The American Mind

Federal Reserve chairman Ben Bernanke has been testifying on Capitol Hill about JPMorgan Chase’s buyout of Bear Stearns. As immediate concerns eased over the financial crisis of a few weeks ago some have questioned the wisdom of the Fed pushing for the buyout and taxpayers taking on $29 billion of risk in illiquid Bear securities.

Here’s video from Bernanke’s testimony before the Senate Banking Committee:

One conservative critic is John Berlau of the Competitive Enterprise Institute. Last week, he wrote:

Forcing the merger of Bear with Morgan, which is basically what the government did, and offering $30 billion in guarantees so there will be very little downside risk for Morgan is a horrible long-term precedent for the taxpayers, shareholders and the U.S. economy.

In this bailout, the government sided with creditors at the expense of shareholders of Bear Stearns common stock. By forcing this fire sale, the Fed ran roughshod over thousands of investors’ interests, and whatever effects this has on the credit market, the precedent may do untold damage to the retail investor market for equity in firms through common shares.

About helping Bear Stearns Bernanke addressed the possibility of setting a new precedent and told Senators the Fed’s actions were dictated by unique circumstances:

Bernanke said ‘we have a very high bar for ‘unusual and exigent,’ so this is twice in 75 years that we’ve used this power.’
In a different environment, he said, the rescue might not have happened. ‘If the financial markets had been in a robust and healthy condition we might have taken a very different view of the situation,’ he said. But, given the weakness and the fragility of many markets, the Fed considered Bear Stearns’s situation ‘unusual and exigent,’ under the terms of the law.

He also promised that ‘we will certainly be very diligent in resisting calls to use this power’ in other situations.

I’m concerned about Berlau’s call for the Fed to renege on taking Bear’s mortgage-backed securities. Talk about setting a bad precedent. The financial markets trust the Fed to stabilize the markets. Stepping away from an agreement after an immediate crisis ceased would bring needless uncertainty to future crises.

A big concern about the Fed’s loan to JP Morgan is they would get dumped with the worst of Bear’s debt securities. Based on a Congressional Research Service report National Review’s David Freddoso wrote:

The only collateral for this loan is the $30 billion in Bear Stearns’s un-sellable mortgage-backed securities, the real value of which is — shall we say — difficult to assess when no one is buying. And unlike most loans the Fed makes, it has no recourse here if the collateral loses some or all of its value. In fact, the CRS report notes, “[T]he agreement has some characteristics more in common with an asset sale than a loan.” The report adds dryly that JPM was unwilling to hold onto these assets itself, perhaps because it “could have believed that the assets were worth . . . significantly less than the current market value of $30 billion.”

However, neither JPMorgan nor Bear Stearns picked what securities the Fed would take as collateral. This is from the Fed’s website [emphasis mine]:

The cash assets consist of investment grade securities (i.e. securities rated BBB- or higher by at least one of the three principal credit rating agencies and no lower than that by the others) and residential or commercial mortgage loans classified as “performing”. All of the assets are current as to principal and interest (as of March 14, 2008). All securities are domiciled and issued in the U.S. and denominated in U.S. dollars.

The portfolio consists of collateralized mortgage obligations (CMOs), the majority of which are obligations of government-sponsored entities (GSEs), such as the Federal Home Loan Mortgage Corporation (“Freddie Mac”), as well as asset-backed securities, adjustable-rate mortgages, commercial mortgage-backed securities, non-GSE CMOs, collateralized bond obligations, and various other loan obligations.

The assets were reviewed by the Federal Reserve and its advisor, BlackRock Financial Management. The assets were not individually selected by JPMorgan Chase or Bear Stearns.

New York Fed president Timothy Geithner told Senators the problem was the amount of assets rather than the quality [via Felix Salmon]:

On Sunday morning, executives at JPMorgan Chase informed us that they had become significantly more concerned about the scale of the risk that Bear and its many affiliates had assumed. They were also concerned about the ability of JPMorgan Chase to absorb some of Bear’s trading portfolio, particularly given the uncertainty ahead about the ultimate scale of losses facing the financial system.

If the economy weren’t so sluggish and the financial markets on edge the Fed would have let Bear Stearn go under. With liquidity concerns and the fear of Bear taking other investment banks down with it Bernanke and Geithner saw reason to act quickly.

Marketwatch readers are more worried about Fed monetary policy that’s led to inflation:

Something the Fed could be blamed for is not acting sooner to open its discount window to investment banks. Bear Stearn’s president thinks doing so earlier would have prevented a fire sale of the firm and not get the Fed into the regulatory and moral hazard mess it’s now in.

[picture via trackrecord]