New Details from Fed Minutes on Bear Stearns Rescue

Minutes from a high-stakes Federal Reserve meeting on the emergency rescue of Bear Stearns are out this morning, and they are revealing.

They provide fresh detail on what went on behind the scenes of the Fed-orchestrated shotgun wedding between JPMorgan Chase and Bear Stearns, including fears of a "contagion" spreading through the market if Bear Stearns was allowed to collapse.

The contagion here refers to the fact that Bear Stearns operated one of the country's largest clearing operations, and a collapse would have cascaded through the system, causing calamity in counterparty trades.

Let’s recap. Bear Stearns had $389b in assets and $387 bn in liabilities at the time it went belly-up. It had $11.9 bn in shareholder equity, or net worth, to support that book of business.

The bonds on its books were getting crushed by the subprime crisis, so much so that two of Bear’s own hedge funds went belly-up last July, with the two former hedge fund managers subsequently arrested for alleged securities fraud and conspiracy, among other things. A cash run on the bank leading up to its St. Patrick's day rescue put Bear Stearns on the brink of bankruptcy.

JPMorgan Chase's chairman and chief executive Jamie Dimon initially balked at the thought of his bank taking on Bear's colossal balance sheet, and rejected a deal. “I tell people that buying a house is not the same as buying a house on fire,” Dimon testified before Congress later (Dimon sits on the board of governors of the New York Federal Reserve).

The Fed then stepped in with an 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. JPMorgan is now digesting Bear's massive $360 bn balance sheet.

Back to the $30b loan JPMorgan got from the Fed to seal the deal, supported by Bear securities that the two sides say were valued, or marked to market, at $30b as of March 14.

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 JPMorgan $30 bn 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 as collateral. The Fed is now holding those assets to maturity and is not marking them to market, analysts note.

JP Morgan subsequently agreed to absorb the first $1b of losses on that $30b if the value of the assets backing its loan declines. Again, if that portfolio drops in value, JP takes the first $1b in losses. If the portfolio zeroes out, the Fed takes a $29b hit. The assets now sit in a Delaware limited liability company.

The Fed minutes show that JPMorgan "had requested assistance in financing a specific pool of assets that Bear Stearns had difficulty financing in the market" and that JPMorgan Chase "believed added significant uncertainty to the level of risk it would assume" in its acquisition of Bear Stearns.

To seal the deal, the minutes show that the Fed gave JPMorgan Chase, among other things, an 18-month exemption from the Fed's statutes requiring banks to hold a certain amount of capital on its books against its risk-weighted assets. Banks also must adhere to international debt to capital ratios under the Basel accords. The capital ratio is the percentage of a bank's capital to its risk-weighted assets.

The Fed let JPMorgan "exclude the assets and exposures of Bear Stearns" from its risk-weighted assets for purposes of applying the risk-based capital requirements" at the bank. The Fed also let JPMorgan "exclude the assets of Bear Stearns from the denominator of its tier 1 leverage capital ratio" requirements, noting that "each exemption would be reduced over time."

The relaxation of the standards was necessary to stop a disaster the Fed says it saw coming if Bear went under.

Also, “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,” New York Federal Reserve Bank president Timothy Geithner testified before Congress in defending the deal.

A fire sale would have created chaos in an already crazy market.

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 in testimony before Congress, in defending the central against criticisms that it should have opened its Fed window to investment banks, not just commercial banks, to help Bear Stearns survive. “We only allow sound institutions to borrow against collateral” at the Fed’s discount window, he testified, adding, “I would have been very uncomfortable lending to Bear given what we knew at that time.”

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