Another viewpoint on Bear Stearns and the FED

Reader sammy sends this link from the WSJ editorials page:

Thebest thing about Sunday night’s Federal Reserve-inspired sale of Bear Stearns to J.P. Morgan Chase is the price. At $2 a share for a total of $236 million, this was less a “bailout” than a Fed-mediated liquidation sale. Bear wasn’t too big to fail after all, though there’s still the issue of the Fed expanding its own moral and financial hazard in the form of $30 billion in guarantees on Bear Stearns securities.

Bear shareholders will essentially be wiped out in this close-out sale, with British billionaire Joseph Lewis alone reportedly enduring paper losses of $800 million on his 9.6% stake. Even on Wall Street, that’s real money. Jimmy Cayne, the Bear Chairman and former CEO who supervised this disaster, will lose a bundle on his nearly 5% holding. This makes the Bear sale different from the Fed-managed Long-Term Capital Management rescue of a decade ago, when investors were left substantially intact. We doubt many bankers will look at Bear’s fate and claim there’s no punishment for financial error.

Bear employees, who hold about one third of its shares, are angry and grousing that they could get more cents on the equity dollar in Chapter 11. Some may even be inclined to vote against the sale, but then they’d have to find a market for that $30 billion in mortgage securities that no one wants to finance.

The hard capitalist truth is that Bear’s most senior managers have mainly themselves to blame. They bought their second or third homes with fabulous bonuses during the good times, and they must now endure the losses from Bear’s errant investment bets. Bear took particular pride in its risk management, but it let its standards slide in the hunt for higher returns during the mortgage mania earlier this decade. There’s no joy in seeing a venerable firm expire, but it has to happen if financial markets are going to have any discipline going forward.

As for J.P. Morgan and CEO Jamie Dimon, remind us to have him negotiate our next contract. He gets Bear’s best assets, including a Manhattan building said to be worth $1.4 billion by itself. Meantime, he gets the Fed to backstop Bear’s riskiest paper. We don’t know the quality of that paper — and we hope the Fed has done its due diligence — but taxpayers are now on the hook for future losses. Some previous Fed officials might have told Mr. Dimon to take all of Bear or nothing at that $2 liquidation price, but Ben Bernanke and Tim Geithner of the New York Fed seem to have been desperate to get a sale announced before markets opened on Monday. Mr. Dimon took them to school.

The Fed is also opening its discount window even further to non-deposit-taking institutions, and for an open-ended amount of lending and mortgage-based collateral. We endorsed this last week as a way of reviving a frozen market in mortgage-related securities. But with its Sunday move, the Fed is going all in. This raises genuine issues of moral hazard. Commercial banks traditionally have access to the discount window — that is, to public money — because they are regulated and have certain reporting and capital obligations.

Will investment banks and securities dealers now have to meet similar obligations if they tap the window? If they don’t, then it’s unfair to the banks that do, not to mention the taxpayers who are lending them the money. Goldman Sachs or Lehman may not want to meet those terms, but they should be asked to do so.

This new risk-taking is an extraordinary expansion of the Fed’s traditional crisis role, and not one to be taken lightly. In talking to central bank veterans yesterday, we were told the Fed has never taken a material loss. Even as a lender of last resort, the central bank has always made sure it had appropriate collateral.

If this latest effort does help to revive the mortgage credit markets, then the Fed’s potential losses may never be realized. On the other hand, no one knows how far housing prices will fall, and steeper declines in home prices will mean steeper losses in mortgage-backed securities. Moreover, if this doesn’t work, Wall Street pressure will build for the Fed to buy up mortgage securities wholesale. This could end up ruining the Fed’s balance sheet, and ultimately its credibility as the lender of last resort.

The Fed is making these commitments under the authority of a Depression-era statute that has rarely, if ever, been invoked. While Congress will tread warily while the financial crisis lasts, hoping the elixir works, you can bet it will eventually investigate this brave new Fed world. Let’s hope the biggest losers are Bear Stearns shareholders, not American taxpayers.