Is it a deft financial move? Or a nauseating corporate handout?
The Federal Reserve's intervention in the collapse of investment bank Bear Stearns has clearly calmed financial markets that recently seemed on the verge of panic. Now comes the backlash. Some populist critics are asking why the feds can bail out Wall Street but not Main Street. And the die-hard free marketeers who run the Wall Street Journal's editorial page have decried Fed policymakers as "pushovers," arguing that the Fed's action enriches JPMorgan Chase, which is buying Bear Stearns, at taxpayer expense.
How to characterize the Fed's action is a matter of ideology more than anything else. But there's certainly some benefit to the public from the Fed's intervention. Here are some of the basic facts, which tend to get overlooked as the rhetoric heats up:
The Fed has extended a loan, not given away money. The central bank has agreed to lend JPMorgan $29 billion as an enticement to buy the troubled Bear and its liabilities. As collateral, JPMorgan is putting up $30 billion worth of mortgage-backed securities and other complex investments, which are basically the most problematic assets on Bear's books. JPMorgan has to repay the Fed loan with interest at the "discount rate," which is currently 2.5 percent.
The risk to the Fed—and to taxpayers—is what happens to those troubled securities, which the Fed is essentially insuring. If they end up being completely worthless, then the Fed would be out the whole $29 billion. Under the terms of the deal, JPMorgan would pony up the first $1 billion in losses.
The securities have some value, but nobody knows what it is. And that's basically the whole problem. The Fed and JPMorgan used accounting principles to come up with a "marked to market" value of $30 billion. But that's notional because right now there's no market for the securities—basically, nobody will buy them. The reason there are no buyers is that the value of the securities ultimately depends on how many mortgage holders default and other unpredictable factors—and the market is spooked. "These are complex, idiosyncratic securities," says Harvard Business School Prof. Josh Lerner. "Even a room full of Ph.D.'s, slaving for months to figure out what they're worth, could still end up way off."
Part of the reason there's so little confidence in the underlying value of mortgage-backed securities is that the initial valuations were obviously far too rosy. But how rosy is still unclear. Once the credit crunch eases, the housing market stabilizes, and the economy rebounds, it will be easier to figure out what they're worth, and buyers will likely emerge.
The Fed could lose something, but probably not $29 billion. The Fed hasn't released any analysis, but its number-crunchers have certainly discounted the value of the securities to account for all the failing mortgages bundled into them. To Bear Stearns and others who bought the securities before they depreciated, the losses have been severe. But since the securities are already marked down, so to speak, they'd probably have to sell at a steep discount for the Fed to lose a lot of money. "The Fed may not see a serious loss at all," says Susan Wachter of the University of Pennsylvania's Wharton School. "It could be just a couple billion, which is not a major bailout."
We won't know for awhile how much it will ultimately cost the Fed. Unlike investment banks, which rely on trading for liquidity and don't hold a lot of cash reserves, the Fed can hold on to the tainted securities indefinitely and sell when the market seems strongest. If it does lose money, the Fed will most likely fund the losses through its own operating streams. Ordinarily, the Fed, which is a government bank, earns a surplus through low-margin, high-volume loans to other banks, and remits its "profit" to the U.S. Treasury for government spending on other things. Any losses would come out of that surplus, and effectively constitute taxpayer money.
Doing nothing might have cost a lot more. The Fed could have let Bear Stearns careen into bankruptcy, which would have meant that the firm's lenders and other creditors would have received pennies on the dollar. That's why a run on Bear already seemed well underway when the Fed stepped in—creditors wanted their money back in full, not in part. And many analysts think a similar run would have materialized at other banks long on risky securities and short on cash.
Another worry is "counterparty risk." This refers to the way complex financial products peddled by one investment bank are woven into the portfolios of many others, which means that tugging on the fabric—by calling in loans, for instance—can destabilize the whole financial structure. The overall effect on an economy that's already teetering could have been dramatic. "Without a deal, take everything we've seen so far and multiply it by 10," says Lerner. "If there were a real panic and GDP shrunk by 5 percent, there'd be an immediate real cost to the government in terms of tax revenues—and to all of our prosperity."
Whether it's a bailout or not, the Fed's move benefits taxpayers directly. If you think the housing crunch couldn't get a whole lot worse, think again. "If the Fed had not stopped this," says Wachter, "the cost of mortgages would have risen, the values of houses would have declined even more than they already have, and the effect would immediately have hit the pockets of American homeowners."
It could happen again. If the economy gets worse and housing continues to nosedive, the value of mortgage-backed securities will fall even more, creating fresh vulnerabilities in the financial system. The Fed has deep pockets and could intervene again, but that could stoke inflation and cause other problems. Then again, that might be better than the alternative.
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