Bear Stearns collapse - was Fed bailout justified?

[beren]

I've heard a lot of good arguments on both sides. Some people say that Bear Stearns made unwise financial decisions, and therefore we shouldn't help them out.

The Wall Street Journal also made some pretty harsh allegations against Bear Stearns CEO:

The Journal reported that Cayne was playing bridge and golf and was often out of touch from his embattled Wall Street firm this past summer while its hedge funds collapsed and helped to spark a credit crisis in global financial markets.

Some people believe that the bailout was necessary:

If it was 2005, Bear would have been allowed to collapse, as the system back then could deal with it, as it did with REFCO. But it is not 2005. We are in a credit crisis, a perfect storm, which is of unprecedented proportions. If Bear had not been put into sounds hands and provided solvency and liquidity, the credit markets would simply have frozen this morning. As in ground to a halt. Hit the wall. The end of the world, impossible to fathom how to get out of it type of event.

On the other hand, some people think the government hasn't done enough:

Senator Charles Schumer, a New York Democrat, accused Bush of not doing enough.

"The president is, indeed, behaving like Herbert Hoover," Schumer said. "We're in the most serious economic problem we've been in a very long time, much worse than 2001. The president's hands-off attitude is reminiscent of Herbert Hoover in 1929, in 1930."

What do you guys think? I'm very confused (and frankly a little scared).

[rstlne]

I voted No. At this late stage, I don't know if anything can be done. This time, it's Bear Stearns. Next week, it could be Lehman Brothers. A month later, it could be Citigroup. They all have significant Level 3 assets and are technically insolvent. (i.e. their potential writedowns are higher than 100% of their capital) The Federal Reserve will likely run out of ammunition before large investment banks run out of problems.

If you follow Austrian Business Cycle Theory, each boom caused by loose monetary policy causes malinvestments that must be cleared out through a subsequent bust. Additionally, the bigger the boom, the bigger the subsequent bust will be. So the ideal time to have allowed a cleansing recession to happen was probably during Greenspan's time when the boom was still in its infancy. But no, instead he loosened the monetary spigots at every single crisis and even at every single hint of a crisis (remember Greenspan's boost to the money supply immediately before the Y2K crisis that never happened?), thus leading us into a situation where the problem could be too big for the Federal Reserve to handle.

[MasterYourCard]

I think the BS bail out as well as the constant interest rate reductions are just delaying and compounding the inevitable contraction, not to mention punishing fiscally responsible people (i.e. those who save and live within their means). Be prepared for the US dollar to take another dive, and for gold and oil to keep hitting record highs.

Either way, I don't envy Ben Bernanke or the unlucky sod who wins the election - they're going to inherit one hell of a mess!

[yourbeginnings]

I voted a big "NO"!!!.

[kav122]

I voted no too, and I also think that we are delaying and compounding the inevitable.

[The Honest Dollar]

The question in the poll is framed incorrectly. The Fed did not bail out Bear Stearns.

What is a bail-out?

A bail-out is "a term used to describe a situation where a bankrupt or nearly bankrupt entity, such as a corporation or a bank, is given a fresh injection of liquidity, in order to meet its short term obligations."

This is not what happened to Bear Stearns, since the Fed did not give any liquidity or money to Bear Stearns. In fact, Bear Stearns sold for less than its headquarters building is worth, and management stake has pretty much been completely wiped out. This means that if anything, the Fed helped along Bear's demise.

What the Fed actually bailed out is the entire financial system.

Bear Stearns (as well as most of the major investment banks) carried significant derivative contracts obligations (in particular credit default swaps). Bear's exposure, i.e. what it has to pay if all of the contracts were executed, was $13.4 trillion - roughly the same as the US GDP. (It wasn't actually at risk to lose nearly that much since the stock market would need to blow up before that actually happened, but that's a sobering number.)

What happens if Bear dies unassisted and no one is left to pick up its obligations? Then it's the buyers of the contract that really get screwed. And some of them probably deserve to be screwed, but not all of them - an en masse screwing will take the market down with the buyers.

Some of the people holding onto Bear's obligations are other banks. If investors believe that these banks will lose what Bear owes them, then they might reach the conclusion that these other banks will soon be insolvent as well, and pull out all their funds. This, of course, is a self-fulfilling prophecy - once investors withdraw, those banks will become insolvent.

So the Fed made a deal with JPM to assume Bear's obligations and keep the market chugging along. Essentially, it did what the government failed to do to prevent the market crash of 1929: take action to remedy a run on the bank.

The Fed did not bail out Bear Stearns.

It had a chance to. It could have provided Bear Stearns enough short- and medium-term liquidity to meet its obligations (which would not be $13.4 trillion - that's just a notional amount assuming, say, the price of all stocks fall to $0, and every put option written by Bear gets executed).

However, the Fed did not do this. And it shouldn't have. It's the responsibility of Bear Stearns to make sure it has a sufficient margin of safety to cover its obligations. Bear can't control what investors think and can't prevent a run on the bank, but it might have taken some precautionary measures by decreasing leverage, reducing risky positions, and improving its own liquidity.

The Fed did not reward Bear for its irresponsible behavior.

I also don't think there's a particular moral hazard here. No existing bank will look at Bear Stearns and think they can get away with anything and the Fed will bail them out. All Bear's story says is that if you massively ignore risk management, the Fed will help your competitors eat you up.

Frankly, I'm sick of people criticizing the Fed.

Everyone has latched on to the news media, which keeps blowing up fears of hyper-inflation, stagflation, and recession. Those fears are not unfounded, but most journalists have only a rudimentary understanding of the stock market and economics.

I don't know a lot about the stock market or economics, but I know enough to understand that they are more complex than the news media would lead you to believe.

People see the Fed cutting interest rates, and journalists correctly identify low rates as a factor in inflation. So everyone boos the Fed because clearly lower rates have not helped the market. They see the downside, but what they don't realize is that there is a lag effect to monetary policy. It'll take a while to see the recovery.

People also fail to understand that recent inflation has mostly been driven by rising commodities (including oil and agriculture) prices. Given volatility in the commodities market, this could easily reverse. Or it could keep its current course. But that's uncertain. The risk of a financial collapse is more immediate and more probable.

Then everybody jumps on the Fed for injecting liquidity into the market. Should the big players be so intertwined that if one falls, they all do, bringing the market with them? No, this is probably a bad thing. But that's a value judgment - it doesn't change the fact that this is the way things are, and the Fed has to do its best to patch a broken system before we can get it back on the drawing board again.

In an economic downturn, the entire economy starts making less money. That means lower tax revenues. That means the budget deficit gets worse. (The tax rebate won't help the deficit - but that's a fiscal policy enacted by politicians, not the Fed.) So in some ways, the Fed is almost trying to protect us from deflation.

I'm not excusing the Fed.

Like I said, I don't know everything about the economy. There might have been better solutions, or preventative steps that could have been taken two or three years ago. In fact, you can argue that the current Fed (chaired by Bernanke) is just dealing with the bubbles created by the last Fed (chaired by Greenspan).

But I do know that the situation is more complex than castigating the Fed for "bailing out" big banks or encouraging inflation.

If you have the time to complain about Fed monetary policy, then you have the time to read a little more about the issues that face the Fed in its decision-making - the issues that aren't glamorous enough for the front page.

[Jeremy]

Well, I was typing up a long response to this poll, but I see that Lily has covered my thoughts more than adequately.

[Xin Lu]

Yup.. Lily is right on the mark. The Fed didn't bail out Bear Stearns and JPM is a private corporation that doesn't have to do with taxpayer money. The Fed is supposed to be a private bank, too. If the government actually pulled money from the treasury and helped Bear Stearns pay off debts, then I would really be pissed.

[rstlne]

I agree that the question was incorrectly worded. What the Federal Reserve did was guarantee $30 billion of Bear Stearns' troubled assets to protect JP Morgan from excessive risk so that the latter would agree to buy Bear Stearns. No taxpayer money was involved.

If it turns out that the assets were not as worthless or as risky as was widely assumed, then the Federal Reserve won't pay out and no harm was done. If on the other hand, it turns out that the assets were duds, the Federal Reserve would create money and credit to pay off JP Morgan but that still won't technically involve any taxpayer money. We pay for that indirectly in monetary inflation.

I'm not worried so much about Bear Stearns as I am about what lies on the horizon. So far, we've seen just the tip of the iceberg. If more major financial institutions fail, not even the Federal Reserve can provide enough guarantees and liquidity to paper over the mess.

[lucille]

In a way I think it was a bad idea because it reinforces the idea that distant investments can be flawed and crooked and still not injure your financial state. But preventing a cascade of bank collapses is probably a good idea right now. I don't know though, they may have just kicked it down the road a bit and then it will be worse.

If they want to stimulate the economy I would rather see some massive government works projects like a way to get everyone off of a gasoline based economy. Maybe electric cars or federal rail system?