Thursday, September 4, 2008

Bailout to Bailout: The Bear Stearns Bailout and Its Aftermath

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Our video for this posting can be found at:

It was soon realized that the temporary loan given by the Federal Reserve to Bear Stearns would not be enough to keep the company afloat. Indeed this was probably already known before the loan's announcement was made on the afternoon of the 14th. The Fed, particularly the New York regional division, worked feverishly all weekend to find a definitive solution to Bear's insolvency. They decided to have JP Morgan take over Bear at a price of $2.52 a share, a rather sharp haircut to the Friday closing price of $30 a share ... and an even steeper discount to the official book value of $84 to $97 a share for Bear stock, which the CEO had announced was unimpaired only two days earlier.

Not only did JP Morgan get Bear Stearns essentially for free, but the Federal Reserve further guaranteed $30 billion (later reduced to $29 billion) of Bears troubled mortgage bonds. JP Morgan was by no means just a lucky bystander in this transaction. Its CEO sat on the board of governors of the New York Fed and got to influence the decision that proved highly favorable to them - in more ways than one it turned out. JP Morgan was a counter party to a large number of derivatives on Bear Stearns books and Bears failure would probably have sunk JP Morgan shortly thereafter. So the Fed's giveaway bailout of Bear Stearns was also an indirect bailout of JP Morgan. Membership (in the Fed) obviously has its privileges. Bear Stearns not being a Fed member wound up being thrown to the wolves.

While JP Morgan and the Bear Stearns bondholders were winners because of the Fed arranged bailout, stockholders and credit default swap (CDS) holders wound up being the big losers. If Bear Stearns had actually declared bankruptcy, the CDS holders would have had a big payday. However, once again the Fed's interference in the market turned winners who had made the correct investment decision into losers by changing the rules of the game at the last moment.It turned out that the stock holders had more clout and wound up successfully agitating for an increase in the takeover price to $10 a share. Even at that price some of the 'smart money' lost big, including British investor Joe Lewis, who lost over a billion dollars, and renowned mutual fund manager Bill Miller whose fund had large holding of Bear stock. The American taxpayer, as per usual, was put on the hook and would also wind up paying for Bear Stearns mismanagement and the Fed's gifting to JP Morgan.

As a result of being blindsided by Bear Stearns failure, the Fed set up the Primary Dealer Credit Facility (PDCF) in March of 2008. For the first time in its history, the Fed allowed broker-dealers to also borrow from them, not just commercial banks. Lehman Brothers was an immediate beneficiary of this new program, which probably kept it from failing shortly after Bear Stearns did. The legality of this new Fed operation was at best tenuous, but the Fed seemed to have little concern for following its mandate of controlling inflation or restricting its activities to those specifically granted to it by the U.S government. After all why should the Fed be concerned about such things since it knew the government was unlikely to try to keep it from doing whatever it wanted to do - legal or otherwise.

NEXT: Run on the Bank, 2008 - Indymac

Daryl Montgomery
Organizer, New York Investing meetup

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