Fed Defends The Indefensible
The Fed Defended Its Bear Stearns Rescue in testimony before the US Senate Banking Committee. Let's take a look.
"We judged that a sudden, disorderly failure of Bear would have brought with it unpredictable but severe consequences for the functioning of the broader financial system and the broader economy, with lower equity prices, further downward pressure on home values, and less access to credit for companies and households," Federal Reserve Bank of New York President Timothy Geithner said in testimony to the Senate Banking Committee.
"If you want to say we bailed out markets in general, I guess that's true," Mr. Bernanke told the Senate Banking Committee, adding the Fed's role in the rescue was necessary given the fragile state of financial markets. "Under more normal conditions we might have come to a different decision" with respect to Bear Stearns, Mr. Bernanke said.
My Comment: Sadly, no one bothered to ask Bernanke if what he did was legal, how many votes were required, who did vote, and why the Fed could not see this coming even though many predicted this would happen.
See Who's Holding The Bag? and scroll down to the section Warren Buffett vs. Greenspan for discussion of Buffett's opinion "The rapidly growing trade in derivatives poses a 'mega-catastrophic' risk."
Responding to a separate question during a hearing of top U.S. regulators on the Bear Stearns rescue, New York Fed President Timothy Geithner said he's doubtful that a new auction facility created by the Fed for investment banks would have helped Bear Stearns escape failure.
"It's not obvious to me that lending freely" to Bear Stearns "would have been a prudent act" by the Fed, Mr. Geithner told members of the Senate Banking Committee.
My Comment: Geithner hedged his bet but I won't. It should be perfectly obvious that lending freely" to Bear Stearns "would NOT have been a prudent act". The whole thing was illegal as it was. The Fed tried to skirt the illegality by lending to JP Morgan on behalf of Bear Stearns. Yet the Fed accepted Bear Stearns assets as collateral. And it put taxpayers at risk to do so.
Bear Stearns CEO Alan Schwartz appeared to contradict Mr. Geithner, telling U.S. lawmakers that the firm may not have failed if the Fed had opened its discount window to investment banks earlier.
Mr. Schwartz, testifying before the Senate Banking Committee, said confidence in Bear Stearns may not have evaporated so quickly had the Fed made liquidity available for all investment banks before being forced to provide emergency funds for his firm last month.
My Comment: What a bunch of nonsense. What are we to do, have the Fed start lending to every corporation, or just those who overleverage themselves to the point they threaten the whole system? And comparing capital levels to other corporations who took equally silly risks is simply no excuse.
"On the evening of Thursday, March 13, 2008, I took part in a conference call with representatives from the Securities and Exchange Commission, the Board of Governors of the Federal Reserve, and the Treasury Department," Mr. Geithner told lawmakers.
"On that call, the SEC staff informed us that Bear Stearns' funding resources were inadequate to meet its obligations and that the firm had concluded that it would have to file for bankruptcy protection the next morning," Mr. Geithner said.
My Comment: Does this sound like a liquidity issue to you? It sure doesn't to me. This is clearly a solvency issue.
"Bear Stearns would have failed without this effort, and the consequences could have been disastrous," Mr. Dimon told the committee in remarks prepared for delivery. "The idea that the Bear Stearns fallout would have been limited to a few Wall Street firms just isn't so."
He said J.P. Morgan couldn't and wouldn't have entered the transaction without the Fed's backstop, but that it was the firm's obligation as a "responsible corporate citizen" to help stem potential systemic risk if it could.
"We did not cherry pick the assets in the collateral pool," Mr. Dimon said. "The assets taken by the Fed consist entirely of loans that are current and domestic securities rated investment grade.
My Comment: This is galling. Everyone is praising the quality of the assets offered to the Fed as collateral, but JPMorgan would not take them outright. Why not? And while the Fed is on the hook for fallout from those assets, what about the other assets JPMorgan picked up for next to nothing? What are those worth? Was JPMorgan acting like a "responsible corporate citizen" or a vulture financing corporation?
And please, don't make me gag over the term "investment grade securities". Bear Stearns itself was investment grade. It went bankrupt overnight.
"There was, simply put, a run on the bank," said Mr. Schwartz, who told CNBC two days before the rescue that Bear Stearns wasn't in the midst of a liquidity crisis.
He said a lack of confidence, rather than a lack of liquidity was to blame for the run on Bear Stearns.
My Comment: Of course there is no confidence. Why should there be confidence? Two Bears Stearns hedge funds went to zero while Bear Stearns was attempting to unload across the globe the very ABCP garbage those hedge funds were stuck in. There has been writedown after writedown at banks and brokerages. People are walking away from homes. Unemployment is rising. Assets are being hidden off the books in SIVs. Very little is marked to market. And Bear Stearns was leveraged to the hilt. There is not going to be confidence for years. Why should there be?
The mess we are in was not caused by lack of confidence, the mess was caused by greed, rampant overconfidence within corporations, and foolish overconfidence in the Fed's ability to bail out anyone big enough to mater. Overconfidence drove banks and brokerage houses to leverage up on garbage that is now imploding. Sadly, the Fed did everything it could all along the way to encourage such risk taking. This of course makes the Fed the root cause of this mess.
Confidence vs. Liquidity
Bear Stearns CEO said "lack of confidence, rather than a lack of liquidity was to blame for the run on Bear Stearns."
Let's explore that idea with a flashback look at statements made by Punk Ziegel analyst Richard Bove as discussed in Confidence vs. Liquidity.
Bove: Investors and banks already have the cash to buy risky loans and investments, he said.
Mish: Disagree strongly. Banks and lending institutions are essentially "all in". In fact, with leverage they are more than "all in" as a Duration Mismatch is Causing Severe Stress Everywhere Banks are very short of cash as what we are seeing is tantamount to margin calls in illiquid assets. But as Bove suggests, borrowing from the Fed at a marginally lower rates does not fix that problem.
Bove: "There is no liquidity problem, but a serious crisis of confidence."
Mish: Disagree strongly. Liquidity (in the form of credit) and confidence are two sides of a double headed coin as well as two sides of a double tailed coin. Confidence and liquidity are both cowards that flee when problems arise. As long as there was confidence in housing there was plenty of credit for loans. Once confidence in housing dropped, liquidity did too. The same scenario is now playing out in junk bonds and LBOs. There is no liquidity without confidence and nor is there confidence without liquidity.
Overconfidence and anything goes liquidity work hand in hand. One look at covenant lite deals, junk funding for stock buybacks, and enormous LBOs that make no economic sense should be proof enough. When confidence died, so did liquidity for the deals.
The only thing that can restore confidence is the very thing the Fed refuses to do: let the free market work.
Caroline Baum had interesting comments about how the Fed handled matters in Fed Should Clarify Link to Bear Stearns Assets.
Watching the evolution of Fed policy in the last six months from focused on inflation to fearful of systemic risk; the series of aggressive, rapid-fire rate cuts; the creation of an alphabet soup of new lending facilities [TAF, TSLF, PDCF]; and the orchestration of a fire sale of Bear Stearns to JPMorgan, one has to wonder about the Fed's M.O. It all has a make-it-up-as-you-go-along quality.
Please see Fed Uncertainty Principle for my comments on the above, additional thoughts on the illegality of the Fed's actions, and a complete theory on self reinforcing observer/participant feedback loops at the Fed and how that distorts the market.
One thing should be clear in all this, the SEC's Open Invite For Corporations To Lie and the Fed's "make-it-up-as-you-go-along" policy are not going to restore confidence. The market may be bouncing now, but don't confuse a bear market rally with restored confidence.