No, Bear Stearns Was Not ‘Rescued’

by Liberty and Power

Over the weekend of 15th-16th March 2008, J P Morgan Chase bought Bear Stearns, at one time the world’s seventh largest investment firm, at a nominal price of $US2 per share or an approximate total of $US240 million. At close of trading on Friday (14th March), the shares were sold at around $US30 each. On the 1st March, the shares had been trading at around $US200 [recte] each. Bear Stearns’ shareholders obtained only 6% of what their shares had been worth on Friday, or 1% of their value a fortnight earlier.

Federal Reserve officials twisted J P Morgan’s arms -- which was why the latter ‘agreed’ to buy. Officials had to provide Morgan’s with a loan & a guarantee against the weakest ‘investments’ -- bad mortgages -- in the Bear Stearns portfolio. These dubious liabilities amount to some $US 33,000 million -- or some 138% of its total purchase price. Thus its unsound investments are one reason for the very very low price that Bear Stearns’ shareholders received -- even from J P Morgan’s & even after a Federal loan + guarantee.

In the absence of Federal Reserve intervention & arm-twisting, Bear Stearns would undoubtedly have had to cease trading. And no doubt it would’ve been taken over, eventually -- at an even lower price. All that govt officials could do was to shorten this time period, & possibly prevent Bear Stearns’ value from falling even further. But even the almighty Federal Reserve -- the world’s largest & most powerful central bank -- could not prevent the huge capital losses that Bear Stearns’ shareholders suffered. In short, even the Fed could not stop the de facto failure of one of the world’s largest investment companies.

What does all this signify? Even the US govt -- the world’s largest & most frightening -- is not & cannot be, omnipotent. True, the Fed’s officials did their best to paper over the cracks -- but that was all they could do.
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The Guardian [London] 17th March 2008: ‘Fed takes emergency steps to prop up bank funding and calm nerves on Wall Street’

The Times [London] 17th March 2008: ‘Bear Stearns sold to JP Morgan Chase under Federal Bank pressure’

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Sudha Shenoy - 3/19/2008

Ah. I see now. The FRS decided to throw Bear Stearns' _shareholders_ to the wolves while rescuing Bear Stearns' _creditors_. In the absence of the FRS, the creditors too would've lost their money. -- At any rate the shareholders lost their capital exactly as they would've without the FRS.

Sheldon Richman - 3/18/2008

Makes sense to me, Bill. Thanks.

John Kunze - 3/18/2008

The WSJ quote above ended with:
"But if those assets decline in value, the Fed would bear any loss, not J.P. Morgan."

So the Fed is guarenteeing something. It appears that the Fed is taking the risk on the large block of mortgage related securities that Bear holds. Presumably J.P. Morgan is responsible for other Bear debt. Bear can't sell its assets without selling its liabilites without going thru bankruptcy. Bondholders will get their principal back. (Holders of convertable bonds will lose any upside.)

Bill Woolsey - 3/18/2008

The credit crunch for Bear Stearns was that those who had been lending to Bear Stearns could not be repaid because no one else was willing to lend to Bear Stearns. They had been borrowing short to finance their activities. They would repay that money when it came due with new money that they would borrow.

This was "solved" by having JP Morgan lend to Bear Stearns. JP Morgan obtained the funds by borrowing from the Fed. I don't believe that the source of the funds is especially important. But, those lending to Bear Stearns were "bailed out," because the alternative was default by Bear Stearns.

The efforts by the Fed to get Morgan Stanley to participate in this, the collateral the Fed accepted for the loans it made, and guarantees against loss made to Morgan Stanley, would all be elements that point to a Fed bailout of the creditors of Bear Stearns.

That the stockholders lost 99% of their investment does mitigate against the moral hazard. They took nearly all the losses that bankrupcy would have generated.

The entire episode is very similar to an FDIC operation using the purchase and assumption method, which wipes out stockholders but bails out depositors. The remaining moral hazard is that depositors in banks that have FDIC insurance don't worry about default.

I presume the Fed's goal here is to encourage people to continue to make short term loans to investment banks that may be holding mortgages. That is, their worry was that if Bear Stearns defaulted, then other investment banks could no longer borrow.

I was a bit puzzled by the tone of Shehoy's piece and some of her comments. The Fed "couldn't" protect the stockholders of Bear Stearns from loss? They didn't. And, I would think, they shouldn't. And they didn't want to. The operation was supposed to "punish" them, while protecting those lending to Bear Stearns. And these lenders were protected mostly to make sure that others like them will continue to lend to still other firms. Another point of emphasis is that the actual losses here (resources were used to build houses worth less than the goods or services that could have been produced with those resources) are coming out of the pockets of the stockholders responsible for the management that made the decisions.

One final point. Morgan Stanley appears to be taking responsiblity for all of the liabilities of Bear Stearns. The Fed is (apparently) guaranteeing some of the weaker assets of Bear Stearns. These are not "liabilities." They are risky assets. I think it is important to avoid switching between the technical meaning of liability (a debt) and a looser meaning (something bad.)

This is standard practice for an FDIC purchase and assumption of a failed bank.

So, I suppose this suggests that short term lenders to investment banks are getting the same sort of protection that those making deposits in commercial banks receive. (That is, those making short term loans to commercial banks.)

I think this is a bad thing. If the Fed owned the entire national debt, there was still deflationary pressure on final goods and services as a whole, then, I would think this sort of thing would be a necessary evil. But the U.S. economy is nowhere near that situation.

Sheldon Richman - 3/18/2008

Sudha, is an implication of your argument that there is no danger of moral-hazard from the Fed's Bear Stearns move?

Sudha Shenoy - 3/18/2008

Reuters have a report that Bear Stearns did _not_ have any 'golden parachute' for its executives. Employees (at various levels) own some 30% of the company. _However_, JP Morgan will give severance pay to ?senior officers who leave.

s.v. www.reuters.com/article/newsOne/ 17th March 2008 'Bear execs lack golden parachutes as stock plan crunched'.

Sudha Shenoy - 3/18/2008

Sorry, that was Reuters.

Sudha Shenoy - 3/18/2008

Interesting. I haven't seen any reference to FRS guarantees to holders of bonds issued by Bear Stearns (but that doesn't mean such a reference doesn't exist.) All the reports I've seen (in various financial/business contexts from papers round the world) refer only to the FRS takeover of bad mortgages & a loan to JP Morgan.

I _have_ just seen (Bloomberg) that some South Korean companies do hold equity-linked securities, bonds & derivatives issued by Bear Stearns. The report says "JP Morgan would take over the debt or liabilities." _Presumably_ Morgan's agreed this in return for the FRS loan? -- can't tell until the archives are eventually opened up.

John Kunze - 3/17/2008

Since the Fed broker a sale of the business to stave off bankruptcy, holders of Bear-issued debt instruments did not. They were, in effect, bailed out. That shareholders were not bailed out is arguably more important, but let's not say that no one was bailed out.

Sudha Shenoy - 3/17/2008

1. The actions of the FRS in the current crisis didn't just fall from the sky. There were a long series of previous actions, pushing out to the present position, in which they looked round for some excuse to do what they did. They found this, currently, in 'emergency' regulations or whatever they cited.

Much the same is true of the expansion of what Americans call 'executive' power.

2. Govt officials operate through legislation -- which is their supreme tool. Legislation simply authorises them to do what they do. They cannot use common law -- that is everyone's tool. govt subjects are ground down between the upper & nether millstones of taxation & legislation.

3. This is not the first time a company (of whatever sort) has sustained losses. Bear Stearns had reached the end of the line of malinvestments, brought on by its managers. No doubt those managers who saw what was coming prudently got out.

But shareholders always had (have) the option of selling their shares, if they feel dissatisfied with management. Some -- many?-- Bear Stearns shareholders may have already done so.

And if they feel a company is mismanaged, other companies had (have) the option of takeover bids. Bear Stearns was perhaps too large an operation for this (?).

Sudha Shenoy - 3/17/2008

1. Bear Stearns' shareholders lost their capital. They were not bailed out.

2. The $US30,000 million of bad mortgages were _held by_ (held by)Bear Stearns _because_ these mortgages _could not_ be sold on. The FRS has acquired several tons(?) of bad paper. That is why JP Morgan's shares rose: much of Bear Stearns' remaining business is viable.

Without the Fed, this is precisely what would've happened: the bad mortgages would've brought Bear Stearns' value right down, & whoever bought the bank -- or parts thereof -- would've _had_ to simply write off the non-performing loans. Thereafter the valuation would've been of the remaining viable business.

As it is, what we now have is a song-and-drama about the Fed galloping to the rescue & absorbing a whole lot of bad debt. But that is all the Fed could do -- it could not prevent the necessary capital losses.

3. ?Greg Mankiw repeats what others have said. The links I gave go to reports from the City of London -- the world's second largest financial centre. There is direct info in the reports about developments.

John Kunze - 3/17/2008

Greg Mankiw provides more background:
http://gregmankiw.blogspot.com/2008/03/bs-bailout.html

Although shareholders are taking their bath, anyone holding Bear Stearns bonds would seem to get off scot free. (We can assume management largely held stock and options, not debt.)

And Mankiw quotes the WSJ:

"To help facilitate the deal, the Federal Reserve is taking the extraordinary step of providing as much as $30 billion in financing for Bear Stearns's less-liquid assets, such as mortgage securities that the firm has been unable to sell, in what is believed to be the largest Fed advance on record to a single company. Fed officials wouldn't describe the exact financing terms or assets involved. But if those assets decline in value, the Fed would bear any loss, not J.P. Morgan."

If this is true, J.P. Morgan gets a large asset for peanuts, without taking a risk on its major liabilities.

It is hard to imagine how government stabilizes the economy without creating moral hazard or bail outs. (And why would we think that they actually it efficiently? They may have shopped for other bids in the last week or two, but why would we think they can run a good auction?)

In fact, Bear Stearns was valued at $240 million, but JP Morgan's market cap is up some $13 billion over the weekend -- the market thinks Bear was a steal.

Craig J Bolton - 3/17/2008

1. Your statement is probably true in the long run, TO THE EXTENT THAT NO ONE CARES. If you believe that the same is true in the short run, when people do care, then we might as well dispense with written laws and constitutions(i.e., as a universal generalization this is nonsense).

2. There has been a debate for decades regarding who controls the fine tuned decisions of large corporate structures. Again, the same distinction as 1: Shareholders may control overall policy, through their purchases and sales, if nothing else, in the long run and to the extent that they are paying attention. In the short run, corporations are run for the benefit of those who have the legal right to govern their day to day operations. So if I'm an investment banker who knows the business I'm currently a part of is going down the tubes, my concern is for a reasonable search time to find a comparable position elsewhere, not whether the shareholders get 1 cent or 2 cents on the dollar. So, yes, there was a rescue, but not of Bear Stern's shareholders.

Sudha Shenoy - 3/17/2008

1. Govt officials will always push through any paper barriers. They get tax revenues & so the most effective means of stopping them doesn't exist.

2. Despite the rhetoric about 'bail-outs' etc -- Bear Stearns shareholders lost their capital: exactly what was reqd in the circumstances. The Fed couldn't prevent this.

Craig J Bolton - 3/17/2008

I am not quite sure what this article is telling us.

Was the FED's action a "good thing" or a "bad thing"?

There were valuable assurances provided backed by public credit and some "arm twisting" to do things that J.P. Morgan would not otherwise have done. Shareholders of Bear Sterns suffered with the intervention and would have suffered without the intervention. Some people working for Bear Sterns probably kept their jobs a bit longer than they would have otherwise and now will have a few more weeks to find employment with another investment bank.

Other than that, about the only thing that has changed is that the FED has now stepped over another boundary that previously more or less restrained the scope of its action.

Sounds like a a "bad thing" on net to me.