Friday, March 14, 2008

great piece on the bear sterns bailout (naked capitalism)

Bear Bailout: Is No One Too Small to Fail?

Listen to this article The news that Bear had to run to the Fed for help with its rapidly deteriorating cash position, and JP Morgan has been muscled into assisting in the rescue is a sign that Bear was deemed too big to fail. The Fed is lending against Bear's collateral (I haven't seen an estimate as to how large this operation is).

First Countrywide, now Bear. Why did the Fed not let Bear collapse? You can attribute it to the Fed's tendency to take responsibility for problems it can't and shouldn't fix, but this one is a trickier call than Countrywide.

Bear is a large prime broker, which means it lends to hedge funds. It is also a significant counterparty in enough different credit markets that its collapse would have at a minimum caused panic as to who might have been hurt. You'd have a further scramble for liquidity and reluctance to lend, which is precisely the condition the Fed has been trying to alleviate.

In particular, according to Bloomberg, Bear was the second largest underwriter of mortgage bonds, The lead manager (I'm assuming Bear was also a significant lead manager) is the only one who knows where the bonds went and is thus in the best position to trade them. So Bear's role as an important market-maker may have played into the calculus.

But the answer to the question of whether Bear should have been allowed to tank depends on how long it would take the crisis to pass. Swap spreads were elevated a full year after the LTCM rescue, but here the relevant metric would be how long the acute phase might take. If it was two weeks or a month, and no one save maybe some middling sized hedge funds (or a lot of teeny ones) would fail, that would have been acceptable. But the Fed couldn't assess this in a 24 hour period. (However, some parties believe that the Fed's $200 million TLSF was in part to assist Bear; if so, they've had at least a week to evaluate this risk. But in that case, I'm not certain they asked the right questions).

I still think Bear should have been permitted to fail. Now every the same size or larger knows the Fed will ride into the rescue. This is a terrible precedent. It also increases the odds of the Fed running out of firepower long before the crisis is over.

I also wonder what Bear employees were paid in bonuses last year (I assume the checks went out in late December or January) and whether cutting that number by 50% would have saved Bear's hide. (CEO Alan Schwartz's blaming the crisis on "market rumors is classic and should be heavily discounted, although one also has to wonder if Bear would have survived if the TSLF had been operational this week).

Analysts believe that JP Morgan may wind up owning parts or all of Bear. It isn't easy to hive off pieces of trading firms, which Bear is. As we have said before, Bear has such a sharp-elbowed, entrepreneurial culture that it's difficult imagining that anyone could manage it successfully, This bailout (which is almost certain to leave the banks owning Bear, given the dearth of other capable and interested parties) has high odds of being a value destroying exercise for JP Morgan.

For the curious, Bloomberg also describes how the Fed has the authority to rescue a non-bank:

The loan to Bear Stearns required a vote today by the Fed's Board of Governors because the company isn't a bank, Fed staff officials said. The central bank is taking on the credit risk from Bear Stearns collateral, lending the funds through JPMorgan Chase & Co. because it's operationally simpler to accomplish than a direct loan, the staff said on condition of anonymity.

Bernanke took advantage of little-used parts of Fed law, added in the 1930s and last utilized in the 1960s, that allows it to loan to corporations and private partnerships with a special Board vote. The Fed chief probably sought to stave off a deeper blow to the financial system from a Bear Stearns collapse, former Fed researcher Keith Hembre said.

``The Fed really doesn't have any obligation to help a non- bank aside from its role or responsibility to keep the financial markets functioning,'' said Hembre, who helps oversee $107 billion as chief economist at FAF Advisors Inc. in Minneapolis. ``They made a judgment, probably an accurate one, that they're not going to function very well if you've got a full-blown crisis with a major Wall Street firm.''


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