The Mother Of All Government Bailouts

Businessmen pass Bear Stearns in New York on Friday, March 14, 2008. The Federal Reserve invoked a rarely used Depression-era procedure Friday to bolster troubled Bear Stearns Cos. and said it will provide even more help to combat a serious credit crisis. JPMorgan Chase is providing an undisclosed amount of secured funding to Bear for 28 days, backstopped by the Federal Reserve Bank of New York.
AP Photo/Mark Lennihan
This column was written by David Freddoso.

"It is sort of lonely out here," says Rep. Scott Garrett (R-N.J.), one of the very few members of Congress questioning the federal bailout of Bear Stearns. Bear is the investment-banking firm that dramatically overexposed itself to the subprime-mortgage market and is now on its way to investment-bank heaven.

In order to avert or postpone the possible economic consequences of Bear's demise, the Federal Reserve Bank is conducting an unusual bailout - so unusual that a new Congressional report, quietly released last Thursday, says it is unlike anything the government has done in the last 70 years. Yet few members of Congress have even questioned the decision since the Fed's opaque processes produced it last month. All of the presidential candidates support it - even John McCain, who at least seems to understand the folly of bailing out irresponsible individual home-mortgage borrowers.

"Government isn't supposed to be in the business of picking winners and losers," Garrett remarks in a phone interview while en route to Washington from New York. "But here we are. Hardly anyone seems to mind."

The short version of this story is that last year, Bear Stearns began to regret its decision to invest heavily in securities backed by subprime mortgages - lightly traded assets that throughout 2007 became increasingly difficult to offload. With billions sunk in securities no one wanted, Bear's stock took a severe beating, falling to $80 by March 3, 2008 - down from $150 the year before. Their subprime exposure finally caught up with Bear around the Ides of March, when its clients panicked and its stock price fell off a cliff. The company had two choices: bankruptcy and the sale of its assets, or a buyout by rival JPMorgan Chase (JPM), backed by the Federal Reserve Bank. JPM's initial offer of $2 per share has since been raised to a still pitiful $10.

The government's involvement here is highly irregular - the March 28 report from the non-partisan Congressional Research Service sheds light on just how bizarre the terms of this deal really are. To begin, the Fed has not used this statutory power to bail out a bad company since it was first enacted during the New Deal. Ironically, the bailout is only legal because no private firm would ever agree to its terms. As the governing statute states, the parties involved must be "unable to secure adequate credit accommodations from other banking institutions" for the government to interfere in this way.

"Nothing like this has ever happened," says John Carney, editor of the financial blog DealBreaker.com. "There isn't even a court precedent related to this. We're reaching back to a power they were given ages ago, that nobody thought they would have to use. Suddenly, here they are, pushing JPMorgan, perhaps the only American bank that could do it, to make the deal."

Even in a sophisticated financial world light years away from the New Deal, the Federal Reserve Bank felt Bear was "too big to fail" - or at least "too connected to fail" - because it was so deeply involved in so many aspects of the homeownership economy. In order to force a buyout, it offered JPM a sweetheart loan, the likes of which no student borrower has ever seen. The $29-billion line of credit comes at the discount interest rate - currently 2.5 percent - over 10 years. This is a rate normally restricted to overnight loans, applied only in special cases to loans that last as long as four weeks.

The only collateral for this loan is the $30 billion in Bear Stearns's un-sellable mortgage-backed securities, the real value of which is - shall we say - difficult to assess when no one is buying. And unlike most loans the Fed makes, it has no recourse here if the collateral loses some or all of its value. In fact, the CRS report notes, "[T]he agreement has some characteristics more in common with an asset sale than a loan." The report adds dryly that JPM was unwilling to hold onto these assets itself, perhaps because it "could have believed that the assets were worth . . . significantly less than the current market value of $30 billion."

"This is not really a loan," says Garrett. "It's a put option on these securities by the Fed vis-à-vis JP Morgan."

JPM has no obligation to repay this loan - which, again, is not really a loan at all, for the Fed will begin selling off the "collateral" before it is repaid. As the new Congressional Research Service report explains:

In the event that the proceeds from the asset sales exceed $30 billion and the outstanding interest, the Fed will keep the profits. In the event that the loan principal and interest exceed the funds raised by the liquidation, the first $1 billion of losses would be borne by JPMorgan Chase, and any subsequent losses would be borne by the Fed. . . .
Nor does the irony end there. If the government actually does recoup its $29 billion plus interest, the next billion dollars raised from the sale goes to JPM (after all, the collateral was valued at $30 billion). And JPM is further entitled to interest on that billion at 4.5 percent above the discount rate that it is theoretically paying to the government on its $29-billion loan. Of course, there is little danger of this actually happening - no one expects the Fed to make a profit on this deal. If it could, then the deal probably would never have been made.

In short, this is the mother of all government subsidies - a non-legislative appropriation that doubles the size of all this year's congressional pork projects combined. Without so much as a vote of Congress, taxpayers are to buy securities of undetermined value for $29 billion - roughly Panama's GDP, or the Federal Reserve Bank's entire annual profit. They take this enormous risk so that JPM, a company worth $146 billion, has enough liquidity to make a major and profitable acquisition for next to nothing. JPM is more than happy to take on Bear's book of client and counterparty accounts - these were probably never in danger of being lost, and it's great business for JPM. The ones being rescued are Bear's bond-holders. They keep their shirts. The stockholders at least keep their socks. The profits from the good times are retained, and the losses are socialized.

Finally, the CRS report notes, the bailout creates an excuse for further regulation of Wall Street. After all, if these firms are going to rely on the Fed to bail out their bondholders, they should be more responsible to the government:

[I]f financial institutions can receive some of the benefits of Fed protection, perhaps because they are "too big to fail," should they also be subject to the costs that member banks bear in terms of safety and soundness regulations, imposed to limit the moral hazard that inevitably results from Fed and FDIC (Federal Deposit Insurance Corporation) protections? If so, should the "too big to fail" label be made explicit so that regulators can better manage systemic risks?
The taxpayers' involuntary generosity also benefits the other large institutional holders of mortgage-backed securities. For these, the bailout holds forth hope that the government will someday be there to save them from the free market as well. But can it save everyone?
By David Freddoso
Reprinted with permission from National Review Online