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March 24, 2008



It does seem notable that, while the initial reaction to the Fed intervention was positive, that positive reaction lasted all of about one day. The Fed thought it was heading off a panic, but after that brief one day of positive response there has been a growing view that the Fed overreacted--perhaps even panicked on its own. We'll see how this plays out. For example, will the 'mistake' in the contract cancel out the advantages for JPMorgan that were also written in?


I seem to remember that TM wondered what would happen if the Bear shareholder refused to sell for $2, but the "one sentence" thing is just too much.


Sebastian Mallaby has a column in the WaPo this morning (go to RCP for the link) re "financial engineering" and the Bear collapse. In the article he discusses two classes of winners and losers in the Bear intervention. And, while he terms the Fed intervention "necessary," he worries that the Fed has weakened incentives for monitoring risks:

Demons On Wall Street

One year ago, with spectacular timing, a Wall Streeter named Richard Bookstaber published a book on financial engineering. He called it "A Demon of Our Own Design," and his argument was that a new breed of "quants" -- or "quantitative" number-crunchers like him -- had created a system too complex to be manageable. The risks embedded in swaps and options were understood by only a handful of math geeks, and a miscalculation in one corner of the markets could send shock waves globally. ...

Bookstaber seemed too pessimistic because he understated the ability of Wall Street players to check and balance one another. ...

Even a year ago, reasonable people disagreed about whether these checks and balances were sufficient. After all, they failed periodically. ... But when the crash came in 1987, the insurance not only failed but also contributed to its severity.

So the case for financial engineering depended on a fine balancing of risk and reward. The risk was that Bookstaber's demons could wreak serious chaos. ...

On the other hand, financial innovation also yielded rewards. Most of the time it controlled risk, reduced the cost of capital, and helped businesses and consumers. Securitized mortgages allowed banks to spread the risk of lending and therefore to charge less for loans, lowering barriers to homeownership. ...

But whatever the balance of risk and reward was a year ago, it is now a couple of shades gloomier. It's not so much that we face a property bust and a recession: Put that down to excessively loose monetary policy from 2002 to 2004 and a failure to regulate low-tech abuses such as no-doc loans with no down payments. Rather, the blow to the case for financial engineering comes from the implosion of Bear Stearns -- and from the Fed's necessary response. Those crucial checks and balances have been weakened.

This may sound odd, because two types of stakeholders in Bear Stearns were made to pay for their excessive risk taking. Shareholders have lost their shirts and thousands of employees will lose their jobs, which should teach Wall Street a grim lesson. But two other types of stakeholders have been given a huge break. As of 10 days ago, Bear's lenders did not expect to get their money back in full; thanks to a $30 billion credit line from the Fed, the lenders now look comfortable. Equally, Bear clients who had bought swaps and other derivatives faced the prospect of their contracts being rendered worthless; that danger has receded. Moreover, the Fed has announced that it is ready to provide emergency loans to other investment banks. The incentive for private lenders and buyers of derivatives to monitor banks' risk has to some extent been blunted.

This is a subtle shift, ... But the shift is disturbing nonetheless. ...


The Fed, typical bail-out people.


A glimmer of light at the end of the tunnel and it ain't a train coming at you.

Existing home sales are up 2.9% for the month of February.


The WSJ's law blog assesses the shareholder's prospects in a discussion with Gordon Smith, a professor at BYU Law School: How Would Shareholders of Bear Fare in Delaware?. Here's the lead in:

At the markets’ close today, Bear Stearns shares were trading at $5.33. It’s not much compared to where the stock was trading early last year, but it’s a significant premium over the $2.34 per share recently offered by J.P. Morgan Chase.

As the WSJ reported this morning, Bear bondholders were partly responsible for the stock’s rise yesterday. Some are eager to see the deal get done and avoid a bankruptcy, so they’re buying up shares to increase their voting position on the deal. That said, the story hinted at the possibility of disgruntled shareholders rejecting the deal outright.

An up or down vote isn’t shareholders’ only recourse. They could — drum roll please — sue to enjoin the deal.

But would would such a suit look like? Could Bear shareholders possibly mount a winning challenge? We here at the Law Blog are too many years removed from our second-year corporations class to come up with a cogent analysis on our own. (All we remember from corporations — or Enterprise Organizations, as it was called at Michigan back in the day — is the phrase ultra vires. But we haven’t the foggiest idea what it means.)

So we checked in with an expert to help us out...

If you want to find out what the professor said, go read it yourself.

And then there's the Deal Journal's discussion: Did The Fed Push Bear Into a Bad Deal? The authors discuss "Did the Fed do the best it could with what it knew, or did it act too forcefully to broker a deal that has turned out to be a disaster for Bear’s shareholders?"

Among other comments:

J.P. Morgan’s deal for Bear Stearns has several unusual features that make the deal particularly favorable to J.P. Morgan and comes at the expense of the shareholders of Bear Stearns, who are losing billions on the $2.40 a share offer. It’s nearly impossible for any rival bidder to break it up, J.P. Morgan already has management oversight of Bear, J.P. Morgan can buy the building even if Bear’s board rejects the deal, and J.P. Morgan can buy up to 20% of Bear’s shares if any other buyer does the same. And the prospects for a legal showdown in Delaware court don’t look so auspicious, one expert told our brother Law Blog.

In the end the Fed didn’t just support any deal for Bear Stearns, it supported this deal, with this buyer, and anyone who considers the price a crime is naturally going to start dusting the Fed and Treasury for fingerprints. What might have looked like a bailout and rescue last week to many now looks like highway robbery to some. Former Federal Reserve Chairman Paul Volcker even commented on the Fed’s “extreme intervention” on the Charlie Rose show, which you can see at the Real Time Economics Blog here.


I've pointed out the inconsistency of the Administration's supposed laisse affaire
policies; re the Bear Stearns bailout. It appears now that JP Morgan was deliberately
shorting the stock. No way the firm's non
subprime assets could be that low. But their were real concerns that BSC collapse could affect the overall financial picture.


Why settle for $10 now? Think Bear Sterns can stall even longer while the Fed and JPM have guaranteed BS trades?

Maybe they can get back to $30?


Probably so, ask Bob Rubin as head of
Citibank Europe, was schlepping the same
grade of securities to the misfortune of
institutions like Northern Rock; logically
he'sthe perfect choice to solve the problem.


Of course JP was shorting the stock, so where all the other smart people. The dem feds should stay out of the markets. Should the foreign buyers of Merrill be more worried now that everyone went long before the feds complained? Is this Bill's democracy and how all those Americans got paid? Will hillary save us and should foreign buyers be worried again?

Citi is all CIA and they squeezed China on all that debt. Now, dem feds wants Citi to run the Merrill buys?


David Bernstein at the Volokh Conspiracy takes a look at the "inadvertently included" sentence. The comments there are recommended.


David Bernstein at the Volokh Conspiracy takes a look at the "inadvertently included" sentence. The comments there are recommended.


Didn't the Fed facilitate a bailout of a hedge fund during the Clinton Administration ?


I think they bailed out Mexico in '94.


And Rubin then head of the National Economic Council ; lobbied for the bailout, despite his holdings in Mexican investments.
Half a dozen years earlier, he engineered the takeover of Houston Natural Gas with
another company, His choice for CEO was a well respected government bureaucrat with
some experience in the Texas oil fields. In fact, besides, Boone Pickens was the only one who made money in Texas oil; that fellow
was Ken Lay and the new company was called



Didn't the Fed facilitate a bailout of a hedge fund during the Clinton Administration?


The US greased the skids for the IMF bailout packages (SK's was the largest I believe) during the Asian Financial Crisis.

The Fed's charter includes the orderly functioning of markets-if Bear collapased it could have forced others to fall as well and would have been highly disruptive in any event. I would note (with the caveat that correlation is not causality) that gold and oil have come off their highs and the dollar has strengthened since the Fed's Bear Stearns action-even with a rate cut thrown in the mix.


The other thing I would note is that Treasury has a new agreement regarding "sovereign wealth funds" during the Bear Stearns news cycle.


Fortune has an article explaining the Bear Rally, and the revised Bear Deal: Bulls run wild at Bear Stearns:
The stock's rise says investors are betting on an even better deal, but this time JPMorgan's hand looks much stronger.

Here's the passage in which JPMorgan's stronger hand is described--and the bad news for shareholders considering trying to scupper the deal:

What's more, the structure of the revised merger agreement suggests it's unlikely that JPMorgan would sweeten the pot yet again. The new pact calls for JPMorgan to buy 95 million Bear Stearns shares at $10 apiece within two weeks. That will give JPMorgan a nearly 40% stake in Bear before shareholders vote on the deal. Bear's directors have agreed to vote in favor of the deal as well, throwing cold water on the notion that Jimmy Cayne, the bank's chairman and former CEO, might put together a rival bid.

Alan Schwartz, Bear Stearns' chief, said in a statement that the JPMorgan share purchase was "a necessary condition to obtain the full set of amended terms, which in turn, were essential to maintaining Bear Stearns' financial stability."

Together, those factors seem to remove any doubt about whether JPMorgan will be able to carry the shareholder vote, whenever it takes place.

It occurs to me to ask, in the unlikely event that this deal winds up before a court, would that court be likely to overturn or require a revision of a deal that was brokered by the Fed? How much deference would a court be likely to show, given the centrality of the Fed's role and the Fed's claim that their actions were required to stave off a financial market meltdown?

Bear clients who had bought swaps and other derivatives faced the prospect of their contracts being rendered worthless; that danger has receded.
That's not the problem with swap positions at all. The problem is that a bankruptcy court could rule the pay side of the swap as liabilities (and cancel it) and the receive side of the swap as an asset and hold the counterparty to it.

Take the classic (simple) interest rate swap of fixed-for-floating. (This would be the sort of position that a responsible, diligent mortgaqe holder would take in order to hedge the risk that the value of the fixed-rate mortgage is fixed while interest rates float.) The value of the the swap at each coupon is the difference between floating and fixed. In any reasonable expectation of future events, that difference is an order of magnitude lower than the value of either side of the swap.

So the risk in a bankruptcy is not that the swap will be cancelled and rendered worthless, but that it will be half-cancelled, and become a huge liability to the counterparty. Enough of those, and the most exposed counterparty goes bankrupt. And then, like dominoes, they all go down.


Well, but cathyf, doesn't it remain that these clients have received a break--the danger to their position, one way or the other, has receded? And this deus ex machina intervention by the Fed (I say that because it was unprecedented) undermines the traditional incentives to monitor risks.

BTW, feel free to explain swaps and derivatives--I haven't a clue.


Rich, this is the WSJ's explanation of the commodity price break:

On Tuesday, two members of the Fed's Open Market Committee formally dissented from the decision to cut the fed funds rate by another 75 basis points, to 2.25%. Markets had expected a cut of 100 points. Even that new and mild Fed caution about inflation seems to have taken the edge off speculators who had been betting that the dollar would continue falling to new lows amid U.S. malign neglect.

From their lead editorial today.



Tomorrow's WSJ editorial seconds Fortune's take on the revised deal:

J.P. Morgan CEO Jamie Dimon is a tough customer, but the way he's rolling over the U.S. Treasury and Federal Reserve is getting to be embarrassing. Too bad our public officials aren't as stalwart in standing up for taxpayers as Mr. Dimon is in defending his bank's commercial interests.

Yesterday, Mr. Dimon called the Beltway's bluff one more time as he renegotiated the terms of last week's merger accord with Bear Stearns. J.P. Morgan agreed to quintuple his price, to $10 a share from the firesale value of $2, in return for enough shares to guarantee that the merger will now be approved by Bear shareholders./b> So Bear Stearns holders get more money, Mr. Dimon gets more certainty, but the Fed still gets left guaranteeing $29 billion worth of troubled Bear mortgage-related securities.


The immediate political message is also terribly damaging. Congress is already poised to overreact to the mortgage turmoil with a general bailout for subprime borrowers, and yesterday's actions will only feed that beast. At least the $2 share price wasn't a bailout for Bear shareholders; at $10 a share, that's a harder argument to sell, especially when taxpayers are also still indemnifying those Bear-J.P. Morgan creditors. This makes us wonder if Treasury Secretary Hank Paulson isn't already preparing to cave to Congress on the larger bailout.

As they like to say on Wall Street, the goal is to leave you with only your socks and a smile. New York Fed President Tim Geithner and Mr. Paulson were the main government decision-makers in dealing with Mr. Dimon, so we recommend they each buy raincoats. They'll need something to wear when they and this bad deal for taxpayers get undressed a second time on Capitol Hill.




Here's what I wanted to emphasize:

J.P. Morgan agreed to quintuple his price, to $10 a share from the firesale value of $2, in return for enough shares to guarantee that the merger will now be approved by Bear shareholders.


This makes us wonder if Treasury Secretary Hank Paulson isn't already preparing to cave to Congress on the larger bailout.


The action of the Fed seems to be classic 19th century British Central Bank when a panic occurs. The Economist frequently has the quote of their founder endorsing this. The key is that the Central Bank has accepted the notes as collateral though not lending to full face value; they still owe the money. Oddly enough JP Morgan, the man, did a similar thing in the panic of 1905 was it? The issue is liquidity; to loan to homeowners would be different. It would attempt to deal with a solvency problem like food stamps does.



...the panic of 1905 was it...

The 1907 Panic [4 meg .pdf]

JP Morgan also was part of the bailout during the Panic of 1893


OK, I've been hammering away, saying that Republicans need to get ready for the economy issue if they want to win in November. Well, here are two "progressives" who are also worried--about the Dems: Democrats and the Economy. Here're the high points, which just may have something in them for the GOP as well:

The economy is either in or sliding toward recession, and according to media accounts, the middle class is getting hammered. The conventional wisdom is that the November elections will be a cakewalk for Democrats, who are perceived to be champions of the middle class.

But the "party of the middle class" has lost middle-income voters in six of the past seven congressional elections and the two most recent presidential races. While the "Bush recession" could redound to Democratic benefit this fall, Democrats could squander this opportunity if they fall into one of three traps on what they say and offer Americans. The traps are:

- Confusing 2008 with 1929. It's not even close. The overwhelming majority of Americans today are not on the brink of economic catastrophe, and Democrats should not treat them as if they are.


- Confusing bad times with pessimism. Even during tough times, Americans are optimists and believers in the American Dream. They believe success or failure is within their control. Eighty percent believe you can start out poor and become rich in America. And while they are anxious over the current economic downturn and the broad changes brought about by globalization, they do not see themselves as victims, and are not comforted by politicians who recite a litany of their anxieties.


- Offering only security instead of success. We're not French. Americans want to succeed, not just get by. They don't dream about a better safety net. They dream about getting ahead.


Two unexpected phenomena are peeking their bright little rays over the morning horizon, too, Anduril.

One, desperate international pessimism over global warming and carbon capping are going to be alleviated in the coming years as the globe cools, and the carbon fever subsides.

Two, by and large it is liberals and Democrats who are most avid for carbon encumbering and blaming man for climate. This is understood by the great muddle, who will be more amenable to persuasion by Republicans as a result.


kim, I agree that Republicans should get a backbone and aggressively make "global warming" an issue. I think it's a winner.

Wayne Jett has a worthwhile article: Investment Bank of Last Resort.

Jett argues several points:

1. The credit crisis was brought about, in part, by Fed policy. In other words, the Fed isn't entirely a white knight coming to the rescue.

2. Current Fed actions appear designed to avoid permanently increasing the money supply (Rick made this point at least a week ago).

3. Bush needs to get involved to steer the Fed into longer term sensible policies. Evaluate it yourselves.

Defective U. S. monetary policy has caused serious dislocations in the credit markets, distrust of credit quality and distrust of the dollar. None of these three serious concerns will be resolved, and certainly not for the long term, without reforming monetary policy. The Federal Reserve is not the cavalry riding to rescue private wagon trains in trouble of their own making. Crises addressed by the Fed are of the Fed’s making. Chairman Bernanke has steered the Federal Reserve into a role of investment banker of last resort, a high risk business whose prospective losses will be paid by further devaluation of the peoples' money.

Orthodox Keynesian theorists see dollar devaluation as a good thing, yet paradoxically argue price inflation is bad and ought to be fought with higher interest rates and higher unemployment. Dollar devaluation makes price increases inevitable, and unemployment is merely one mechanism for lowering the standard of living. Keynesian doctrine guiding the Federal Reserve may get the economy through this federal election year without catastrophe, but it is incapable of producing a good outcome over the longer term.

President Bush needs better economic advice. Someone should tell him he can issue an executive order requiring the Federal Reserve to allow markets to set the overnight funds rate, while at the same time requiring our central bank to target $500/oz. gold as the dollar’s value. Otherwise, after November 4, high inflation, high interest rates and economic recession will tarnish the legacy of his originally successful 2003 tax cuts.

Rick Ballard

I have some doubts as to the election hingeing upon McCain's understanding of monetary policy. If he knows any more about it than the great muddle, that fact has been carefully concealed to this point.

The muddle's state of mind re the economy is tied to the unemployment rate, price of gas and CPI reports. That's for the sharper of knives in a drawer which provides few tools suitable for cutting anything but butter.

JPM's bout of indigestion provides some amusement but not quite as much as the idiotic writing concerning "steep declines" in the price of houses which hold the "median" up as the grail of evidence without mentioning that the jumbo loan window remains closed. The muddle will gobble up the misinformation and be amazed at the results when the jumbo window opens again and the "median" jumps accordingly.

Playing the muddle like a fiddle is McCain's task and he's doing just fine at the moment. Not unexpectedly.


Understanding of monetary policy may not be crucial in the election--but the "progressives" I quoted above are not recommending making monetary policy an issue anyway. They're recommending, if I read them right, putting out a message of optimism and commitment to success, as opposed to a message of pessimism and just surviving. That probably means they'll be touting hope, fresh blood and competence and moving beyond policies that have led to a credit muddle.

What I'M suggesting is that McCain needs to go beyond his standard message of cutting waste and raising taxes--you can argue with the fairness of that characterization, but there's enough in McCain's past to muddy the waters on those issues (as there is with virtually any Senator who has a track record--guess who doesn't have much of one and will try to wield that lack like a sword?). What McCain needs is a semi-coherent commitment to growth and success.

As for housing prices, we're getting close to only half a year to go to the election--six short months. Banks will be aggressively seeking to unload homes they've foreclosed on, and that will almost certainly bring the average price down. That's not a reason for doom and gloom, but is a potent weapon for disinformation of the type that we've seen in past elections. McCain needs to be ready to counter this with a message of growth and success--not just cutting spending and raising taxes. In fact, while fiscal responsibility is always a winner, I believe McCain should be arguing for lower taxes and a reformed tax system to maximize the effect of the growth and success message that I hope he puts out before the public.

Rick Ballard

I roughly agree Anduril. Just not on the timing. This campaign is going to be about boredom (among other things) and coming out early with specifics would, IMO, be a killer.

The two recent examples of elections where the economy was a major issue ('80 and '92) involved an incumbent. McCain has no responsibility for the economy and can afford to wait and watch for a bit. Besides, I shudder when thinking about him applying that mediocre intellect to any particular problem. Better to let the brighter around him lead him slowly to the water and wait patiently for him to drink.


It's not clear to me that I've ever suggested McCain should be butting into the continuing Dem debacle--I just keep saying things like (see above) "McCain needs to be ready to counter" the economy based attacks that are sure to come later. Of course there's no point in getting out in front on an issue that's still developing. This is a time for learning, in an area in which McCain has never shown any previous interest.


For a little educational break, how subprimes work in 45 stick figure drawings


For a little educational break: how subprimes work in 45 stick figure drawings


Well, cathyf, I admit it--I can see I've been a chump all my life. Living within my means, paying my mortgage every month, saving for my kids education, never taking vacations, only borrowing for essentials. I should've been an investment banker, one of the really smart guys. I could've had it all.

One question: where does the Fed come in? Heh. There was no stick man for them.


Heh--Cathyf--your link is a five chuckler!!

I loved the line--

"Gee, we didn't see that coming."


I thought the exchange between the outraged citizen and the accountant was priceless--it comes up so unexpectedly, but kinda sums up the attitude of professionals toward the public.


Per the WSJ:

"Demand for expensive goods fell 1.7% in February, an unexpected decline, while a barometer of capital spending by businesses tumbled 2.6%, a second straight drop. Meanwhile, new-home sales slid 1.8% in February to the lowest mark in 13 years, while the median price also declined to $244,100."

More reason to believe the economy will be an issue this fall.

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