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: http://www.youtube.com/watch?v=G8Mn67rNCFQ

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

http://investing.meetup.com/21

Government Investment Pools Dry Up

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.

While the downgrades of the bond insurers threatened U.S. municipalities with higher future interest costs, it became obvious in November 2007 that there were far more immediate risks to public finances when there was a run on Florida's Local Government Investment Pool . The run began when word got out that the Investment Pool had exposure to $1.5 billion in defaulted and downgraded SIVs. Florida had to freeze withdrawals to prevent the fund from collapsing. The municipalities that got out early were lucky, all others had to find emergency funding to meet their payrolls for police, firemen, hospital workers, teachers, and other employees.

Local, State and Government investment pools existed in at least 20 states and were essentially special money market funds that bought short-term debt and were set up to get higher yields that would otherwise have been available. Little did they know that these slightly higher yields were being produced by taking on massively higher risk through exposure to subprime toxic waste that the big brokers (Lehman in Florida's case) were more than willing to sell to them. Problems were by no means isolated to Florida either. In the last days of November, Montana school districts, cities and counties withdrew 10% of the total $2.4 billion in its investment fund after the rating on one of the pool's holdings was lowered to default. The state of Maine had invested 3% of it money, apparently on Merrill Lynch's advice, into a fund only two weeks before its credit rating was lowered to junk status. Financial difficulties with government investment pools were also reported in Orange County, California and Seattle, Washington.

While the losses of the Government Investment Pools were certainly serious, were they isolated of were they likely to spread? If these ultra-sophisticated money-market funds got into trouble, wouldn't it be reasonable to assume that the money market funds open to the individual investor might suffer similar problems in the future? By the late fall of 2007, it had already been reported that Bank of America, SunTrust, Wachovia and Legg Mason had taking steps to prop up money market funds that contained securities of possibly questionable worth. And it looked like the formerly safest of investments were in some cases becoming among the riskiest.

Next: Subprime Freezes Over

Daryl Montgomery
Organizer, New York Investing meetup

For more about the New York Investing meetup, please go to our web site: http://investing.meetup.com/21