What the Bear Stearns resolution tells us about the Fed

At "A Dash" we read and respect sources reflecting many different viewpoints, trying to find the best sources on various subjects.

The market was shocked today by the terms of the Bear Stearns "rescue."  It certainly was no bailout for the shareholders or management.  There are those who expect government actors to behave like a deer in the headlights.  We have the uncomfortable feeling that some pundits actually want our economy to fail and for many average investors to lose their money, their jobs, and their homes.  Why?  To prove their uber-bearish predictions to be correct?  To sell books?  To lock in short positions? 

Our perspective is quite different, directed at the mainstream of investors.  This is not a game between bulls and bears.  It is about life chances for the many.  We wish that those who are most vocal in criticizing policy would also offer some solutions.

The Reality

The Fed is not playing by the rulebook  of the bearish pundits.  At "A Dash" we have maintained that it is not wise to fight the Fed, and that Bernanke will do whatever it takes to solve the various problems.  It is unfortunate that we do not have a stronger President right now, or even better policies would be available.  There are proposals in Congress, but progress might be difficult.

Today was a day when there could have been a major systemic failure and a stock market collapse.  Instead, timely action stabilized credit markets and counter-party risk.  It was no help to Bear Stearns shareholders, but it was good for the U.S. and global economies.

John Mauldin, collecting information and writing in his widely-disseminated thoughts, observes as follows:

As I have been writing, the Fed gets it. Their action today is actually re-assuring. I have been writing for a long time that they would do whatever it takes to keep the system intact. As one of the notes below points out, this was the NY Fed stepping in, not the FOMC. The NY Fed is responsible for market integrity, not monetary policy, and they did their job. And you can count on other actions. They are going to change the rules on how assets can be kept on the books of banks. Mortgage bail-outs? Possibly. The list will grow.

Yes, tax-payers may eventually have to cover a few billion here or there on the Bear action. But the time to worry about moral hazard was two years ago when the various authorities allowed institutions to make subprime loans to people with no jobs and no income and no means to repay and then sold them to institutions all over the world as AAA assets. And we can worry in the near future when we will need to do a complete re-write of the rules to prevent this from happening again.

This is exactly what we have argued for months.  The Fed will not be constrained by the "old rules" and will basically do whatever it takes.  It is not just about the level of interest rates.

The Logic of Government Action

As we have observed, none of the leading bloggers or media pundits has any real expertise about how government policymakers behave.  Here is a key concept:

Government leadership is difficult!

It is frequently the case that the "best" course of action, selected on some rational basis, is very unpopular.  This is the current case with the subject of "bailouts."  These might be bailouts of investment banks, investors, bad lenders, bad borrowers, and other folks who have screwed up.

A large portion of our society is more interested in punishing those who have made mistakes than they are in looking at the systemic effects.   This pervasive sentiment makes it difficult for political leaders to act.  Getting the average citizen to see the general interest is a major political challenge, beyond the capability of a lame-duck president.

Once again, John Mauldin has an argument, even drawing upon a theme we had planned for a future article (scratch that!):

But for now, we need to bail the water out the boat and see if we can plug the leaks. Allowing the boat to sink is not an option. And get this. You are in the boat, whether you realize it or not. You and your friends and neighbors and families. Whether you are in Europe or in Asia, you would have been hurt by a failure to act by the Fed. Everything is connected in a globalized world. Without the actions taken by the Fed, the soft depression that many have thought would be the eventual outcome of the huge build-up of debt would in fact become a reality. And more quickly than you could imagine.

Our Take

We are delighted that a sophisticated observer like Mauldin has grasped the fact that the Fed will continue to take imaginative and aggressive actions.

This contrasts sharply with most of the media coverage, which continues to portray everyone in government as stupid, naive,  and ineffective.

One of the reasons that people in government choose those jobs over private-sector finance is the desire for power and policy influence.  This is something that is little understood by those who took different career paths.  We suspect that the hedge fund and media critics of the government and the Fed will be getting a lesson about this in the months to come.

Comments

[Jeff]

Barry -
Thanks for stopping by with your comment. We agree that this is hardly a bailout for Bear. This means that we should all drop the "moral hazard" rhetoric, right?

The WSJ today had a very good article on the events leading to the decision. The details are completely supportive of my analysis, written before that article appeared.

It says nothing about "embarrassment" but it says a lot about avoiding systemic failure.

There is a simple fact here. The Fed has taken many decisive actions that you and other pundits did not forecast, but we did on several occasions. You can expect the Fed to continue in this policy approach, addressing issues that affect all of us.

There is a clear division for investors. We suggest not fighting the Fed. The FOMC is not going to follow your ideas of what they should do.

Once again, we always appreciate it when you take time to comment here.

Jeff

[Barry Ritholtz]

Rescue? Bailout? Hardly.

This was an orderly liquidation that spared the market of a panic (and the nation of the embarrassment) upon the 5th largest investment bank in the USA going belly up.

[Christopher Tinker]

Jeff,
Surely what the Fed has done is simply take out the Shadow banking system from needing to exist? If you can repo every mortgage or corporate bond issued back to the Fed - why would you need a SIV to hold mortgage assets in? Much better for the Fed to see credit creation under its control than outside of its remit. By stopping mark to distress model pricing from driving down asset valuations and pushing margin calls and haircuts to levels where asset values go into a death spiral, the introduction of a asset backed repo/swap facility meant that it suddenly became in every creditors' interest to force Carlyle Capital to the wall, seize the assets and then repo them back to the Fed and value them at the correct price. Nice work if you can get it I guess. I've written a long article on this and other thoughts if you are interested and want to email me with your contact details

[shrek]

Yes, the fed can save all of us. Its a prosperity creating machine.

[VennData]

"...But the time to worry about moral hazard was two years ago when the various authorities allowed institutions to make subprime loans to people with no jobs and no income and no means to repay and then sold them to institutions all over the world as AAA assets..."

Bush's 2004 Zero-down Bill is a Hit

"..http://www.boston.com/business/articles/2004/10/05/zero_down_mortgage_initiative_by_bush_is_hit/

By '...various authorities?" Mauldin meant the GOP, right? Oh... sorry as Paulson said, we don't want to blame anybody.

Better "various authorit(y)" timing probably would have saved Carlyle and Bear.

[barry]

Surely you jest! A glance at the last 25 years shows a repeated pattern of a GOP administration in an election year 'nationalizing' the assets of one institution while protecting the interests of other institutions.

The 'nationalization' of Continental Illinois National Bank in May 1984. Stockholders equity went to zero. But hundreds (if not thousands) of investors in CINB certifcate of deposits were bailed out by the nationalization.

The 'nationalization' of Silverado S&L in 1988. Don't even get me started!

BSC was sent to $2 to avoid their counterparties from having to pay any consequence and causing turmoil in an election year! Taxpayer funds were used for this. If this is 'free markets' then freedom=slavery, war=peace, and ignorance=strength.

Only a long time Bush II apologist like Mauldin will assume that we all have forgotten the past.