Bailout ?

The press is infatuated with that word, "bailout", and unthinkingly applies it to all sorts of actions. I wrote about the "Unreliable Media" in one of my first blog posts on February 13, 2007. My informal, long term study of the media has proven to my satisfaction that the press/media is almost always wrong on some material part of any story. Their incessant use of "bailout" in the instance of the JP Morgan takeover of Bear Stearns is another.

A reader's question was passed to me privately: Was use of taxpayer money justified in the Bear Stearns case ? Now that is quite an interesting question and is connected to my first paragraph here. Let's review the facts. I've written before about my opinion of Bear Stearns as a firm, so will used the acronym, "BS" for its name. Now first we need to examine if taxpayer money in fact was used to "bailout" BS and who at BS was "bailed out".

1. BS needed a guarantor of its counterparty trades or it would have had to file for bankrupcty to prevent a disorderly liquidation of its assets. So BS called the Fed for help in finding one.

2. JPM was the clearing firm for BS trades and had desires for some of BS businesses, plus had a fine credit rating and reputation for successful acquisitions.

3. The Fed asked JPM to look at buying BS and becoming guarantor of BS trades.

4. JPM said yes, but wanted a non-recourse loan from the Fed for the worst of BS assets.

5. Fed said fine, it would lend JPM that money on a non-recourse basis.

6. Final terms are that BS stockholders get $10/share for a stock that was worth $150/share recently, and even over $80 just a few days ago. AND BS counterparties and lenders get a JPM guaranty.

So who was saved from big losses ? The BS lenders and counterparties. Who are they ? Probably every other big bank, mutual funds, Street firm and pension funds and every other financial institution in the world. Who saved them ? J. P. Morgan bank did, in exchange for buying a firm for a low price and with the Fed non-recourse loan.

Now let's examine that loan. In substance, it appears to be a sale of assets to the Fed as they bear the losses and receive any profits, other than the first $1 billion of losses are borne by JPM. We don't know the price of those assets being "sold" to the Fed, but the impresion is the "market" price, likely the market prices as booked by BS at its end of quarter as updated. So those assets already have a big, big haircut. Blackstone will manage the assets for the Fed and will slowly liquidate them or let them run out as the underlying loans are paid or default and have realized losses. By the way, I suspect those assets are paying interest currently and the interest is a lot more than the discount rate, hence the net Asset-Fed loan is cash-flow positive. Long term reality will determine whether the Fed loses money or makes a profit net of current interest income and the Fed gets that "profit".

So what if the assets eventually lose money, i. e., realize less than the already heavily written down "market" value plus net income ? The non-recourse loan is an asset on the Fed's balance sheet and will have a writedown. How does the Fed - a bank - fund the loan ? The Fed gave a $30 billion balance to JPM as bank reserves which flow into the entire US banking system. Now all profits of the Fed are given to the US Treasury, namely, its income on that huge balance sheet of US Treasury securities the Fed holds in its role as the reserve bank of the US. [The Fed's cost of money is zero as it simply gives out dollars it creates.] So if the Fed eventually loses money on the BS asset loan, it will give less $ to the Treasury. So what happens ? The Treasury sells more T-bills to offset the loss which may in turn be bought by the Fed in its open market operations, hence the "loss" may be monetized. Or others will buy the extra T-bills issued by the Treasury, and it is funded into the US government debt which will never be paid off as the US economy continues to grow. Interest only is paid. Maybe some little bit of taxpayer money some day gets taken, likely indirectly by an infinitessimally small tax increase in the distant future. Or not if the theoretical loss is monetized.

So this is quite complex and the road to the taxpayer's pocket is quite a lengthy and winding one. Another way to look at it is the Fed will eventually monetize any losses on the BS loan.

[This is very different from the original "bailout, viz., Chrysler in the early 1980s, when the Treasury directly guaranteed Chrysler bonds. Even then, Chrysler survived and paid the bonds off and the Treasury made money on warrants it had smartly gotten as part of the package.]

Is the Fed's action justified ?

YES, this is precisely the raison d'etre of the Fed, the reason that it was created in 1913, in response to the Panic of 1907. In that panic, J. P. Morgan, Sr. led the banks to use reserves to save the US banking system with help from John D. Rockefeller. Those two individuals were the giants of the times. Congress rightly decided that the government needed to create a governmental reserve bank to act as a lender of last resort to give the US dollar and banking system more governmental backing and not need to rely on private individuals in times of crisis.

A collapse of BS would have locked up a huge amount of trades, counterparty obligations and loans on a huge swath of the US financial system in a lengthy bankruptcy process at a very fragile time. It would be incredibly stupid and really insane to let that happen now. The obligation of the Fed was to prevent it. So they did. That is their core job. Bernanke did his job correctly ... PERIOD.

Use of the word "bailout" by the press is simply wrong ... again.

PS: Suppose the Fed did nothing and BS collapsed. That would have led to huge losses in the financial system ... and huge tax writeoffs on corporate and individual tax returns ... and hence huge drop in US government tax collections. So the Fed prevented that and likely save the US government, and hence the US taxpayer, huge sums. A very profitable intervention, indeed, for the US taxpayer.

PPS: I added a bit to CVX yesterday.

Word of the Day

"Plangent" - adjective [$10]
Plangent means loud, reverberating
Sentence: The plangent speaking style of many Babblevision, Blabberg and other newscasters drive me to turn them off.