Over the past several days, the eyes of the sports world have been focused on the selection of basketball teams for post-season play with predictions suggesting that practically any team could win it all. We call this whole fray “March Madness.”
At the same time, the eyes of the financial world and many a concerned investor have been trained on another form of March Madness – the unprecedented Federal Reserve (Fed)-mediated sale of one of the nation’s largest underwriters of mortgage bonds accompanied by fears of Chicken Little’s prediction that the sky is falling.
To some people the sale of Bear Stearns to J. P. Morgan Chase for $236 million was a reversal of the traditional rags to riches story because in this case, billions upon billions of dollars were lost by shareholders. Incorporated in 1985, Bear Stearns’ shares sold for about $170 a year or so ago (and $57 a week or so back). The sale price of $2 per share this weekend – and even that required the central bank to take the risk on certain assets – brought fears among some investors that more problems could be in store.
Little need to explain how it all came about since the story is so well known because of the mortgage-related investment crisis the nation has been enduring, but perhaps a couple of thoughts on the matter might be appropriate.
While there have been rumblings over the past several months about the weakness of the subprime mortgage situation, it was the collapse of two internal Bear Stearns hedge funds, both of which had extensive investments in mortgage securities, which sparked near panic in the market.
Gradually, difficulties escalated until last week when financial markets began to turn against Bears Stearns and its cash position dwindled to just $2 billion. It was soon recognized that something had to be done to lessen the atmosphere of uncertainty.
Initially, it was hoped that the Fed would open its discount window and allow Bear Stearns time to swap bonds for the cash required by customers. Several factors, foibles, and feared possibilities nixed that idea and forced federal regulators, as well as Washington policymakers and Wall Street bankers, to seek an alternative solution.
Normally, in matters related to a troubled financial institution, the Fed prefers to find a private-sector answer such as a sale or the creation of a special financing agreement. At first, the Fed agreed to lend Bear Stearns money, going through J. P. Morgan, for up to 28 days. Almost immediately after the release of the news, virtually indicating that one of the nation’s leading investment corporations was near collapse, there was a drop in confidence that such a fix would work. An indication of grave concern was noted by the deep drop in the market.
Various other scenarios were discussed in myriad meetings and conference calls over the past several days until at last it was agreed that J. P. Morgan would buy Bear Stearns, but not on its own. Assistance was needed, and that is where the Fed guarantee entered the door. In taking the action it did, the Fed acted without precedent.
Over the weekend, decisions were made that resulted in the placement of Bear Stearns into the arms of J. P. Morgan. To make it happen, the Fed agreed to remove from circulation a significant portion (some $30 billion) of hard-to-trade securities and to offer Wall Street investment banks direct loans. This latter move is not receiving a lot of media attention, but it (along with drops in the discount rate (the Fed’s lending rate) and the Federal Funds rate that banks charge one another) sent a clear signal that the Fed is going to keep liquidity in the financial markets.
Such dramatic strokes seemed to be required because the more traditional tools at the hands of the Fed, such as dropping interest rates, had not made substantial inroads in solving the situation. While there is some fear in the financial world that the government has set a precedent for aiding flagging financial institutions, thereby leaving taxpayers accountable for losses, there has been relative little backlash of this sort because all players involved realized today’s unique situation required this kind of action. I, for one, give them high marks.
So is Chicken Little right? I don’t think do. The opening of the Fed to investment banks tells us that more loans may be necessary, but it also provides an automatic mechanism to avoid further meltdowns. Moreover, some of the large lenders have actually reported better-tha n-expected earnings in the ensuing days. Most important, the Fed is showing the commitment and flexibility to do what is necessary. We learned a long time ago that this was the proper thing to do, and those old lessons will serve us well in the future.