Morgan's the Big Winner; Lehman in Trouble As Well?

Includes: BSC, JPM, LEH
by: Steve Waldman

My earlier post had very short shelf life indeed. Monday came on Sunday this week. So, what was the deal? Buyer (J. P. Morgan) does get Bear on the cheap. Bear stockholders get paid a token amount, but really next to nothing. The Fed does bear residual risk, both explicitly via a $30B "+/-" nonrecourse financing arrangement and implicitly since J.P Morgan is even too bigger to fail now. The most important bit, though, is here:

[T]he Federal Reserve Board voted unanimously to authorize the Federal Reserve Bank of New York to create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets. This facility will be available for business on Monday, March 17. It will be in place for at least six months and may be extended as conditions warrant. Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities. The interest rate charged on such credit will be the same as the primary credit rate, or discount rate, at the Federal Reserve Bank of New York [which is simultaneously reduced to 3.25%, or the Federal Funds Rate + 25 basis points].

You might call this the "anti-Bear-raid" provision. If this had been in force last week, Bear Stearns would still be a proud Wall Street titan, and we wouldn't have heard a thing. This should be sufficient to head off a round of competitive consolidation by rumor and guile.

Overall, it looks like J.P. Morgan comes out a big winner, Bear stockholders are the losers, and Bernanke & Co. did better than they might have. If, as I speculated, the bankruptcy rumors were BSC execs playing chicken with the Fed, the Fed won. Whether JPM's windfall was luck or craft, we may never know, but parsimony and good sportsmanship suggest we call it fortune, absent evidence to the contrary. At least this deal is makes some effort to think about incentives. An important player has finally been allowed to fail, and a set of perverse incentives was carefully eliminated.

Still, this arrangement is very, very generous to everyone other than Bear. One was sacrificed that all might survive. (Was it karma, coincidence, or something else that the one firm that refused to participate in the LTCM bailout would be the only firm not bailed out during the Great Credit Crunch of 2008?)

It's worth noting that the Fed has now committed yet more of its dwindling balance sheet to stabilization, and on easier terms than ever before. Keep a close watch on H.4.1. There's no doubt that the Fed is taking on a lot of credit risk, and is providing a lifeline to other firms no more or less worthy of being made an example of than Bear.

A few puzzling details: The Fed has provided roughly $30B nonrecourse financing (meaning that the Fed absorbs the credit risk) for "largely mortgage-related" assets, but according the J.P. Morgan's presentation of the deal (hat tip Calculated Risk), mortgage-related assets will account for only $20B. What's the other 10B "+/-" about? No mention is made of Bear's role as derivative counterparty, although "JPM will guarantee the trading obligations of BSC and its subsidiaries effective immediately".

Perhaps some of this was discussed in this evening's conference call. I haven't had a chance yet to listen or read a transcript.

Update II: Yves Smith and Calculated Risk both point to signs that Lehman Brothers may be in trouble as well. Given the Fed's new facility, if you think (as I do think) that the Fed would lend taking a 15% haircut from par on Monopoly money to prevent another major firm from falling, I have a hard time seeing Lehman going under.