Commentary

Fed Saves Bear

The Federal Reserve broke new ground when it facilitated the purchase of Bear Stearns by JPMorgan Chase. Although Bear is ranked fifth out of the top five US investment banks, it was still counterparty to over $10 trillion in derivatives contracts and swaps. Therefore, the Fed decided it was necessary to accept Bear’s $30 billion pile of rotting mortgage-related debt as collateral, allowing the new owners breathing room. Without this guarantee no one would have dared purchase Bear and it would have descended into the abyss, very likely taking the global credit markets along with it. That would have been bad.

Even though Chase has to pony up more dough to buy Bear (shareholders balked at the original $236 million bid, equivalent to $2 a share – the company’s stock was trading at $170 a share a year ago), many say the new price of $10 is still a steal. This is because Bear Stearns’ headquarters building alone could fetch several times the original bid price, and, analysts peg its brokerage business to be worth a few billion dollars. But, the real sweetener is the Fed’s guarantee to assume responsibility for Bear’s massive and quickly souring mortgage portfolio. If the mortgages used as collateral fail – no problem, the Fed’s guaranteed ‘em.

The Fed was established in 1913 to help avoid banking calamities and smooth out the wild boom and bust cycles in the economy. (The Panic of 1907 almost laid waste to the industry.) It’s mission was to regulate short-term interest rates and become the lender of last resort for banks. In order to borrow from the Fed, member banks would have to abide by its regulations.

The Fed’s over-the-weekend decision to bail out an irresponsible investment bank raises questions about what rules such entities will have to follow in return for resuscitation. If this is the start of a new Fed policy, investment banks should be forced to follow rules just like their commercial banking cousins. Otherwise, it looks as though the Fed has rescued speculators with public funds (US taxpayers will foot the bill if Bear’s collateral becomes worthless). If there are no strings attached, a serious moral hazard has been introduced to the system of global finance. Investment banks will know that if they bet really, really big, their failure will bring down the entire credit market, and the Fed will have no choice but to ride to the rescue. And this would be really really bad, too.

© 2008 Splendid Marbles.