Monday, April 07, 2008

Bear Stearns was NOT Bailed Out

Some History

Bear Stearns, founded in 1923, had been an aggressive player in the financial markets for many years. It was a pioneer in mortgage-backed securities in the 1980s, and was heavily involved in the packaging of sub-prime mortgages during the housing boom. As the prices of these securities slipped last year, Bear bought not only for its own account but also for its hedge funds.

Bear's purchases were financed with short-term borrowings that were collateralized against these securities. But as the market continued to tumble, lenders demanded more cash to secure their loans. When Bear knew it would not have enough cash to cover the margin, it went to JPMorgan, one of its lenders. Both then turned to the Fed to arrange a $30 billion dollar loan guarantee against Bear's assets to prevent the firm from going bankrupt.

After the Fed guarantee was announced, Bear stock dropped to $30, which was what traders thought the company was worth at that time. That is why the $2 price announced days later was such a shocker.

A Bailout?

Was the Fed's loan a bailout of a Wall Street firm that deserved to go under for making risky bets? And how much is the taxpayer going to lose as a result of the Fed deal?

The Fed loan probably did prevent Bear from going into insolvency, but it hardly "bailed out" investors. Bear sold for $172 a share last year, once valuing the firm at over $20 billion. The Fed agreed to back a sale at $2 a share, or about $250 million, which represented a 98.4% wipeout for investors. As a result, Bear as a firm was to disappear, its assets absorbed by JPMorgan, which will probably dismiss half of Bear's 16,000 employees. Meanwhile, the higher price agreed to a week later actually reduced the Fed's exposure to Bear's troubled assets.

The Details

The Fed agreed to lend $29 billion against a portfolio of mostly sub-prime securities that Bear Stearns had "marked to market". It is important to recognize that this sum does not represent the face value of these securities, which is far higher than $29 billion. Instead, the sum represented the extremely depressed market prices brought on by the crisis. JPMorgan, which oversaw the valuation of these securities and also assumed some of the risk, claimed it was satisfied with the prices that Bear determined.

The higher $10 price that was agreed on a week later required JPMorgan to take a loan against the first $1 billion of Bear's securities, lowering the Fed's guarantee to $29 billion. Given the 120 million shares of Bear Stearns outstanding, the reduction in the Fed's contribution is approximately equal to the $8 increase in the price Bear stockholders will receive.

The $30 billion in assets will be deposited in a newly-created corporation established for the purpose of administrating and selling these securities. The Fed will earn an interest on its portfolio at its ongoing discount rate (currently 2.50%, 25 basis points above the targeted Fed funds rate), and JPMorgan will receive a higher interest rate of the discount rate plus 450 basis points, (currently 7%) on its $1 billion loan.

All proceeds from the sale of Bear's assets will first go to repay the full $29 billion principal and interest due to the New York Fed. Only when all interest and principal is fully paid to the Fed will any further proceeds go to satisfy the $1 billion in subordinated notes due to JPMorgan Chase. Once JPMorgan's note is satisfied, any further proceeds will go entirely to the Fed.

In short, unless the default levels soar above the level now anticipated, the Fed will likely recover the entire proceeds of its loan and more.

It is my opinion that not only will the Fed get its money back plus interest, but will earn a profit on the transaction. As bad as the housing market is, many of these securities are being quoted at prices below most worst-case scenarios. Two years ago, any security that was "asset backed" - and particularly "real estate backed" - was considered golden and priced with almost no risk.

Today any security with the words "real estate" attached is considered toxic and priced to reflect that view. The reality, as usual, is somewhere in between.

The Fed did not bail out Bear at taxpayer expense, but enabled the financial markets to continue to function. History will call the Fed's action the right move at the right time.


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