Setting the Record Straight: Taxpayers Not Funding JP Morgan's Bear Buyout

Includes: BSC, JPM
by: Stone Street Advisors

Since news of its imminent collapse and the actions of the Federal Reserve to prevent it, much of the criticism heaped upon JP Morgan’s (NYSE:JPM) takeout of Bear Stearns (NYSE:BSC) has revolved around whether it amounts to a taxpayer-funded bailout of Wall Street. Countless media reports would have their readers believe that this is indeed the case, but I have yet to read a single compelling explanation of how exactly this is the case. It does not take much effort to stoke the populist fire by quoting anonymous sources or citing vague ‘reports’ supporting this conclusion. To date, not a single account I have read attacks the crux of the matter, which is to explain the mechanisms, or under what circumstances taxpayer funds were, or could be used to fund the transaction.

I’ve scoured information on the Federal Reserve’s website and spoken with respected authorities on the subject, none of which suggest that taxpayers are footing the bill for the transaction. The likelihood that taxpayer funds will every be used at all is slim-to-none. One source I spoke with, a respected Finance Professor (of Markets & Banking, among other subjects) went so far as to say that he doesn’t expect either JPM or the Fed to take any significant loss as a result of the Bear deal when all is said-and-done.

Before anyone jumps down my neck, let me elaborate.

Two weeks ago the Fed released its quarterly update of the collateral pledged against its loan to JPM was marked down to $28.9 Bn from ~$30 bn when the loan was first made. Maturities on the assets pledged extend out 10-20 years or more, according to what I’ve seen, although the Fed is relatively mum on the exact composition of the portfolio.

To illustrate what would happen in an extreme case, lets consider a semi-arbitrary situation in which the default rate on the pledged assets is 100% (which is very unlikely, baring global financial catastrophe or something on that scale), with zero recovery on any assets, spread out evenly over 15 years. In this example, these are not simply mark-to-market accounting losses (how they’ll actually show), but economic losses, just to illustrate the point. In this example, the Fed will have to absorb ~$2bn per year over that 15 year period, a figure which may seem extreme, but as I’ll explain, is relatively insignificant in the grand scheme of things.

In “Purposes & Functions of the Federal Reserve”, pp. 11, it states:

The income of the Federal Reserve System is derived primarily from the interest on U.S. government securities that it has acquired through open market operations. Other major sources of income are the interest on foreign currency investments held by the System; interest on loans to depository institutions; and fees received for services provided to deposi­tory institutions, such as check clearing, funds transfers, and automated clearinghouse operations.

“Ok, BFD, so what?” you say. Relax my young padawan, for the truth shall set you free:

After it pays its expenses, the Federal Reserve turns the rest of its earn­ings over to the U.S. Treasury. About 95 percent of the Reserve Banks’ net earnings have been paid into the Treasury since the Federal Reserve System began operations in 1914. (Income and expenses of the Federal Reserve Banks from 1914 to the present are included in the Annual Report of the Board of Governors.) In 2003, the Federal Reserve paid approxi­mately $22 billion to the Treasury.

In 2007 this number was $38.7bn, up from $29.1bn in 2006 (pp. 360 of the report). Even if we take the low number from 2003, the $2bn annual loss from the above extreme example would only represent less than a 10% hit to the funds contributed to the Treasury by the Fed.

For those who still don’t get it, let me explain. While the Fed is funded and overseen by Congress, it is “private within the Government;” it is effectively a self-funded entity operating as a “private” organization within Government. The loan extended by the Fed to JPM (via Maiden Lane, LLC) was a direct extension of credit from the Fed’s balance sheet, not from an appropriate of taxpayer monies, which so far as I can tell, would have required specific Congressional action.

When this information is taken in its entirety the only possible “hit” to taxpayers would be a budgetary shortfall resulting from poor budgetary planning (e.g. if the budget was based on receiving X dollars from the Fed, only to actually receive X minus whatever “loss” the Fed absorbed from collateral losses in the Bear collateral). Even in this situation, taxpayers still are not actually funding any part of the transaction, only the foregone funds – which were never a certainty to begin with – of the difference between the estimated Fed contribution and its actual contribution in a given year.

May I be missing something (or potentially many things)? Absolutely. But all the research I’ve done suggests that one thing is certain (or at least as certain as anything can be these days): Taxpayers are NOT funding the purchase (“bailout,” whatever) of Bear Stearns.  Until, or unless someone can provide clear, factual support that this is not the case, journalists, pundits, and even those of us on The Street need to resist the urge to propagate the unsubstantiated claims of those who cannot or will not back up such claims.