Straight Talk About Bear Stearns

Last week the Fed brokered a deal to sell failing investment bank Bear Stearns to JPMorgan Chase. At the same time, the Fed announced that it would be willing to lend directly to Wall Street brokers.

If you are a casual observer of financial markets, you will be forgiven for believing that the Fed’s move last week was a good one. After all, the stock market—which had been in danger of further losses—has, for the time being, been stabilized; many analysts have lionized Bernanke for making a sound and bold move.

This week Business Week put Bernanke on its cover and added to its headline “Bernanke reinvents central bank to avoid catastrophe.” If only that could be true. What Bernanke has done is to postpone the day of reckoning; and by so doing, he has set the stage for an even bigger crisis.

Last week, legendary investor Jim Rogers pulled no punches when he critiqued the Fed’s move. It is well worth 12 minutes of your time to listen to this very colorful interview.

No, Rogers is not exaggerating—the Fed has indeed bought hundreds of billions of dollars of junk assets. In the JPMorgan Chase case, the Fed has guaranteed $29 billion dollars of losses on the junk mortgage backed securities that Bear Stearns held.

As Rogers points out, none of this is in the Fed’s mandate. As the Fed bails out those who took bad risks, it is destroying the dollar; and it is setting the stage for a true collapse of the economy.

Indeed, it is also true what Rogers said about Wall Street bonuses. In 2007, Bear Stearns’ bonus pool was $2.06 billion dollars. Under bankruptcy laws, had the Fed allowed Bear Stearns to go bankrupt, all of that money would have had to have been repaid by the employees who took those bonuses home.

None of the Fed’s actions are legal, as John Hussman, president of Hussman Investment Trust, points out:

The Federal Reserve decided last week to overstep its legal boundaries – going beyond providing liquidity to the banking system and attempting to ensure the solvency of a non-bank entity. Specifically, the Fed agreed to provide a $30 billion “non-recourse loan” to J.P. Morgan, secured only by the worst tranche of Bear Stearns’ mortgage debt. But the bank – J.P. Morgan – was in no financial trouble. Instead, it was effectively offered a subsidy by the Fed at public expense. Rick Santelli of CNBC is exactly right. If this is how the U.S. government is going to operate in a democratic, free-market society, “we might as well put a hammer and sickle on the flag.”

What is a “non-recourse loan”? Put simply, if the homeowners underlying that weak tranche of debt go into foreclosure, they will lose their homes, and the public will lose as well. But J.P. Morgan will not lose, nor will Bear Stearns’ bondholders. This will be an outrageous outcome, if it is allowed to stand.

Paul La Monica, writing yesterday at CNN Money, observed that already other banks are lining up for a Fed handout:

Now other banks appear to be angling for a spot at the Fed trough. In an interview with the San Francisco Business Times last week, Wells Fargo Chief Executive John Stumpf said his bank “would not be averse to a Fed-assisted transaction” and added that “fixer-uppers don’t bother us.”

Well, who wouldn’t be interested in a fixer-upper if you knew that the Fed would be there to help you deal with all those losses? Heck, I’d buy the house from that Tom Hanks movie “The Money Pit” if a friendly central banker was willing to reimburse me for all the renovation costs.

Not surprising, others are arguing that if the Fed can bailout Wall Street, why can’t the government do more for the homeowner. Proposals are gaining traction in Congress that would forgive the amount that a homeowner is underwater. Congressman Barney Frank wrote this month in the Washington Post:

We propose to tell those who either originated or purchased mortgages that are now extremely unlikely to be repaid that they should write down their existing obligations to a level that represents current market value. After — and only after — the loss is taken, the government would facilitate refinancing mortgages for homeowners who could meet repayment obligations at the new, written-down level.

It is easy to forecast how all of this is going to unfold. More and more extreme proposals will be floated and implemented. When the economy collapses in exhaustion, those who learned nothing will tell us “if only we had done more.” This will set the stage for even more dangerous and draconian measures.

All of this economic madness is, and will be, fueled by the false beliefs that we hold collectively as a society. These beliefs include the ideas that the Fed can prevent economic cycles and that government should manage prices. Until these beliefs are finally examined and seen to be false, the economic carnage that these beliefs will cause is likely to be enormous.

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8 Responses to Straight Talk About Bear Stearns

  1. Frank v2 says:

    Dr. B,
    From an economics perspective I concur that these bailouts are creating a false sense of security. Jim Roger’s is right on the mark in my opinion. Interest rates should be allowed to rise to correct the situation. I remember the high interest rates in the early 1980’s and at that time cash was king. Those that had money did well. Those that had to borrow money struggled. My first new car loan had an interest rate of 16 3/4%. Needless to say my wife and I worked like heck to pay that loan off in 12 months. Unemployment was high, but the economy did rebound in a couple of years. Gold is now hovering at $1000 an ounce, and our dollar continues to plummet against international currencies. I have a good portion of my retirement funds tied up in Canada where I worked for 20 years and I have been debating, in light of the strong Canadian dollar, selling those mutual funds and bringing the money down here. But I am going to hold off. I believe our dollar is going to continue to fall until interest rates are allowed to climb again in order to properly allow the economy to correct itself. And the Canadian economy, being resource based, is continuing to grow, no longer just feeding the US (our biggest trading partner is Canada), but now China and India. I think the Canadian buck is going to continue to gain strength against US currency, particularly in light of the current Fed moves. And as Roger’s suggests, we know we are going to be in real trouble when Bernanke is forced “to collect rent from his helicopter”, or opens a used car lot! And I don’t think that that is out of the realm of possibility. I believe that things are going to get a lot worse and we are only stalling the inevitable. Meanwhile, keeping one’s money under his or her mattress might be an economically prudent move. Sure the money might get contaminated with bed-bug droppings, but that still might be a safer place than investing in the US stock market or worse yet, putting it in a bank account. At least under the mattress we will get some return on our investment, albeit an unwanted one  .

  2. Frank,

    In this economic climate preservation of capital is paramount. Unfortunately given current interest rates to savers, taxes on the meager interest that is earned, the falling dollar, the fact that gold has already had a big run-up, the possibility of a stock-market and bond-market meltdown, questions about bank safety, and potential inflation, there is no obvious way to accomplish this.

  3. Jim D says:

    Somewhere along the line, the business world lost sight of the normal business cycle and came to believe that markets should do nothing but go up and that people should never lose money in the markets. A great deal of blame for that should go to Alan Greenspan for poorly using the tools the Fed has at its disposal to allow first the dot-com bubble, then the housing bubble, then the equities bubble. Like many other cycles, the markets needs its periodic downturns to clear out the dead weight, firgure things out and get things back on track. Now, not only is the government completely overstepping its bounds bailing out private industry for bad decisions made by people who ostensibly (being phd economists and such) seriously out to have known better, but it continues to cater to Wall Street’s screaming and continues to try to prop up the economy. The credit crunch is a good thing (for now). Since everyone has stopped the lending, this could be the opportunity they need to actually think about who their lending to and why, restoring sense and order to the credit market and rebuilding the trust (not to mention the value of the ratings systems that betrayed us with faulty ratings) that will allow the credit market to flow in a fashion that works for the long term. The market needs to be allowed to correct itself without the ignorant ham-fisting of the government screwing up the works catering to the rich.

  4. Jim,

    Sadly, it may take a generation or more until the beliefs that you describe change. In the meantime we will all pay the price.

  5. Bob G. says:

    Once the pendulum is in motion it will not come to rest in the middle until it is allowed to run it’s natural course unaltered by competing forces on each side of the mid-point.

    It seems that those parties with the vested power and authority to do so are more interested in having non-market forces interefere with the natural consequences of risk based behaviour. They would have those who made the choices that brought about the chaos be spared what the market would bring them and have those who made good choices pay for it.

    The cause and effect model is effectively replaced with a protectionsist model that is an illusion based on short term feel good politics. This is fueled by the overall economic ignorance of the general public and the willingness of those who know better to defer the day of reckoning to the near future where the consequences will be unimaginable and catastrophic for the average American.

    This is much deeper than most realize because it affects the culture of consumption and immedate gratification that has developed exponentially over the last 3 decades.

    Bob G.

  6. Bob,

    I agree with you. Let’s hope we are both wrong because as you say “the consequences will be unimaginable and catastrophic for the average American.”

  7. E says:

    Dr. B,

    Unlike you and this consortium of responders, I very much like the Fed’s move. In these dire and tumultuous times, strong measures are needed. I think, to be honest, that we should with all due vigor and deliberate speed ask, encourage, and beg the Fed to lower still all the interest rates — perhaps eliminate the interest rate altogether — for big banks. When we’ve effectively eradicated the interest rates on overnight lending, the Fed should then enthusiastically buy every bad asset on the market, CDO’s or otherwise, from any financial institution wishing to sell them. In fact, why stop at corporations? Permit us the esteemed privilege of gladly purchasing any residential short sale available — under the banner “to prevent a full dissolution of the financial markets”. We should then ask Congress to have the Treasury print money. Print trillions upon trillions of dollars, and dump it onto the worldwide markets and cheer when a energy costs and goods soar. I am in much agreement with this strategy.

    Your most disagreeable friend,

    E

  8. E,

    I have had a rough day and I especially appreciate the smile you put on my face. Just wait till you see tomorrow’s post!

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