And the #1 Threat to America -- Bear . . . Stearns

I am still trying to fully wrap my head around the Bear Stearns meltdown, the federal bailout of the company and the apparent purchase of Bear Stearns by J.P. Morgan for the fire sale price of $2 per share, seemingly backed by the guarantee of us taxpayers. 

I am no economist so I hesitate to make grand pronouncements about such matters, but a couple of things do leap to mind. First, the concept of "moral hazard" of which our libertarian and right wing friends seem so fond when applied to the poor, seems to have no place in the world of high finance.  Then, by all means, the government should jump in with both feet and bail out those who have been foolish, provided that there are enough zeroes involved in the foolishness.

The second thing that concerns me (and keeps me from condemning outright the bailout) is that this problem seems to have depths that defy assumptions. I got a small taste of it this past summer when one of my clients experienced a twenty percent loss in its bond investments in one month.  This occurred in an investment grade only bond vehicle maintained by one of the largest investors of institutional assets in the country.  When I inquired after this debacle as to how much of the portfolio had been invested in sub-prime related securities, I was advised that between 25% and 50% of the assets at any one time were so invested.

If that is true of a "widows and orphans" type fund maintained by a highly reputable investment house, one shudders to think how much of this crap is out there and how much dislocation we have to suffer before the problem is resolved.  But this second Bush recession (third if you count his father's) may well prove a long and painful one. 

(Oh, I had to add this to the post, courtesy of Atrios -- ultimate financial ass clown Jim Cramer urging investors to buy Bear Stearns at $147 per share in June 2007.  Seemingly anyone can tout stocks on the teevee.  Maybe Cramer could get together with the guys who brought you "Dow 36,000" and really screw up the finances of millions.  Why do these guys get to keep their jobs -- where, once again, is the moral hazard?)

[Thanks to litbrit for her help]   

Comments

[yoyo]

YEah but did you see Cramer's breakdown when he heard abotu his buddy spitzer?

[Stephen]

The issue here is simply one of perception. Bear Stearns is a huge company with - at least until recently - an enormous and extremely valuable portfolio. For it to go under would deal a massive blow to the American economy. The same could be said for the other banks and financial companies that were worth hundreds upon hundreds of billions of dollars. It really is a problem for them to go under. While Bear Stearns's problems may be of their own making, that has to be set aside for the greater good.

An individual homeowner or other type of investor, however, doesn't affect the economy that much. And a subprime borrower usually has even less effect on the economy than other investors. It's not like they're shareholders or some other needs-to-be-protected group. Part of what it means to be an American is to understand that "you win some, you lose some," right?

Of course, tens of millions of individuals, when put together, can have a much larger effect on the economy than Bear Stearns. Tens of millions of Americans that stop paying their mortgages, or go bankrupt, or lose significant portions of their pensions, or lose their construction jobs - that matters a great deal more than Bear Stearns or Citigroup or any of the other industry giants, because much of what BS and Citi control is basically imaginary money. The "value" of their holdings fluctuates by millions of dollars every day without it mattering at all to the functioning of our economy. But the individuals now losing their homes, pensions and jobs don't deal with that type of imaginary money at all. Their money is all real, and it's the true engine of this consumer/service economy. They use their money to buy things and services, and fluctuations in their worth have a direct impact on the number of goods and services being purchased in a given area.

What conservatives, libertarians and way too many Democrats have done is train themselves to never, ever view Americans in the aggregate when it comes to things like this. No matter how many people are no longer able to make their house payments, this will never truly be cast as a national problem. They're just a bunch of individuals. Any power they have as a group is seen from the way they affect companies like Bear Stearns which are seen as having the true power to shape our economy. This way they can exclude individual people from their real economic role and from any significant assistance program.

It's a neat trick.

[low-tech cyclist]

So far, so good, Stephen - but could you clue a financial ignoramus like me into how Bear Stearns' collapse "would deal a massive blow to the American economy"?

I mean, their 'assets' are shares in other corporations (which won't be affected by BS' going under), CDOs and assorted other funny-money instruments (ditto), all of which will be picked up by other investors at market value when BS' assets are sold off.

BS' investors will obviously feel some pain. Their employees (who own much of BS' stock) I feel some compassion for, but they've probably made out pretty well on the way up, even relative to upper middle class folks like me. They'll be looking for jobs, but they should have some boodle to tide them over. Their larger investors...so what? They're rich. They don't need a bailout.

My picture is surely incomplete, but where's the bear moonwalking through the basketball players that I don't see?

[Sir Charles]

l-t c,

I think the problem with Bear, and the other investment houses is that through the use of leverage, debt, that is, and such practices as buying on margin, they have managed, in the modern day equivalent of alchemy, to create "assets" that simply do not have any underlying value. A house of cards, as it were, or in Atrios's pungent phrase, the "big shitpile." So when confidence is lost and push comnes to shove, the sale of these assets renders you a value of say $2 per share rather that $147 per share.

I am not sophisticated enough to give you the full run down on how they've managed to commit this particular act of financial suicide, but suffice it to say if it is not an isolated incident, but rather merely the first bill to come due on Wall Street then we are in for some difficult times.

I would happily sit back and say let them all go down the tubes, but the destruction of the credit markets in the U.S. has enormous implications for everyone, here and abroad.

[low-tech cyclist]

Sir C - I'm aware of the Big Shitpile, the pile of CDOs and whatnot that may or may not be worth five cents on the dollar.

It's the jump from Bear Sterns going bust and actually having to sell those assets off at market value - whatever it turns out to be - and the destruction of the U.S. credit markets, that's the missing step. It's got that "then a miracle occurs" look to it, though I'm willing to give the benefit of the doubt to what I've been told: that there's some real causal connections here that haven't yet been outlined satisfactorily.

Have any of the econ-bloggers explained this one?

[Sir Charles]

I think Atrios has given some pretty good explanation of how the big shitpile came to be. Krugman has been all over this for quite some time as well and Nouriel Roubini has done a really good job of dealing with it in depth.

The problem is that Bear Stearns has not acted in isolation but appears to simply be the first victim of these dubious practices. If the rot is as deep in other big banks then you could have enormous dislocation in the financial markets, significant harm to institutional investors, more flight from the dollar, etc.

No one seems to have a handle on how deep the problem runs, which I think may be the biggest problem here.

[low-tech cyclist]

This whole mess reminds me of my late great-uncle Sam, who was a bankruptcy trustee, and something of a wizard at it. He had a knack of taking charge of a corporation that was in for-real bankruptcy, as far as everyone else was concerned (not to reorganize, but to sell off the assets and pay off the creditors at 30¢ on the dollar, if that), and finding an overlooked asset or two that could be turned into a moneymaker (and he'd be the one to take charge of doing so, which was part of his wizardry) so that everyone wound up more or less being made whole.

It seems to me that what these CDO-laden investment houses need is someone like Sam. If he were alive and thirty years younger than he'd be right now, I wouldn't even say 'someone like' him. But if handled right, it seems that most of the mortgages that are wrapped up into these CDOs can produce an income stream if renegotiated: even the borrowers in the worst shape can afford to stay if the mortgage is reduced to five cents on the dollar, and I'm sure that many borrowers can afford to pay forty or fifty or seventy cents on the dollar.

So if Bear Sterns is effectively being sold off at two cents on the dollar, it would seem to me that there's a problem in that the interests of those pseudo-asset holders who would benefit from a realistic renegotiation of those mortgages aren't aligned with those empowered to renegotiate them.

That seems fixable, if the Fed wants to step in and knock heads. And Bear Sterns, Citigroup, etc. having to renegotiate these assets to get an average of, say, thirty cents on the dollar seems a lot better for them (let alone for the homeowner/borrowers, whose ability to spend in a normal fashion will have a lot to do with our ability to recover) than seeing them vanish almost entirely.

Again, I'm wondering what I'm missing.

[litbrit]

ltc: think Underwear Gnomes!

[low-tech cyclist]

litbrit - had to Google them. At least now I know where the meme:

1. (insert random activity here)
2. ???
3. Profit!!

that I've seen all over the place came from.

But that's still just a variation on the older "then a miracle occurs."

If all we've got between:

1. Don't bail out Bear Stearns

and

3. Collapse of U.S. credit markets

is

2. ???

then I for one would be perfectly happy to see Bear Stearns go under.

I say "would be" because I still fully expect that there is a better explanation, and if Brad DeLong or someone like him had an hour or two to deal with my ignorance, he could probably make it clear to me what the connection is.

[litbrit]

ltc--exactly! I'm not disagreeing with you; rather, I'm pointing out that there is a "name" for that which irks you!

[Joe]

I did some minor work for Bear years ago. I think (as has been acknowledged) the big problem is that Bear packaged and sold a ton of CDOs and CDOs or CDOs of CDOs that are ultimately backed up by Big Shitpile. The institutions that bought these CDOs are municipalities and insurance companies and pension funds -- the type of things that cannot go insolvent without screwing over millions of people who depend on them for retirement or health/life insurance payments or basic city services.

How these securities work is that some sort of SPV or SPE owns title to the underlying securities. But they usually don't actually hold anything -- Bear or another manager tells the SPV/SPE what the cash flow is for a particular month or quarter, and the entity is just a passthrough for this payment. Usually, there is some provision whereby the assets do get put to the SPV/SPE in the (then thought) very unlikely case that Bear or the manager goes belly up.

Therein lies the problem. As long as Bear or somebody is making orderly payments to the SPV/SPE and then ultimately the investors, then chaos is avoided. Granted, the lower tranches are getting screwed (and increasingly, so are the higher tranches), but it's an orderly process. The losses will gradually accumulate over several years. But, if Bear goes belly up and all of the underlying assets are put to the SPV/SPE, then we have a huge problem. Investors (and again, these are usually big institutional investors that we cannot afford to lose all at once) will be forced to sell the assets for pennies on the dollar and take huge bloodbaths in the process.

So, to make a long story short, what the bailout does is allow investors in the Bear-backed CDOs to spread out losses over several years, thus avoiding catastrophic present day losses.

[Stephen]

Joe,

Thanks for that. It's a much better explanation than what I could give.

I was trying to get across in my comment that the idea of the American economy going under because of BS and a few other large corporations is the conventional wisdom of politicians and the business media.

Economic systems, despite conservative/libertarian best efforts, are not rational. They're not irrational either, but what I like to call a-rational. An economic system is a lot like a religion, depending far more upon the faith of those involved than what we would consider to be the real world.

So to answer low-tech's question, the missing element is the belief of those who control government policy and the message that the rest of us receive. If these people believe that BS is big and important enough to bring us all down, then by Ben Bernanke they'll make it happen. It's a self-fulfilling prophecy. If the Fed's extreme, unprecedented decision to require the rest of us to bail them out is enough to placate and convince them that we'll be ok, then they'll make that happen.

[low-tech cyclist]

Joe - could you define SPV and SPE? (ShitPile Victim and ShitPile Exploiter? - I kid, I kid.) Thanks.

[Joe]

"could you define SPV and SPE?"

Special purpose vehicle or special purpose entity. Usually an offshore trust (occasionally LLC or other corporate entity) that holds nominal title to the assets backing up the CDO. The equity is usually nominal -- $1000 when I dealt with them in the early '00s, and they are usually owned by some independent charitable entity. That said, they are usually heavily restricted in what they can do by the noteholders (who will hold hundreds of millions in obligations).

I should also say that my exposure was pre-Enron. Things may have changed slightly since then.

[Sir Charles]

l-t c,

I know just enough about this stuff to be a danger to myself and the community.

Here is a post today by Roubini who talks a little bit about the dangers inherent in these non-bank banks and the idea of the feds bailing them out.

http://www.rgemonitor.com/blog/roubini/249924

I think Stephen nails part of the issue here, which is that when confidence erodes in this system and people start demanding cash back from the likes of Bear or Lehman, they simply don't have the liquid assets with which to pay. (Earlier today, Lehman's stock was down 30% -- despite the assurance -- or possibly because of them -- by its CEO that there was no liquidity issues.)

There is a very complex set of factors at work here involving leveraging of assets with these bonds used as collateral, the loss of marketability in those bonds, the subsequent write downs thereof, followed by demands of creditors for greater security -- and then the death spiral followed by the abyss. Should the feds just let that happen? I don't know enough to understand what the implications of non-action would be.

[Sir Charles]

l-t c,

Krugman's take on things. Well worth reading, albeit scary.

http://www.nytimes.com/2008/03/17/opinion/17krugman.html?_r=2&ref=opinion&oref=slogin&oref=slogin