Bear Stearns Buy-Out Elicits Anger & Understanding

On Sunday, March 16, JPMorgan Chase offered to buy troubled investment house Bear Stearns for US$2 a share, less than a tenth of its value just two days before. The deal - which was rushed through so that it could be announced before world markets opened on Monday - was backed by the U.S. Federal Reserve, which guaranteed US$30 billion worth of Bear Stearns' riskier assets.

Reaction to the Bear Stearns buy-out was fast and furious. Commentators criticized the U.S. government's role in the deal and pitied Bear Stearns shareholders.

Jim Rogers, a former investment partner of George Soros who has made a fortune investing in commodities, believes the Fed should have let Bear Stearns fail.

"Investment banks have been going bankrupt since the beginning of time," he told Bloomberg News. "Let somebody go bankrupt - it's not the end of the world."

In 1907 Wall Street suffered a rash of broker bankruptcies, he said. "America recovered from that and had a very nice future."

In 1966 Japan's financial community experienced a similar collapse. "Every broker in Japan was in bankruptcy." And yet the country survived that and became one of the great economic powerhouses, Rogers said.

The U.S. Federal Reserve "asked JPMorgan to 'buy' the company and then guaranteed much of the risk. For all intents and purposes it's the same bloody thing as a taxpayer-funded nationalization, as the Fed is assuming the risk for funding [Bear Stearn's] 'illiquid assets,'" wrote Markham Lee at SeekingAlpha.com.

Most seasoned market watchers seem to agree with that assessment, but said the Fed made the right decision. One of the dangers of intervening in such a way is that it creates "moral hazard" - it signals investors and financial-institution decision makers that they will be protected from the consequences of their ill-advised actions. Bear Stearns shouldn't have been so heavily invested in risky mortgages, right? So they should pay for their mistakes.

The problem is, "the moral hazard risk is inevitable at this advanced stage of the crisis," wrote Mohamed El-Erian, co-chief executive officer and co-chief investment officer of Pimco, in an editorial for the Financial Times. "Indeed, the question is not just what happens to irresponsible lenders and imprudent borrowers. It is also about the damage that is being inflicted on others as the financial system freezes."

"Failure to act would have plunged Bear Stearns, a major underwriter of mortgage bonds, into a messy bankruptcy and touched off even greater ripples of investment uncertainty," said an editorial in the Wall Street Journal.

"For macro reasons, the Fed had no alternative," Paul DeRosa, a partner at Mt. Lucas Management Co., told Bloomberg News.

With the buy-out, JPMorgan has guaranteed Bear Stearns's counterparty risk, its creditors are safe, and the stockholders are left holding the bag. "And that's how it should be," wrote Bloomberg News columnist Caroline Baum.

Since the beginning of the subprime crisis, banks have seen the value of the assets they hold, particularly mortgage-related ones, fall, Baum explained. At the same time, their liabilities haven't changed. This has resulted in an erosion of their capital, or assets minus liabilities. When bank capital declines below regulatory minimums relative to assets, financial institutions have to sell assets, which can lead to the kind of downward spiral the Fed was looking to prevent.

"The Fed had no choice but to aggressively intervene as it did," The Wall Street Journal editorial said. "And if the Fed has to intervene again to forestall liquidity crunches as the lender of last resort, then all power to them."