The Fed and Bear Stearns Collateral: Back Door Buying of Mortgage Securities
The just-announced terms for the JP Morgan buyout of Bear Stearns include a dramatically different role for the Fed.
In the last iteration the Fed was taking collateral from JP Morgan without recourse. In the new version JP Morgan takes the first $1 billion of risk and the Fed the next $29 billion, a change that seems minor, but might well cover any actual losses.
The big difference in the new terms is that the assets will be independently managed in accordance with Fed guidelines. If there is a profit, it will accrue to the Fed. This may not constitute legal ownership, but to us, it is a distinction without a difference.
Many of the pundits and CNBC anchors are acting as if they know the value of the collateral. "Send your toxic stuff to Ben," was one flippant example. In fact, none of us knows the true value because we do not have a functioning market in these securities. Some astute observers believe that the underlying loans may perform much better than the market expects. If this proves to be true, the Fed and the taxpayers may make a profit. That was not the objective of the Fed involvement. The motivation was to avoid the systemic failure that might have started with Bear’s counter-parties. The new deal terms accomplish this with a better alignment of risk and reward.
The Fed action is testing the limits of its authority concerning asset purchases.
Whatever one’s opinion of the merits, this deal is certainly creative. It is not something one would see from a Fed that was "behind the curve." For those who suggest that the Fed is merely reacting to events, we wonder how such an action could have been taken in anticipation.
Updating the Bear Stearns Stock Price Mystery
Last week we examined why Bear Stearns stock was trading above the deal price. We attributed buying in Bear Stearns to Joe Lewis and speculators hoping for a sweetened bid. We suggested that gaining cooperation and avoiding legal issues were possible reasons for increasing the bid. We do not expect rival bidding. With a new deal price of $10, the stock is trading $12.75, off a high of $13.80.
The market seems to believe that the terms of the deal are now open for further negotiation.
[Disclosure: No position in Bear.]