The Brinkmanship at Bear Stearns

Could Bear Stearns (BSC) have survived if the Federal Reserve had opened its discount window to it sooner? The answer: Doubtful. Was it right to rescue Bear Stearns (BSC)? The answer: Yes.

The dramatic details of the collapse of Bear Stearns, an 85-year old institution, will be taught in business schools for years to come. It's a tale still unfolding--it's a story that's a must read for investors.

And it's a story loaded with controversy. Here's one of the biggest points of contention.

Bear Stearn's chief executive officer Alan Schwartz said in testimony before Congress that the Federal Reserve could have stopped the fifth-largest U.S. securities firm from collapsing if the central bank had opened up its discount window sooner to lend money directly to investment banks, including Bear.

The Fed did so on March 14, after $10b was sucked out of Bear in one day, putting the firm on the brink of bankruptcy. JPMorgan Chase (JPM) stepped in and is now buying Bear for just $10 a share, down drastically from Bear's peak of $170. JP only did so after it got a $30b loan from the Fed, backed by Bear securities that the two sides say were valued at $30b as of March 14. 

JPMorgan has agreed to absorb the first $1b of losses if the value of the assets declines, but taxpayers are at risk for the remaining $29b. At the time of its collapse, Bear had $389b in assets and $387b in liabilities against $11.9b in shareholders equity. JPMorgan is now digesting Bear's colossal balance sheet.

``It is highly, highly unlikely in my personal opinion that we would be in the situation we find ourselves in today'' had the Fed opened its discount window sooner, Schwartz told members of the Senate Banking Committee. Opening the discount window to non-commercial banks was an historic move the Fed has not made since the Great Depression.

Let's recap. Bear Stearns had $389b in assets and $387b in liabilities. It had $11.9b in shareholder equity, or net worth, to support that book of business. That's operating on a shoestring. The bonds on its book were getting crushed by the subprime crisis, so much so that two of Bear's own hedge funds went belly-up last July.

"We only allow sound institutions to borrow against collateral" at the Fed's discount window, Timothy Geithner, president of the New York Federal Reserve, said in testimony. "I would have been very uncomfortable lending to Bear given what we knew at that time."

Even if the discount window was opened to Bear sooner, the credit rating agencies were ready with their battle axe of a downgrade, and Bear would have sucked that window dry as it was hemorrhaging customers and cash.

Keep in mind Geithner's quote for now, it's important. Because the question is, if the Fed wasn't comfortable with Bear's collateral assets at its discount window, how can the Fed now be comfortable with the $30b in Bear securities used as collateral to back its $30b loan to JP to facilitate the deal? More on that in a minute.

What's chilling is talk of the dangerous cascade of wipeouts that would likely have taken place if the country's fifth largest investment house was allowed to collapse. 

If the Fed didn't rescue Bear, a bankruptcy "would have touched off a chain reaction of defaults at other major financial institutions," shaking the confidence in the credit markets, and hurting the mortgage market, the muni-bond market, even the student loan market, says JPMorgan Chase's CEO Jamie Dimon. As Fed chairman Ben Bernanke says, thousands of counterparties to trades at Bear would have been slammed too. 

Let's start at the beginning.

Though many say subprime writedowns at HSBC early in 2007 were the canary in the coal mine signaling the coming credit crisis, it was the collapse of Bear's own two hedge funds, which had invested in subprime securities, last July that ignited the downward spiral in the credit markets still rocking the world of finance today. Bear Stearns had to bail out the funds and take possession of many of their holdings after Merrill Lynch (MER) hit the fund with margin calls. The SEC immediately began monitoring Bear's capital position.

Bear then hung its hat on a deal with China's Citic Securities, where both sides of the aisle planned to swap $1b worth of investments in each other. Thinking that deal (which eventually never materialized) plus its roughly $20b in capital was enough to get by with a $360b balance sheet, Bear meandered along. It's unclear if Bear approached others for a capital infusion, and if potential investors turned away not liking what they saw.

Then Bear's slow bleed began early this year. The firm's capital position dwindled to $8.4b in January, then rose to $21b in March, notes Christopher Cox, chairman of the SEC.

Soon, fixed income and stock traders began hearing rumors that European financial institutions had stopped doing business with Bear.

And traders really started to back off in February through early March.

Hedge funds that had used Bear to borrow money and clear trades were withdrawing cash from their accounts, and large investment banks stopped accepting trades that would expose them to Bear. The firm's liquidity evaporated, with cash balances insufficient to cover maturing debt. Cash reserves dwindled to $5.9 bn from $18.3 bn. And it owed Citigroup $2.4 bn, reports indicate.

JPMorgan's chief executive Jamie Dimon has said Bear Stearns called him on the evening of March 13 (his birthday), saying its cash was drying up, that it could not meet its obligations the next day and that it needed emergency help. JPMorgan then contacted the New York Federal Reserve, Dimon said.

On a 5 a.m. conference call on the morning of March 14, Geithner spoke with Treasury secretary Henry Paulson, Fed chairman Ben Bernanke and other officials to figure out a course of action. The endgame: avoid bankruptcy at all costs. The ripple effects of a bankrutpcy would be catastrophic, as Bear operated one of the biggest clearing houses. JPMorgan, being Bear's clearing bank for its repo deals, was in on the process. The Fed gave Bear a 28-day, $25b non-recourse loan, via JPMorgan. Bear thought it could take the next 28 days to find a buyer for the firm.

But that Friday, billions more dollars were withdrawn from Bear Stearns. Its financial resources plummeted to $2b as customers, trading partners and investors fled. Bear was on the brink. Bankruptcy was imminent.

That Friday, any possibility that Bear could go it alone evaporated after three credit ratings agencies downgraded Bear Stearns. That sealed Bear's fate for good. Customer flight accelerated, as contracts governing counterparty trades with Bear stipulate that those contracts must be broken in the event of a downgrade. Collapse was imminent if Bear didn't find a buyer by that Sunday night.

That weekend, marathon negotiations began. Another buyer was "prepared to write a multibillion check to invest in equity," but since that deal would have required another financial institution to help finance a buyout, it fell apart, Schwartz testified. Though he didn't identify the potential buyer, word is the interested party was J.C. Flowers, the private equity shop.

Fearing panic selling when the Asian markets opened late Sunday night, Bear Stearns's negotiating leverage "went out the window," said Schwartz. JP's Dimon then balked at the thought of his firm taking on the colossal amount of Bear's liabilities, and rejected a deal. The Fed then stepped in with its initial $30b loan, and then JPMorgan agreed to buy Bear Stearns for $2 a share, or $236m. JPMorgan increased its offer to $10 a share a week later amid a revolt by the smaller firm's shareholders, picking up a business with $360b in assets and liabilities.

"I tell people that buying a house is not the same as buying a house on fire," Dimon testified (interestingly enough, the Fed lent Bear $25b under its new program of direct lending to investment banks, separate from the $30b to do the deal--$13b of the $25b was paid back over that weekend, with the Fed earning $4m in interest).

The Fed came up with as novel a rescue as it could. Using a creative read of section 13A of the Federal Reserve Act, the New York Fed agreed to lend JP $30b over 10 years at a small 2.5% rate, a loan backed by a similar amount of Bear Stearns' assets. Never before had the Fed taken on mortgage-backed securities. If that portfolio drops in value, JP takes the first $1b in losses. If the portfolio zeroes out, the Fed takes a $29b hit.

And here's what's key. "By agreeing to lend against a portfolio of securities, we reduced the risk that those assets would be liquidated quickly, exacerbating already fragile conditions in the markets," Geithner says. A fire sale would have created chaos in an already crazy market. Expect an orderly unwinding of those assets over a number of quarters.

Now the debate is just what is in that $30b pool of assets, given that the Fed is taking on this credit at a time when the government is already levered to the hilt, what with what is going on at Fannie Mae and Freddie Mac. The New York Fed hired Black Rock, 49% owned by Merrill Lynch, to cherry pick the best assets off of Bear's books to use as collateral. Both sides signed a confidentiality agreement covering those assets--why tip your hand to the market and invite unwanted arbitrage?

Only broad descriptions are available. The Bear assets are collateralized mortgage obligations, the majority of which are obligations backed by the likes of Freddie Mac, as well as asset-backed securities with things like adjustable rate mortgages, as well as commercial mortgage-backed securities, collateralized bond obligations, and cash assets consisting of investment grade securities rated BBB- or higher.

But how sound is that $30b worth of collateral?

JP's Dimon testified: "We could not and would not have assumed the substantial risks of acquiring Bear Stearns without the $30b facility provided by the Fed." That comment led Sen. Robert Menendez to ask:  "JP Morgan would have never gotten involved [in the deal] but for your [the Fed's] guarantee" that it would swallow $29b in Bear's assets and not hit up JPMorgan for other collateral if those Bear assets zero out. Menendez wondered, is that a vote of confidence in these assets?

And remember what Geithner said at the outset, that "only sound institutions" can borrow against collateral at the discount window and that he would have been "uncomfortable" lending to Bear.

What suddenly turned Bear's assets golden for the $29b loan, what turned those sows ears into silk purses over night?

Another issue is poor oversight. Clearly, the crazy quilt of banking regulations, many of which pre-date the Great Depression of the 1930's, have not kept up. Critics argue that lax regulatory oversight was partly to blame for the subprime mortgage catastrophe that is now a global financial crisis.

But was there any talk in Congressional hearings of forcing investment banks to set aside much more in capital reserves? There was a little.

Any talk of forcing investment banks to pay premiums into an FDIC-style insurance pool, given that they can now access Fed money at the discount window? Yes, investment banks don't take on deposits like commercial banks, instead, they operate on short-term funding in the repo market. Still, if derivatives can be devised with apparent ease, why not regulatory protections?

And was there any talk of forcing lenders to keep on their books the riskiest strips of their securities backed by mortgages they originate, an incentive to exert some oversight over delinquent borrowers? Not a whisper.

And if the Federal Reserve is acting pre-emptively to avoid recessions by cutting rates, will it pre-emptively yank the punch bowl from the drunks by hiking rates in good times?

And why can't the regulators come up with guardrails that will pre-emptively stop such crises from blowing into the markets in the future? Yes Fed examiners now poring through the books at Morgan Stanley (MS), Merrill Lynch (MER), Goldman Sachs (GS), and JPMorgan Chase (JPM) work, but it's oversight done after the fact. What can be done ahead of time?

Is the Fed creating "moral hazard" by letting Wall Street firms make big risky bets, knowing they will get a taxpayer-backed rescue if they fail? As is becoming uncomfortably common, the lender of last resort is not the Federal Reserve. It's the US taxpayer.