The American Mind

We all know the Federal Reserve is providing $30 billion in financing for JP Morgan’s buyout of Bear Stearns. One reason JP Morgan got this was “Why not get the Fed to spot some cash, making the deal that much more digestible?” Another reason might have been to protect the bank’s balance sheet.

According to Fortune’s sources JP Morgan wanted the Fed to take $30 billion of Bear Stearns’ mortgage-backed securities as collateral to prevent JP from having to revalue its own mortgage-backed securities:

But the value of Bear’s balance sheet wasn’t the only worry at JPMorgan. Bear execs say JPMorgan was also worried that without help from the Fed, buying mortgages from Bear (BSC, Fortune 500) could force JPMorgan to write down the value of its own mortgage holdings.

That fear stemmed in part from the sharp decline in the value of mortgage debt this year, along with the different calendars the firms report on. At the end of February, Bear had $16 billion in commercial mortgage-backed securities, $15 billion in prime and Alt-A mortgage bonds and $2 billion in various subprime bonds, JPMorgan said. The value of those securities has been in sharp decline, along with U.S. house prices. Indeed, values in the mortgage securities market have plunged just over the past month, as investors in lenders such as Thornburg Mortgage (TMA) – which is dealing with unmet margin calls triggered by plunging prices – will surely tell you.

JPMorgan’s fiscal year ends Dec. 31, so the firm’s mortgage holdings are marked to prices that prevailed then – before the bloodbath of the last month. But Bear’s latest quarter ended just last month – and Bear executives told Fortune that in that quarter, they marked their mortgage desk’s portfolio down by $2.5 billion.

As a result, Bear Stearns’ mortgage-portfolio marks could have been lower than JPMorgan’s – and bringing the Bear Stearns loans onto JPMorgan’s balance sheet could have resulted in a so-called marking event that would have forced JPMorgan to apply Bear’s freshly lowered values to its own mortgage book. That could have led to billions of dollars worth of writedowns at JPMorgan – even assuming JPMorgan’s marks were entirely appropriate as of Dec. 31.

Such a markdown by one of the strongest financial companies could further spook already frightened financial markets.

U.S. taxpayers are on the hook for billions in Bear Stearns’ debt. But the Fed and Treasury Secretary Paulsen felt Bear falling would have shocked markets in a deleterious way.

“How the Bear Stearns Deal Got Done”