The Big Bailout

There is every reason to believe that the spectacular collapse of Bear Stearns is only the beginning and a huge bailout of the US financial system is going to be needed, underwritten, of course, by the US taxpayer.

As to how this came about, Krugman writes in today's NYT:

Between 2002 and 2007, false beliefs in the private sector — the belief that home prices only go up, that financial innovation had made risk go away, that a triple-A rating really meant that an investment was safe — led to an epidemic of bad lending. Meanwhile, false beliefs in the political arena — the belief of Alan Greenspan and his friends in the Bush administration that the market is always right and regulation always a bad thing — led Washington to ignore the warning signs....

The result of all that bad lending was an unholy financial mess that will cause trillions of dollars in losses. A large chunk of these losses will fall on financial institutions: commercial banks, investment banks, hedge funds and so on.

Readers may note that Bear Stearns was one-third employee-owned. Greed however overrides any sense of responsibility, even from employee shareholders.

Krugman tells us:

...Bear has a particularly nasty reputation. As Gretchen Morgenson of The New York Times reminds us, Bear “has often operated in the gray areas of Wall Street and with an aggressive, brass-knuckles approach.”

Bear was a major promoter of the most questionable subprime lenders. It lured customers into two of its own hedge funds that were among the first to go bust in the current crisis. And it’s a bad financial citizen: the last time the Fed tried to contain a financial crisis, after the collapse of Long-Term Capital Management in 1998, Bear refused to participate in the rescue operation.

Bear, in other words, deserved to be allowed to fail — both on the merits and to teach Wall Street not to expect someone else to clean up its messes.

But the Fed rode to Bear’s rescue anyway...

...because those b**tards could take all the rest of us down as well.

Gretchen Morgenson explained it in Sunday's NYT:

If Bear Stearns failed, for example, it would result in a wholesale dumping of mortgage securities and other assets onto a market that is frozen and where buyers are in hiding. This fire sale would force surviving institutions carrying the same types of securities on their books to mark down their positions, generating more margin calls and creating more failures.

As of last Nov. 30, Bear Stearns had on its books approximately $46 billion of mortgages, mortgage-backed and asset-backed securities. Jettisoning such a portfolio onto a mortgage market that is not operative would, it is plain to see, be a disaster.

But, who knows what those mortgages are really worth? According to Bear Stearns’s annual report, $29 billion of them were valued using computer models “derived from” or “supported by” some kind of observable market data. The value of the remaining $17 billion is an estimate based on “internally developed models or methodologies utilizing significant inputs that are generally less readily observable.”

In other words, your guess is as good as mine.

Since Bear Stearns sold for $250 million, less than the $1 billion or so that its office building is worth, we know the answer now - its portfolio is a net liability.

And this is **after** the Federal Reserve chipped in upto $30 billion:

In addition to the financing the Federal Reserve ordinarily provides through its Discount Window, the Fed will provide special financing in connection with this transaction. The Fed has agreed to fund up to $30 billion of Bear Stearns’ less liquid assets.

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Final thought, from Morgensen's article:

“For the government to print money at the expense of taxpayers as opposed to requiring or going about a receivership and wind-down of any insolvent institutions should be troubling to taxpayers and regulators alike,” said Josh Rosner, an analyst at Graham Fisher & Company and an expert on mortgage securities. “The Fed has now crossed the line in a very clear way on ‘moral hazard,’ because they have opened the door to the view that they are required to save almost any institution through non-recourse loans — except the government doesn’t have the money and it destroys the U.S.’s reputation as the broadest, deepest, most transparent and properly regulated capital market in the world.”