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.]

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  • Bill March 24, 2008  

    This is the first intelligent post I’ve seen on the Fed financing component of the Bear deal. The truth is no one knows exactly what securities the Fed is taking. I haven’t even seen informed speculation. All we know is that the Fed thinks the market value was 30bb on 3/14. Are they overpaying, was the real MV 25bb? Were the assets worth 45bb the week before? What is the par value of the portfolio? On average MBS are grossly underpriced to fundamental value due to enormous liquidity pressures and financial stigma. The Fed could be getting a fantastic trade here, until we see CUSIPs no one knows.

  • jck March 24, 2008  

    What we know is that the balance outstanding under the arrangements involving JPMorgan and Bear Stearns is exactly ZERO as of wednesday 19th.
    H.4.1 statistical release, in line “Other credit extensions”

  • Bill March 24, 2008  

    I’m not an expert on the H.4.1 and I don’t understand what you are implying. Are you saying that the Fed is not “financing” these assets or that the assets have zero value?

  • Seemingly Useless March 25, 2008  

    JPM seemingly did steal BSC stock but the risks of the acquisition are still unknown. I think investors are being superficially bullish by the fact that it is a fed-backed deal. What is a mystery is the stock movement for JPM. The market priced in a $2 bid acquisition last week so shouldn’t JPM stock decline if they are paying five times more to acquire a questionable company. Nothing fundamentally has changed since the last 2 weeks, silver lining or not.

  • Zyndryl March 25, 2008  

    Sorry, but I am still waiting for proof that the taxpayers are even involved here. The Fed is a private corporation that has special monopoly rights. It is not supported by the taxpayers.
    Unless that $30 billion is coming from Treasury and not the Fed itself, its not taxpayer money.
    The fact that people like financial authors of articles like this should know better, but don’t is rather disturbing. The WSJ just posted an opinion piece displaying the same level of ignorance. Amazing.