Crises Averted, Not Crises Solved

Includes: BSC, JPM
by: Mike Steinhardt

The market action since the Bear Stearns (NYSE:BSC) fiasco has obviously been optimistic, but the positive vibe is troubling to me. It rests on the hope, belief and happiness that the Fed and Treasury will stop at nothing to prevent the system they failed to regulate to suffer any of the extreme downsides of capitalism. I understand how that makes many investors happy and relieved. It just does not work that way for me because I actually believe in success and failure as a consequence of capitalist behavior involving reward and PUNISHMENT for taking risks.

Personally, I am still trying to figure out how the Fed’s actions with regards to the initial $30 billion (now $29 billion) is legal. Forget about whether it averted a crisis. Was it legal? If someone does something that benefits the planet but they kill someone along the way to make that happen, was it legal for them to do so?

I’ve heard a bunch of people say they were acting in their capacity as lender of last resort. Really? To whom were they lending? When I think of the lender of last resort concept, I actually imagine lending to the bank in trouble. That was Bear Stearns and they did not get a loan. I understand the legal application of Section 13-3 of the Federal Reserve act for the conduit loan to JPM they made on Friday March 14th. However, as things eroded over the weekend and on Sunday night, it appears that the Fed did not advise Bear Stearns that the PDCF would be announced until the deal was signed with JPM. It didn’t become the lender of last resort to investment banks until after it excluded Bear Stearns.

I don’t care about Bear Stearns or their investors and I have had no personal position affected directly by this transaction. I do care about the integrity of our system and this deal is not filled with integrity. It is filled with the Federal government picking winners and losers in a “direct credit” environment. It is filled with using obscure clauses within the Federal Reserve Act. It is filled with deception. It is filled with making up new lending facilities [PDCF] coincidentally within hours of this transaction. It is filled with rule bending by and at the permission of the federal government such as allowing JPM to acquire 39.5% of Bear Stearns. If the Fed’s actions are not illegal, then the legal trickery to justify their position just goes to how messed up this deal is.

I understand why this deal was done. It averted a crisis of potentially epic proportions in the meltdown of credit default swaps and the counterparty risk problem. Many people are happy and relieved by that. At what cost? At any cost? But was it done legally to the point where it is perfectly defensible? Does the legality not matter as long as it temporarily averted a crisis? Does the legality not matter because the Federal Government was taking the action? Do the actions not matter regardless of the damage done to capitalism?

I am intrigued by the transfer of the $30 billion worth of assets. If it is not done as part of a bankruptcy / receivership….what right does the Delaware LLC being formed by JPM have to manage these assets? When did or will this transfer take place? Before or upon the acquisition of BSC by JPM? If this deal gets delayed long enough and if Bear Stearns has to file bankruptcy on its remaining operations, will this transfer not be a fraudulent conveyance?

And finally, how will the marking of the new entity’s assets be handled? It will be interesting to see how this will be handled given that the Federal Government will benefit from or be hurt by the mark-to-market or mark-to-model choices. And whatever they do will become the de facto standard for everyone else. If the government can do it, then certainly every other investment bank can do it. Does anyone wonder how transparent the financial reporting will be on this new LLC? I cannot wait to see it.

Last fall, a crisis was averted in the commercial paper market by the Fed intervention. It was not solved. When I see investors return to optimism, they are doing so as a result of something bad not happening, not something good happening. I’ll be optimistic when I believe the bad stuff has either played out or has been solved. That has not happened with the mortgage crisis despite all the freezes and Hope Now policies. Similarly, with the Bear Stearns “taking of last resort” a crisis was averted. But the crisis was not solved. The CDS disaster was just delayed.