a $29 billion promise to JP Morgan that guaranteed JP Morgan’s buy out of Bear Stearns, with most of the Reserve’s $29 billion collateralized solely by mortgage-backed securities on Bear Stearns’ books. Reserve Chairman Ben Bernanke said that their $29 billion guarantee is not in danger of being called by JP Morgan because the mortgage-backed securities are of “high credit ratings”. Thus, Bernanke concluded that everyone who called the $29 billion offered by the Reserve to make the deal work is patently wrong. Ummmm, if the $29 billion guarantee is not in any danger of ever being called, then why was it 100% necessary to convince JP Morgan to agree to move forward with the deal?

If Ben Bernanke doesn’t understand by now that credit ratings on mortgage backed securities are virtually meaningless, then he should resign tomorrow. I say that sarcastically as I know that Mr. Bernanke fully understands how meaningless the U.S. credit rating system is today. He obviously makes such comments to fool the sheep herd that subscribe to the mantra of ignorance is bliss. Ultimately, JP Morgan is much more likely to call on a large portion of the Federal Reserve’s $29 billion guarantee than not, which means the Reserve will then have to print more monopoly money and push an untenable situation that presently teeters on a cliff into an even more untenable situation. Ultimately this is why the Federal Reserve and Warren Buffet are both wrong.

Furthermore, it’s not like banks have never failed before. People seem to think that bailouts are the only solution and that Armageddon will arrive if we don’t bail out these banks. The reality is that the actions undertaken by the U.S. Federal Reserve are exacerbating the problems, not making them better. Economies across the world have experienced multiple bank failures before only to emerge much stronger in future years. The U.S., is unwilling to endure such maneuvers that would be tantamount to political suicide during an election year. Normally in an election year, the incumbent government will do everything in their power to artificially manufacture a strong economy and stock market as a strong economy has the greatest singular correlation to winning an election. Today, the government with the help of the U.S. Federal Reserve, has a much different agenda - do everything in their power just to keep things from falling apart until after the election in November. Banks that engage in zero risk management and put bottom line profit and greed on the top of their mantle and thus fail deserve to fail, as their failures are a natural progression of a free market. The only part of this equation that does not deserve the fallout are naïve stockholders, but stockholders inevitably only get hurt during these bank failures due to the outright immoral behavior and bold faced lies of the executives managing these institutions.

If the executives didn’t outright lie month after month after month to their shareholders about the true state of affairs at their institutions, there would be an orderly exit from their shares, the shares would decline month after month, but shareholders would have a chance to exit with minimal losses instead of having to offload shares in a panicked stampede that results when management perpetually suppresses the truth until the truth can no longer be hidden from the public. In any event, even bank failures cause short-term pain in the economy to be amplified, such a weeding out process is 100% necessary to the recovery of an economy as the economy’s financial industry will be much strengthened by the weeding out of charlatans and the elimination of those companies most guilty of employing little or no risk management in the pursuit of profits. The strong recovery of the Asian tigers after the 1997Asian financial crisis bears out this point. I would argue that bailouts are then anti-free market and anti-constructive when trying to turn an economy around with solutions sustainable longer than several weeks or several months.

Instead of extolling the virtues of free-market intervention to reward outright deception and greed that will most likely end up poorly for the common American taxpayer as such actions will almost certainly cause the dollar to lose future purchasing power, we should be taking a closer and much more critical view. It’s not just this one act per se, because $29 billion is not a large sum compared to the $17 trillion or greater supply of dollars tumbling around the system worldwide. But that’s just my point. The numerous, intervening inflationary actions undertaken by the U.S. Federal Reserve over the past few months similar in nature to their bailout of Bear Stearns have had the aggregate effect of trivializing a $29 billion cash infusion as “nominal” because in comparison to the hundreds of billions of dollars being made available through unprecedented Term Auction Facilities, it is a small amount. And when $29 billion becomes a trivial figure due to debased currencies in highly inflationary environments, that’s dangerous. While these collective actions can serve to maintain the illusions of hope, they certainly have not contributed any meaningful discourse towards a path of sustainable economic recovery. And for this reason, Warren Buffet is wrong. The Peak Investment Crisis is still very much alive and it’s time to brace yourself for the worst, unless of course, you actually enjoyed the interest rate environment of the Paul Volcker/ Jimmy Carter years.

Comments

[argentish]

I was surprised by Buffet's lauding of the Fed's machinations in the Bear Stearns/JPMorgan affair. It is disappointing to see an investor noted for his probity putting his stamp of approval on actions that many regard as a common stock market manipulation. Buffet's words have revealed a side to his character hitherto hidden from public view and call his competence in handling large sums of his investors' money into question.

His comment on the Fed's actions brought to mind what economist Thomas Sowell wrote in another context: "Can anyone seriously believe...that subsidizing irresponsible behavior is the way to get responsible behavior--either by the people involved or by those who see them getting away with it?"

[MetroInvestment]

You have 2 choices: Rip the bandaid off, pulling healthy tissue and the scab, causing bleeding until it eventually clots, or run it under luke warm water and slowly pull the bandaid off salvaging the healthy tissue, and the scab. In medicine you try to save what you can, and do no harm. The latter is what is typically done...it may take longer to remove the bandaid, but the risk of collateral damage is mitigated. People who own anything subprime have found that the bad apples in the bond porfolios, however small, have caused the entire porfolio to lose an enourmous amount of its underlying value. If and when housing stabalizes, so too will these financial markets...likely sometime in '09 after the election. It's better to have visibility, albeit poor, than chaos.

[J.S.]

MetroInvestment, I love your medical analogy of the scab. Very nicely put. The only area in which I respectfully disagree is the extent of bad apples that still exist in the global financial system. I still think that financial institutions are being less than aboveboard about the level of "junk" that they currently still hold on their books and what worries me is that nothing is being done to remove the "bad apples" from the system. For example, the Feds only guaranteed $29 billion to JP Morgan if Bear Stearns's assets go belly up. But what about taking constructive measures to fix the system and to permanently extract the bad apples from the system? I'd feel a lot better about things if long-term sustainable solutions were being implemented.

[fxtrader07]

the huge mistakes occurred before the bear stearns-takeunder (or was it rather a covered-up jpm-rescue?!). when a global domino-effect threatens world financial markets AND the real economies alike anyone who does not try to prevent a systemic collapse would be nuts. next thing you know, people would come out in anger "why the fed did nothing to prevent a complete meltdown and all the resulting harm to society". that's the choices these days. the financial system has grown into each and everything, often being useful, but as often rather like a parasite on the general economy/society. the danger is, a collapse of the parasite might cut off vital functions for the real economy and society as well. nobody is helped claiming you warded off moral hazard but the patient dies in the operation. the truly sad thing is, that chances for a thorough overhaul of the financial system, including strict limits to financial leverage at all market participants -banks, investment banks and hedge funds - are remote to nonexistant. as often with humans, the real cure will not start unless the patient almost died. most people prefer small changes to somehow fix things for some time rather than larger and more painful ones to really restore health.
if regulators and governments and central banks refuse to learn the lessons and fail to crack down on the whole financial system, the overblown and utterly desastrous "incentives" to execs then there will come a day when too big to fail will turn into too big to fix anymore. it will then really be just a question of when, not if.

[taxmarc]

I believe there are many in the investment community who agree with Mr. Kim's analysis and know that the action by the Federal Reserve is nothing more then a "fix" to a problem they created after the dot com bust in 2000 when invetors lost trillions of dollars and deflation was looming on the horizon. The big difference now is there are many individuals who are getting ready to retire and are going to be dependent on their mutual fund equity money for that retirement. So the Fed has a vested interest in keeping the markets "healthy" even though they are wrought with "cancer". Having said that and knowing the Fed is in that posture what do you do? Do you stay out of the market completely by putting your (and my) 401(k) money in money market funds losing the gains from a manipulated stock market or take the risk that the Fed will keep things "healthy" for the time being as the largest group of Americans get ready to retire?

[Indexor]

First off, I have to learn not read any comments by MetroInvestment early in the morning as I eat my morning bowl of raisen bran.

Second, Warren Buffett and Charlie Munger are both - "Overrated." Mr. Buffett appears to be taking his victory lap after a long and successful career. He appears quite enamored by Becky Quick of CNBC and has learned well that everyone is looking for quick soundbites, not constuctive thoughts that lead him to believe the worst is over.

Mr. Kim has several other excellent thoughts as well. The derivatives market has been out of control for quite some time and the refusal of Mr. Cox to take on this challenge, or any other for that matter, show just how impotent both our government and regulators have become. To think that our financial industry can be fixed by putting it under the control of one super regulator such as Mr. Bernanke at the Fed is almost as laughable as the Democrats concoction of the super delegate, and would likely produce similar results.

I believe Mr. Bernanke overstepped his authority in the Bear Stearns deal, but since there is no accountability in Washington, he'll simply continue to watch us skip on down the yellow brick road, as he continues to manipulate the levers behind the curtain. Our country is quickly falling apart at the seams and neither Obama, Hillary, McCain, Bernanke or anyone else in Washington possess the cahoons to do anything about it. Investing in U.S. stocks or bonds is nothing more than a crapshoot going forward, regardless of what Mr. Buffett whispers in Becky Quick's ear.

[AJS]

I felt a little shock when reading this article. I'm so amazed that there's someone shameless enough to make such a comment like 'Ben Bernanke and Warren Buffett are wrong'. No one can be sure about the future, about where market will go tomorrow. One thing that I know, if Mr. Kim is smarter and better than Buffett and Bernanke, then he will be the richest man in the world and chairman of the Fed.
Adios...

[sivere]

Maybe, but this is right on intervention towards the fed:

TakeBackTheFed.com

[thkugrace]

I agree that the bailout is economically unethical. Seeing stupid, reckless firms like Bear Stearns take the full blow would provide a strong incentive for other firms from using similar tactics in the future and reap benefits for the industry in the long term. Additionally, it would also apply some pain onto the economy which would be directed back at the Fed rightfully so, for not supervising the industry. Unfortunately, it had more to do with Greenspan's Fed. I believe the Fed and the additional pressure from Congress to act will lead to additional oversight and/or rule changes which the industry won't like but are richly deserved. I think the pain of mega-billion dollar losses experienced by these investment banks together with the expectant new oversight and future rule changes imposed are all we can expect and or desire in a free market economy. The prospect of actually allowing Bear Stearns to go BK may have a much stronger effect than desired for the entire industry and the whole economy. It would probably be overkill just to force change. Change that can be had for a lesser cost.

[pharma]

People sometime forgot that Mr. Buffett is a businessman. He runs and takes care of a very large investment company. His company is not much different from Goldman Saks and other investment banks. Therefore, the Fed is his business partner.

Consequently, the main driver behind every single statement he makes is well-being of his own company. So, do not be fooled by his appearances. He is not a monk. He is a very shrewed businessman.

Finally, big businessmen are all politicians! Do you trust them?