Did Bear Stearns Deserve a Taxpayer-Backed Bailout?Published: April 09, 2008 in Knowledge@Emory
On April 3, members of the Senate Committee on Banking, Housing, and Urban Affairs grilled Federal Reserve Chairman Ben S. Bernanke on the Fed’s decision to offer a $29 billion guarantee from the Treasury Department to a financially ailing Bear Stearns. The move was an unprecedented taxpayer-backed bail out. Professors from Emory University’s Goizueta Business School note that the current crisis at Bear Stearns is certainly a difficult, complex, and extraordinary one, but at the heart of the matter remains whether taxpayer funds should be used to prop up an investment firm.
According to Narasimhan Jegadeesh, professor and the Dean’s distinguished chair in finance at Emory University’s Goizueta Business School, Bernanke had to choose between the proverbial rock and a hard place. The investment bank’s bankruptcy would have created significant uncertainty in the financial markets, and it could have brought down other financial institutions. Jegadeesh adds, “What the Fed did was to guarantee $29 billion of a $30 billion Bear Stearns portfolio, primarily composed of mortgage-backed securities. JPMorgan Chase was required to bear the first $1 billion of any loss in value of this portfolio. Any forced liquidation of this portfolio by Bear Stearns would have occurred at fire sale prices, which in turn, would have led to margin calls and potential bankruptcy risks by other institutions that held similar securities.”
The professor adds, “The Fed brought in market discipline to some extent in this bailout by marking the value of the underlying portfolio to the market, and passing on the risk of the first billion dollar loss to JPMorgan.” He notes that there is certainly a question about the precedent that this action would set and the possibility for this happening again. “It could be a bad incentive, especially if other institutions act as though taxpayers would bail them out because they are too big to fail. But I doubt that there would be any more bailouts in this cycle.”
Assessing the Landscape
Wall Street faced a similar crisis in 1998 with the failure of hedge fund Long Term Capital Management. In that case, the Fed coordinated the takeover of LTCM by several investment banks,” says Jegadeesh. “The Fed got involved in that situation for the same reason as in the case of Bear Stearns. It feared that liquidating the LTCM portfolio at fire sale prices would destabilize the markets. However, in that case, there was no taxpayer support, and so there was no real controversy. “If the Fed needs to use this power, it has to be few and far between.”
The investment banks bailing out LTCM actually came out of the deal with a small profit because of the eventual recovery of LTCM’s portfolio value. The Bear Stearns situation has played out quite differently, he notes. The Bear Stearns financial woes come from investment vehicles tied to the subprime mortgage debacle.
On March 13, Bear Stearns informed the Federal Reserve of their liquidity problem and the need to file for bankruptcy the next day, unless funding was found. Regarding the situation, Bernanke said to the Senate panel that the “news raised difficult questions of public policy. Normally, the market sorts out which companies survive and which fail, and that is as it should be.” However, the “interconnected” nature of the financial markets, he reasoned, necessitated the Fed’s quick and landmark action and prompted the backing by the Treasury Department.
Bernanke added, “The sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence. The company’s failure could also have cast doubt on the financial positions of some of Bear Stearns’ thousands of counterparties and perhaps of companies with similar businesses.” The Fed’s decision was simply meant to prevent shocks to the economy “through its effects on asset values and credit availability.”
To the Rescue
The behind-the-scenes efforts and backing by the U.S. Treasury Department ensured that JPMorgan Chase would purchase Bear Stearns, says Goizueta’s Jegadeesh, and even allowed them to up the per share purchase price. He adds, “JPMorgan wouldn’t have taken them over without a guarantee. And if Bear Stearns had to sell the company at fire sale prices, it would have driven down the share price of financial firms with similar instruments.”
Originally, terms of the JPMorgan Chase purchase of Bear Stearns set the per share price at $2. But with the Fed’s backing, JPMorgan Chase revised their offer. According to the revised merger agreement, each share of Bear Stearns common stock would be exchanged for 0.21753 shares of JPMorgan Chase common stock (up from 0.05473 shares), reflecting an implied value of approximately $10 per share of Bear Stearns common stock based on the closing price of JPMorgan Chase common stock on the New York Stock Exchange on March 20, 2008. In the deal, JPMorgan Chase would purchase 95 million newly issued shares of Bear Stearns common stock, or 39.5% of their outstanding common stock after giving effect to the issuance, with the transaction set to be completed on or about April 8, 2008.
JPMorgan Chase also agreed to guarantee Bear Stearns’ borrowings from the Federal Reserve Bank of New York, and the company will bear the first $1 billion of any losses associated with the Bear Stearns assets being financed and the Fed will fund the remaining $29 billion on a non-recourse basis to JPMorgan Chase. As news of the deal swirled through Wall Street, various news reports indicated that Bear Stearns’s employees were bracing for a mass layoff of a chunk of the financial firm’s employees.
Jeff Busse, associate professor of finance at Goizueta, adds, “I believe in letting the market sort itself out in most instances. In this case, Bear Stearns cannot be happy with the way this ended. Many employees are losing their jobs. Small and large fortunes have been lost. This is not a good outcome for most stockholders, so I don't see this as directly leading other institutions to throw caution to the wind in their risk management.”
The crux of the matter, says Busse, is that Bear Stearns was using a lot of leverage. “Some reports say they were levered as high as 30-to-1 in some of their strategies,” he adds. “Other banks served as counterparty to some of Bear Stearns's highly leveraged strategies. If Bear failed, then their counterparties would have potentially lost substantial amounts. There may have been a very large snowball effect. It's unclear how devastating the effect would have been, but it is likely that it would have resulted in a lot more lost jobs than what will now result.”
A Look Ahead
In a statement, Jamie Dimon, chairman and CEO of JPMorgan Chase, said, “We believe the amended terms are fair to all sides and bring more certainty for our respective shareholders, clients, and the marketplace. We look forward to a prompt closing and being able to operate as one company.” Alan Schwartz, president and CEO of Bear Stearns, added, in a statement, “The substantial share issuance to JPMorgan Chase was a necessary condition to obtain the full set of amended terms, which in turn, were essential to maintaining Bear Stearns’ financial stability.”
Ray Hill, adjunct senior lecturer of finance, admits that Bernanke was placed in a very tough spot. “On the one hand,” he notes, “if they went under, Bear Stearns was intertwined with billions of transactions. It might have created a meltdown.” And, while Hill agrees with the assessment that the precedent of the Treasury backing up Bear Stearns may create future problems of moral hazard, it still may not be the wrong move. “I am glad I am not in Bernanke’s position, as it’s very hard to estimate the amount of chaos that could happen if Bear Stearns went under. I think he thought that it was better to take the risk off the table.”
Of course, says Hill, right now may not be the best time to consider oversight proposals, even though they seem to be in need. “In the midst of a crisis, it’s difficult to decide the best thing to do,” he adds. “Often, there is an overreaction and an attempt to over-regulate then.” The regulations proposed by Treasury Secretary Henry Paulson call for a number of changes to current regulations, including folding the Commodity Futures and Trading Commission into the SEC, Fed oversight of the mortgage industry, and more.
For now, the biggest concern appears to be giving assistance to an investment firm—assistance traditionally reserved for banks and savings and loans. Hill adds, “One of the primary reasons the Fed exists, according to central banking doctrine, is to prevent a bank failure from leading to a systemic meltdown. Now, we realize the same thing can happen with an investment bank, and there doesn’t seem to be a quid pro quo as there is with a traditional bank, in terms of balance sheet regulation.” Former Federal Reserve chairman Paul Volcker has publicly questioned the Fed’s decision on Bear Stearns.
The Pitfalls of Wall Street
The Bear Stearns/JPMorgan Chase story will continue to unfold and evolve, with time serving as the true judge of the Fed’s decision. T. Clifton Green, associate professor of finance at Goizueta Business School, notes, “Hindsight may show that some of the specific actions of the Fed were misguided, but at the time, financial panic seemed to be a real concern. We continue to talk about a recession, but fears of a financial panic have largely subsided thanks to the actions of the Fed.”
There are hopes that Wall Street might learn a lesson from the recent upset in the markets associated with the plays in the subprime sector. Says Green, “In my opinion, people often take on too much risk because when times are good, it’s human nature to get lax with the details and assume things will work out ok. Individuals and investors assumed that the good times in real estate and the economy would continue, and they over-extended themselves.” He adds that many firms underestimated the likelihood of default, rather than assuming they would get rescued in default.
Green also concurs that regulation on the financial markets tends to be backward looking rather than forward looking. “I don't think we'll have another S&L type crisis, and in my view, we're unlikely to have another similar mortgage crisis. That said, it's hard to prevent over-optimism from creeping in when we've had a boom in a sector of the market, and this is not likely to be the last financial market crisis.”
But Busse concedes that the “devastating loss of an iconic American firm should result in other firms taking appropriate steps to significantly reduce the probability that this happens to them.” A knee-jerk response to over-regulate won’t solve the matter either, he noted, and may create more problems in the market. He concludes, “The inner-workings of these institutions are too complex to regulate without creating incredible inefficiencies. They are self-correcting in many respects.”