Off Topic: Bear Stearns Bailout — It's the Prime Brokerage, Stupid
By now you all must be up on the news about Bear Stearns being sold for $2 a share to J.P. Morgan Chase. That’s roughly $236 million for an 85-year-old investment bank that was worth $20 billion only a few weeks ago. If you read the top dailies today — The Wall Street Journal, The New York Times and The Washington Post — you will get a 360-degree view of the crisis.
However, the big question is why did the Federal Reserve decide to underwrite $30 billion of its less liquid assets in order to get J.P. Morgan to buy Bear Stearns? It’s a big risk the Fed is taking, and I want to know why. After all, it’s the American taxpayer who would be left holding a bag of rocks if things go sour.
Given that the intricacies of Wall Street, the credit markets and other such big money topics isn’t something I write about on a day-to-day basis, I turned to Paul, who in a previous life was an investment banker. He pointed me to this article in the Money & Investing section of today’s Wall Street Journal that essentially said: prime brokerage.
Bear Stearns is the second-largest prime brokerage firm in the country, with a 21 percent market share. As part of the prime brokerage business, hedge funds would use their stock holdings and borrow money, many times the value of their stock from Bear Stearns, and then redeploy it in the markets. Bear Stearns, thanks to its stellar credit rating, could easily raise gobs of money that it in turn loaned to hedge funds. They had built up a portfolio of around $136 billion of these assets. (I am not sure how they are really assets, but maybe I am just way too skeptical.)
In the days leading up to the financial crisis, the hedge funds had started to get worried about the credit worthiness of Bear Stearns and decided to pull their money. Now had Bear Stearns gone bankrupt, there would be a lot of hedge funds out there being forced to dump their stocks into the market just to meet their obligations. In other words, the downward spiral that would have ensued would have become a vortex that would have sucked down entire financial markets.
And that would have put the confidence in the entire financial system at risk. Sooner or later that would start to impact Main Street, and then things would get ugly. Fears of a depression were trotted out just last week.
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Om,
The reasons for the bailout are clear (for me at least). However, it bugs me for several reasons:
Using taxpayer money to bail out private enterprise goes against free market dynamics
Bear Stearns and all of the rest of the investment banks reported record profits the past 2 to 3 years before the so called sub prime crisis
Once again we’re seeing hypocritical policy from the party that claims it is for a smaller role for the federal government. Under the current administration, we’ve seen the taxpayer funded bailouts of United Airlines, American Airlines, and US Air, massive tax credits given to the oil companies (who also reported record profits), and now the bailout of Bear Stearns.
I believe in free markets, which include corrections. The management of Bear Stearns is clearly incompetent, as is the management of the major airlines. In my opinion, the capital markets would be better off in the long run. The markets would have turmoil in the short run, but over the long run we don’t need Bear Stearns, United Airlines, American Airlines, or any other ‘ol boy companies being managed by brainless fat cats.
I know my post is acidic, but hey, it’s an “off topic” response! :-)
Thx Om. I appreciate the research.
It isn’t a bailout when the existing shareholders are completely liquidated, particularly when 1/3 of the shares were held by employees who worked there for a long time.
It was the least worst option.
Gee, where are all the posts saying “Y’mean, they paid someone real money for virtual shares; for something you can’t touch?!?”
Excellent analysis! As far as I see it, bailing out Bear Stearns is simply staying off the inevitable, although – as you explain, it’s easy to see why the govt did it – its best to at least try to avoid a recession.
Boom and bust scenarios like we are (or will be) experiencing are IMHO due to a massive mis-alignment of personal incentives in the financial world. High risk-takers are actually rewarded handsomely because huge bonuses are aligned to the profits made without taking into account the potential risk of the investment – thus the traders, bankers, mortgage brokers, IFAs etc are rewarded at bonus time each January simply by riding the bull market but consequently not penalised sufficiently when everything goes to shit. Sure they might lose their jobs but they probably would have done anyway even if they had managed their risk properly because of the cumulative effect of the greed of everyone else.
Unfortunately the people affected the most are the common folk who screw up on their (mis-sold) mortgages and when the funds that their pensions are invested in tank.
I totally get why the ripple effect of Bear, Stearns crashing and burning would have created a wake that could have done serious damage to our financial markets. This, in itself, is reason enough for the government to step in.
Those who haven’t read, ‘When Genius Failed: The Rise and Fall of Long-Term Capital Management’ would be wise to do so, as it does a good job of connecting the dots on a complex topic.
What I struggle with, however, is how to reconcile bailouts with the capitalist credo that ‘He who takes the risks, gets the rewards.’
In this case, the American people take the risk by our tax dollars plugging in the preservation capital (or default guarantees). Shouldn’t there be some mechanism whereby they get real or phantom equity for when the tide inevitably turns?
Mark
My Blog: http://www.thenetworkgarden.com
Like Mark, I am discouraged by the government’s weakening of the risk/reward relationship. It is telling Morgan Stan that it can have any rewards it can wring from Bear, but that the risk will be borne by the taxpayer.
ps of course that’s not the only discouraging thing…
It’s days like these when the “free marketeers” show their true colors.
March 7 the feds announced the third straight month of job losses, plus more than half a million people losing hope and leaving the workforce permanently. Bush response? Cut $2 billion from federal employment and training programs.
March 14 investment bank Bear Stearns threatens to collapse. Bush response? $30 billion bailout.
They’ll jump into the market to manage risk and prevent a cataclysm when it’s their friends in the hot seat. The rest of us average bears have to get by on top ramen and cartoons: http://blog52.wordpress.com/2008/03/17/not-so-much-smarter-than-the-average-bear/
American greed did what Muslim radical terrorists are unable to do. Bring down the US economy. All corporate executives who make reckless decisions based upon their self-greed should forfeit the ill-gotten gain. Corporations should reward executive who have the long-term interest of the company and the country as the priority for their decisions.
Andrew, JP Morgan Chase is not one and the same as Morgan Stanley.
JP Morgan is buying BS, not MS. Small detail, I know, but worth clarifying.