Bailouts - Bear Stearns, Housing

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
April 8, 2008

IN THIS ISSUE:

1. The Demise & Bailout Of Bear Stearns

2. How The Bear/Morgan Deal Went Down

3. Right, Wrong Or The ONLY Thing To Do?

4. What Does The Fed Get Out Of This Deal?

5. Congress To The Rescue On Housing Crisis?

6. Conclusions – If Any

Introduction

The massive Fed bailout of Bear Stearns over the weekend of March 15-16 left investors wondering many things. First and foremost, why was such a massive government bailout required, versus letting Bear go into bankruptcy? Second, why was the Fed so involved – was it that critical? Apparently so. Third, why did the Fed commit up to $30 billion of taxpayer money, for the first time ever, to rescue Bear Stearns, a private investment bank?

Those are only the opening questions. The remaining list of questions goes on and on. For example, how many other financial institutions may have to be bailed out? How many other investment banks and prime brokers are overburdened with subprime and other mortgage related debt problems? What will the Fed do with them? Is this just the tip of the iceberg?

The conspiracy theorists are going crazy with the Fed bailout of Bear Stearns, and why not? A massive government-backed bailout of a major US investment bank by one of the largest US money center banks – J.P. Morgan-Chase. What juicier story could the conspiracy buffs ever hope for? Rumors and speculation continue to mount.

As you might expect, Congress responded by getting its mitts onto the latest Bear Stearns fiasco. The Senate Banking Committee initiated an official investigation of the Bear Stearns bailout and took testimony last week, including the testimony of J.P. Morgan CEO Jamie Dimon and Bear Stearns CEO Alan Schwartz last Thursday.

Interestingly, the stock and bond markets had little response to the latest developments with J.P. Morgan and Bear Stearns. And why should they have, actually? What’s a meager $30 billion in a $13+ trillion dollar economy? Perhaps the financial markets were calmed by the fact that the Fed stepped in and rescued a major investment bank to the tune of $30 billion.

So, what does this mean for average investors like us? Some say not much. Should we care that the Fed elected to come in with $30 billion of taxpayer money – for the first time ever – to rescue an investment bank like Bear Stearns? Maybe, maybe not. I’ll try to give you some answers below.

In addition to the Bear Stearns deal, the government passed legislation last week intended to bail out American homeowners who are at risk of defaulting on their home mortgages. Never mind that many should have never been granted these mortgages in the first place. But now, the libs in government feel compelled to bail them out, along with many homebuilders and others in the housing sector (it’s an election year after all).

So much to try and cover in just a few pages. I’ll do my best. Let’s get started.

The Demise & Bailout Of Bear Stearns

Bear Stearns is (was) one of the largest global investment banks and securities prime brokerage firms in the world. In 2007, Bear Stearns reportedly had revenues in excess of $16 billion. Despite strong revenues, the subprime mortgage meltdown made 2007 a disastrous year for Bear Stearns, one of the nation’s largest underwriters of mortgage bonds and subprime mortgage securities in particular.

Beginning last summer with the housing slowdown, Bear Stearns has stood as the prime example of how Wall Street’s big bets on securities based on risky home loans went south. Many believe it was the collapse in June last year of two internal Bear Stearns hedge funds which were heavily invested in mortgage securities that kicked off the full-fledged market panic in subprime debt and related securities in the last half of 2007.

Bear Stearns lost so much capital that in the fall of 2007 it formed a partnership with China’s Citic Securities, in which the two firms swapped shares. In December 2007, Bear Stearns announced the first loss in its eight-decade history, saying it lost about $854 million in the fourth quarter alone. The firm also said it had written down $1.9 billion of its holdings in mortgages and mortgage-based securities, up from the $1.2 billion it had anticipated the month before.

Rumors began to circulate that Bear was in trouble. In January of this year, Bear’s longtime leader, James E. Cayne, stepped aside as CEO and was succeeded by Alan D. Schwartz, previously president. Schwartz assured shareholders, customers and counterparties that Bear was still in strong financial shape and had a capital reserve reportedly in excess of $20 billion. Nevertheless, the rumors intensified.

By early March, lenders were cancelling credit lines and clients were frantically pulling assets out of the company. Bear’s share price plummeted from around $90 in January to only $10 by March 13. Rumors of liquidity woes had become reality as the bank run drove Bear to the verge of bankruptcy by Friday, March 14.

As the crisis unfolded, Bear executives contacted J.P. Morgan-Chase about a possible takeover. Both firms contacted the New York Federal Reserve Bank and advised president Timothy Geithner of the seriousness of the situation, who in turn contacted Fed Chairman Ben Bernanke. The SEC and the Treasury Department were also alerted, along with the Fed Board of Governors.

How The Bear/Morgan Deal Went Down

The details of what followed are too complex to cover in this limited space, and some of the details are still not known. But in general, the deal went as follows. J.P. Morgan was very interested in acquiring Bear but was simply not willing to swallow the company whole. The Federal Reserve Bank of New York reportedly loaned J.P. Morgan $25 billion, which was in turn loaned to Bear, just so the company could open its doors on Friday, March 14.

Where that reported $25 million ultimately went is still uncertain, but it presumably allowed Bear to make good on its clients orders to withdraw their money in droves.

Over the weekend of March 15-16, which has been characterized as a round-the-clock pressure cooker, a deal was struck for J.P. Morgan to acquire Bear Stearns, but not without the $30 billion bailout by the Fed. J.P Morgan would acquire the assets of Bear Stearns and also take on most of its liabilities. The Fed would pony up $30 billion in a loan to Morgan, which was reportedly collateralized by so-called “investment grade” securities on Bear’s books.

The takeover deal had to be completed by the afternoon of Sunday, March 16 – before the Asian stock and bond markets opened, and it was. There was considerable concern that if Bear went bankrupt on Monday, March 17, there would be absolute chaos in the global financial markets.

Right, Wrong Or The ONLY Thing To Do?

Opinions on whether the Fed should have committed $30 billion to orchestrate the bailout of Bear Stearns run the gambit. Many on and around Wall Street believe that the Fed did the right thing to save Bear Stearns from bankruptcy that would surely have followed on the morning of Monday, March 17. Obviously, most members of the Federal Reserve Board of Governors, the Treasury Department and the Securities & Exchange Commission agreed with the bailout.

Countless others across the spectrum are anywhere from disappointed to outraged that the government intervened, with taxpayer dollars, to save a private investment bank that got into trouble. Many believe that Bear Stearns should have been allowed to fail, regardless of the consequences that might have followed in the global financial and credit markets.

Those who are most outraged by the bailout tend to default to the issue of “moral hazard” – the idea that the government bailout of Bear Stearns will lead other Wall Street players to assume that they, too, will be the recipients of a similar rescue should they get into trouble over their risky lending practices.

Bear Stearns’ stock was trading around $90 at the first of the year, but had plunged to near $10 per share by March 13. With the moral hazard issue in mind, the Fed reportedly insisted that J.P. Morgan would pay only $2 per share for the stock. This virtually wiped out the Bear shareholders. A week later, however, J.P. Morgan increased the offer to a price of $10 per share, which was more in line with the market price of the shares.

In any event, many questions remain regarding whether the Fed did the right thing or the wrong thing in the Bear Stearns bailout, especially with its commitment of potentially $30 billion in taxpayer money. Emotions remain very high on both sides.

The real question is, was it the ONLY thing the Fed could have done in light of the circumstances? The answer is, we may never know. Why? It is impossible to know just how severely the global investment and credit markets would have seized up if Bear Stearns had been allowed to go bankrupt on March 17.

Many who support what the Fed did believe that the global credits market would have gone into cardiac arrest, and a worldwide depression would have followed had Bear not been bailed out. Those who oppose the bailout seem to believe that either something much less chaotic would have followed, or that the Fed should not have intervened no matter what might have happened in the credit and investment markets, not to mention the global economy which is teetering on recession.

What Does The Fed Get Out Of This Deal?

Whether you agree with the Fed bailout of Bear Stearns or not, it is interesting to consider what the Fed got out of this deal. The Fed loaned J.P. Morgan $30 billion of taxpayer money to make the takeover happen. That $30 billion loan is collateralized by supposedly $30 billion worth of Bear assets that the Fed may be able to unload over time.

Initially, there was a widespread view that the Fed took Bear’s worst assets – presumably subprime and related debt – as its collateral on the $30 billion loan to J.P. Morgan. Many observers took the position that the assets the Fed took as collateral would be worth nothing.

But in their Senate Banking Committee testimony last week, Fed Chairman Ben Bernanke and J.P. Morgan CEO Jamie Dimon stated that the Fed did not get the worst of Bear Stearns’ assets. Mr. Dimon stated that Morgan did not “cherry pick” the Bear assets. Mr. Dimon testified: “We are acquiring some $360 billion of Bear Stearns assets and liabilities. The notion that Bear Stearns's riskiest assets have been placed in the $30 billion Fed facility is simply not true.”

Whether or not that is actually true, I would not dare to speculate. What is clear is that we will probably never know the makeup of the Bear assets that are supposedly collateralizing the $30 billion loan.

But what I think is clear enough is that the Fed took on many Bear assets as collateral that are subprime and related mortgage-type assets. The theory is that the Fed can hold these assets indefinitely, presumably until well after the housing slump has passed, and may ultimately make a profit on these securities. That remains to be seen, but I am highly doubtful.

Congress To The Rescue On Housing Crisis?

Just as surely as May flowers follow April showers, it was only natural that “populist” congressmen would begin clamoring for a mortgage bailout for John Q. Public once the Bear Stearns deal was made known. Actually, the idea of bailing out those who could no longer pay their mortgages was floated back in 2007 when the whole subprime debacle began, but it certainly gained momentum when the Fed put up our tax dollars to help bail out Bear Stearns. As Senate Majority Leader, Harry Reid said, “We helped Wall Street…but now it’s our opportunity to take care of people on Main Street.”

The help he is talking about came in the form of a bipartisan, multi-billion dollar Senate bill aimed at addressing current and anticipated home foreclosures, as well as other problems stemming from the bursting of the housing bubble. However, a number of critics from both sides claim that, as with most “solutions” formulated within the vast committee we know as Congress, this bill misses the mark.

The major provisions of this piece of legislation are as follows (read carefully):

To assist homebuilders and other businesses (including banks) affected by the housing slump, there is a provision to expand the ability of these businesses to use current losses to offset past profits and recoup taxes paid in previous years. Presumably, this will mean that more of these businesses will be able to stay afloat.
The bill also provides for a new standard property tax deduction of $1,000 for couples and $500 for single taxpayers who do not otherwise itemize their deductions for income tax purposes. Another tax provision would give a $7,000 tax credit spread over two years to those who buy and move into foreclosed homes. The goal of this tax benefit is to keep foreclosures from remaining vacant, which can lead to other problems such as further downward pressure on the value of nearby homes.
The bill also includes other provisions aimed at preventing the blight that might accompany a glut of foreclosed or abandoned homes. $4 billion in block grants were authorized so that communities will be able to buy and refurbish vacant homes, as well as $10 billion in federal tax-exempt bonds designed to provide mortgage resources to lower income first-time home buyers, as well as a way to refinance existing subprime mortgages.
Next, the bill makes another $100 million available to provide counseling for homeowners who are facing financial problems and possible foreclosure. Supporters of this provision claim that such counseling can help to avert foreclosures for many.
For returning war veterans, the bill extends the length of time a lender must wait before initiating foreclosure proceedings from three months to nine months after the veteran’s return.
Finally, the bill contains a broad rewrite of the Federal Housing Administration (FHA) law that raises the dollar limit on mortgages that FHA can insure from $362,790 to $550,000. The limit had temporarily been raised to $729,750 by the economic stimulus bill, but the increase in the mortgage bailout bill will be permanent.

Perhaps just as noticeable as the key provisions are items that were not included in the final draft of the Senate bill. One such item was a provision that would have allowed bankruptcy judges the power to cut interest rates and principal balances on problem mortgages to help subprime borrowers keep their homes. Current bankruptcy law allows judges such leeway on investment properties and vacation homes, but not on primary residences.

The bankruptcy provision was met with stiff opposition from Republicans and the mortgage banking industry. They say that allowing bankruptcy judges to modify the terms of primary residential mortgages would require the mortgage industry to factor that contingency into their pricing, potentially increasing the costs of mortgage borrowing for everyone. They argue that the last thing the housing industry needs is another impediment to obtaining a mortgage loan.

Another provision that didn’t make it was one supported by House Member Barney Frank that would have expanded the FHA’s ability to provide foreclosure assistance by providing $300 to $400 billion in new loan guarantees. Democrats are expected to reintroduce these two provisions in future bills, or maybe even as amendments to the current bill before its final passage.

As you might expect, there is no shortage of criticism of the new mortgage relief plan. Economists claim that the relief provided is likely to be too little, too late. They say that the bankruptcy and expanded FHA loan guarantees in the bill probably would have had the best chance to have an immediate effect on the housing crisis, but they were eliminated.

Other critics point to a Joint Committee on Taxation estimate that approximately 40% of the total benefits in this bill will be directed toward businesses instead of families needing help with their mortgage payments. This just goes to show you that it’s important to have good lobbyists!

Many have also criticized the bill for the removal of the bankruptcy law modification. The nonpartisan Center for Responsible Lending estimates that as many as 600,000 foreclosures could have been prevented had this provision been enacted. Others say that removing this part of the bill effectively favors the mortgage industry over borrowers. Since some of these same mortgage industry players may have actually helped to create the subprime crisis through questionable lending standards, this is a bitter pill indeed.

And the criticism doesn’t stop there. Many have a hard time bailing out individuals who lied about their income to get a mortgage loan, or took on far more debt than their incomes would ever justify. There should, after all, be some level of personal responsibility required in such transactions. The same is true for some businesses that will now benefit from the ability to recoup past tax payments.

As the bill is debated in the Senate and then by the conference committee, let’s remember that there can be many changes to the current provisions of this bill. Plus, it’s an election year, so not only does populist legislation become more appealing to members of both parties, it also may mean that passage of the bill must occur very soon; otherwise it may get swallowed up by election posturing, which often makes any bipartisan action less likely.

As it presently stands, the bill fails in that any bailout undermines the principles of personal responsibility. However, even if you do believe that individual homeowners deserve a bailout, the bill largely fails in that respect as well. Let’s look at the major benefits subprime homeowners may expect from this legislation:

1. First, the homeowners will receive financial counseling that may help with budgeting personal finances so that the mortgage payment becomes affordable. But if people really do not have the money to pay their mortgages, counseling won’t solve the problem.

2. Next, homeowners may qualify for a special deduction of their property taxes, up to a maximum of $1,000. While this sounds nice, even at the maximum income tax rate of 35%, a $1,000 deduction will only net $350, and that would be available only after income taxes are filed and a refund is received. I don’t know of many people with a monthly mortgage payment that low, and most subprime homeowners won’t be in the maximum income tax bracket. Thus, the “bailout” may help make a partial payment...one month...next year;

3. Homeowners may qualify for refinancing of their subprime mortgage by drawing upon the $10 billion in tax-exempt bonds authorized by the bill. This is a good thing, but considering the scale of outstanding subprime mortgage debt, it amounts to little more than a drop in the bucket;

4. If foreclosure is the eventual outcome, the homeowners may be happy to know (but I doubt it) that their local government can use some of the $4 billion in grant money to buy and refurbish their home for resale;

5. Then, any new family buying the newly refurbished home may qualify for a $7,000 tax credit which, unlike the property tax deduction given to the homeowner, reduces taxes dollar-for-dollar. If the purpose of the bill is to help individuals struggling with subprime mortgage loans, you have to ask why this huge tax benefit is not given to the original homeowner. If the goal is to prevent a glut of vacant housing, aren’t the original owners just as good at this as new owners?; and

6. Finally, and perhaps worst of all, the bill allows for homebuilders, banks and the mortgage companies that were involved in subprime mortgages to recoup past taxes to cover current business losses. How does that benefit current homeowners? It doesn’t! What else is new?

Conclusions – If Any

The Fed’s participation in the bailout of Bear Stearns was not unprecedented. In 1998, the Federal Reserve Bank of New York engineered a $3.6 billion bailout of Long Term Capital Management, a huge hedge fund that got in trouble. The NY Fed orchestrated that bailout by raising money from the fund’s major creditors, which just happened to be mostly the major money center banks around the world.

What is unprecedented in the Bear Stearns bailout was the use of taxpayer money and the willingness of the Fed to accept subprime and related mortgage instruments as collateral for the loan. Clearly, the Fed, the Treasury Department and the Securities & Exchange Commission believed that if Bear was allowed to file bankruptcy on Friday, March 14, it would have led to mass chaos in the global financial and investment markets.

Prior to the Bear collapse, the Fed had been taking other actions in an effort to address the credit crisis. Since late last summer, the Fed has increased its offering of repurchase agreements, which can function as loans to primary broker-dealers. On several occasions this year, the Fed has increased the size and frequency of its Term Auction Facility auctions of short-term cash. On March 12, the Fed announced its so-called Term Securities Lending Facility, which allowed primary dealers to pledge a wider range of collateral in order to borrow Treasury securities.

Then on March 17, the day the Fed made the Bear Stearns announcement, it also unveiled its new “Primary Dealer Credit Facility” which is an overnight loan facility that will provide funding specifically to primary broker-dealers in exchange for a specified but wider range of eligible collateral and is intended to improve the functioning of financial markets.

The Primary Dealer Credit Facility is reported to make available up to $200 billion (and probably more if needed) for at least the next six months. In his Senate testimony last Thursday, Fed Chairman Bernanke said that apprx. $35-$40 billion in PDCF loans have already been made to primary dealers.

These actions and others not mentioned make it clear that the Fed is very concerned about the credit crisis that has resulted primarily from the bust in the housing markets. The thought of letting a financial giant like Bear Stearns go bankrupt in the current economic and financial malaise was not an option for the Fed.

It was also very clear in the Senate Banking Committee hearings last week that no one on that committee was serious about reversing the Fed deal to bail out Bear Stearns. Yes, the Senators asked some tough questions of Fed Chairman Bernanke and the others that testified last Thursday, but none argued for the bailout deal to be unwound.

Whether we agree or disagree with the Fed bailout of Bear Stearns, it is clear that the Fed stands ready to act as the lender of last resort not only for banks, but also primary broker-dealers, at least so long as the current credit crisis continues.

That raises the obvious question: how many more prime brokers could also get into trouble due to subprime and related mortgage instruments? Unfortunately, no one knows the answer at this point. Only time will tell.

Finally, let us not forget that this is an election year, and politicians on both sides of the aisle want to be seen as doing something to help people and get us through this economic slowdown. It seems to matter little if such actions really make any economic sense; some believe the latest Senate home foreclosure bill is one such example.

In this current environment, the issue of personal responsibility has all but disappeared. Just dole out the money and get re-elected. That’s what it’s all about, unfortunately.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

April 3 Senate Banking Committee testimony by New York Federal Reserve
President Timothy Geithner on the Bear Stearns/J.P. Morgan transaction.
http://www.ny.frb.org/newsevents/speeches/2008/gei080403.html

Wall Street Journal assessment of the Bear Stearns/J.P. Morgan transaction.
http://online.wsj.com/article/SB120726465133788093.html?mod=djemEditorialPage

The Last Days of Bear Stearns.
http://money.cnn.com/2008/03/28/magazines/fortune/boyd_bear.fortune/?postversion=2008033104

Subprime bailout is not the answer (and the reasons why).
http://www.investmentnews.com/apps/pbcs.dll/article?AID=/20070904/FREE/70831017/1003