Grin and Bear Sterns It

I recently heard a great joke that reminded me of the recent economic and market conditions, and the emotions surrounding every trading day. I should preface this by saying that if you are not familiar with Bulgarians, you should know that they have endured a brutal history, which has earned their citizens a reputation as being some of the most untrustworthy and cynical folks from the former Eastern bloc. Here's the joke: Two Bulgarians meet each other on the street. The pessimist says, "Things can't get worse!" to which the optimist says, "I think they can get worse!"

For employees and investors of Bear Stearns, the Bulgarian pessimist's words rang loud and clear in March. On March 14, Alan D. Schwartz, the CEO of Bear, seemed stoic as he conducted a conference call to explain the nation's fifth largest investment bank's dramatic move: it had received emergency funds from J.P. Morgan Chase & Co. and the Federal Reserve Bank of New York to meet its obligations and to protect against rumors that had been swirling around the firm for months and had accelerated over the preceding week. In other words, Bear's liquidity had fallen so much that it needed cash – and fast.

The mechanics of the deal involved using a little-used Depression-era provision of the Federal Reserve Act. J.P. Morgan would borrow directly from Fed's discount window and relend to Bear Stearns for 28 days. (Unlike investment banks like Bear, J.P. Morgan had the advantage of being able to borrow directly from the Fed.) The money that was to be borrowed would be secured by collateral furnished by Bear. Under terms of the deal, the Fed, not J.P. Morgan, would bear the risk of losses if the Bear Stearns collateral were to fall in value. The news caused the Bear Stearns' stock price to close down 47% on Friday to $30 per share. To put the price in perspective, this is a stock that was trading at $170 a year ago.

The following Monday (3/17), there was a stunning turn of events: 85-year old Bear agreed to sell itself to J.P. Morgan for two dollars per share! To help grease the wheels of the deal, the Fed approved a $30 billion credit line to J.P. Morgan and said that it would effectively take over the huge Bear Stearns portfolio of distressed mortgage-backed securities. Authorities stepped in because Bear did business with so many large firms (counter-parties) and was a significant player in markets for debt, particularly for securities backed by mortgages. If Bear were to fail, many of the counter-parties would become ensnared, prompting a potential domino effect throughout the brokerage and banking industries.

The mainstream media jumped on the story with headlines that repeatedly said the government is "bailing out Bear." How unfair, said populist CNN's Lou Dobbs. Your taxpayer money should not be used to ease the pain of Wall Street-ers! Employees of Bear Stearns, who owned 30% of the company, surely did not see the deal as a bailout – within days of the announcement, I saw someone wearing a t-shirt, emblazoned with, "Jamie Dimon (J.P. Morgan's CEO) stole my company and all I got was this lousy T-shirt."

Before you jump on the "bail-out bandwagon," it is important to understand why this deal occurred. The Fed engineered the Bear Stearns transaction because it was unwilling to risk the unwinding of a mammoth bank's assets in an already-weakened market highlighted by a lack of liquidity. The crisis started last August, when trading in many kinds of junk bonds, mortgage-backed securities and auction-rate securities had ground to a halt, as investors could not determine the "true" price of many of these securities. This left some of the nation's largest financial institutions holding illiquid assets. As a result, their counter-parties were not interested in dealing with them. Here is the key issue of the Bear Stearns story: the problem at Bear was not confined to one company – financial institutions are interconnected through swaps and loans and if Bear were to fail, other institutions' solvency might be called into question, creating a systemic run on counter-parties in general.

Of course, the situation was made worse because of the vast leverage employed by financial institutions. When leverage is high, it is imperative to understand what the underlying asset is worth – without that information, market participants will seize up. This is why the real estate boom and bust has morphed into a far reaching systemic problem. Lou Dobbs-types scoff at this notion and believe that only when asset prices drop and some of the big guys fail will the system's problem's ease. The Fed was averse to this course of action because it might have triggered a wider financial system failure and potentially could have thrown the US into a deep recession.

This year, the Fed has taken an aggressive posture to prevent that very outcome. Ben Bernanke may have been a little slow on the trigger last year, but 2008 has been an entirely different story. The Fed has lowered rates by 2% this year, for a cumulative 3% since it started its easing campaign last year. Additionally, the central bank has employed Depression-era facilities to facilitate smoother financial market operations and help thaw the frozen system.

The Fed has turned to creative policy measures to help narrow credit spreads and provide liquidity. In December, we saw the introduction of the Term Auction Facility (TAF), under which the Federal Reserve auctioned term funds to depository institutions (all depository institutions that were eligible to borrow under the primary credit program were eligible to participate in TAF auctions.) The TAF allowed banks to borrow at relatively attractive rates against a wider range of their assets than previously permitted, which encouraged institutions to increase their pace of borrowing by mid-February.

In March, the Fed pulled another rabbit out of its hat: the Term Securities Lending Facility (TSLF). The TSLF made money available to the twenty large investment banks that serve as primary dealers and trade Treasury securities with the Fed. This program allowed the Fed to hold as collateral a wide array of investments, including the now-tarnished mortgage back securities, and had no limit on the amount of money that could be borrowed. Soon after the TSLF was rolled out, the Fed added the Primary Dealer Credit Facility (PDFC), which opened the Fed's discount window to the 20 primary dealers with no limit on the amount of money that can be borrowed and liberal requirements on collateral accepted. In other words, the Fed was working hard to lubricate the system and was doing everything in its power to stave off financial instability.

While I understand how many believe that those who created this mess should suffer, Fed officials are thankfully pushing aside the worries about "moral hazard" so that financial system does not become crippled altogether. I see the Fed actions as necessary to help halt the forced sell-off of high quality mortgage backed securities. These moves are less financially-motivated than confidence-builders. Clearly the root of the economy's fundamental problem cannot be solved by the Fed. After all, the central bank cannot stop housing prices from falling. But what it can do is provide liquidity to financial institutions which might prevent what is known on the street as a "death spiral," or a bank run.

And one last note about the shotgun marriage of J.P. Morgan Chase and Bear Stearns: one week after the initial $2 deal was announced, J.P. Morgan CEO James Dimon quintupled the Bear bid to about $10 a share, succumbing to shareholder and employee pressure. Additionally, the Federal Reserve revised its participation as well: it reduced its coverage from $30 to $29 billion of potential Bear Stearns losses. The price appears to be firm at this point, which certainly improves the situation for shareholders, who have endured a healthy dose of pain and suffering. For the rest of the investment community, the near-failure of a large investment bank may be the beginning of the bottoming process of the credit crunch. But remember, it is a process, not an event, so don't be surprised if a couple of more shoes were to drop before this mess is all over.

Jill Schlesinger, CFP, is the Chief Investment Officer of StrategicPoint Investment Advisors. She can be heard weekly on “Making Money Show”, Saturdays from 9am to noon on WHJJ-920 am.