The Federal Reserve’s actions to bail out Bear Stearns have far reaching implications for all investors and taxpayers. Two well-respected columnists at the New York Times ? business reporter Gretchen Morgenson and Op-Ed columnist and Princeton economist Paul Krugman ? have strongly criticized the Federal Reserve’s decision to bail out Bear Stearns.
Morgenson, whose column appeared on Sunday morning March 16 before the announcement of the purchase of Bear Stearns by JP Morgan at a fire sale price of $2 per share, wrote of the possible consequences of living in a world where regulators will rescue “even the financial institutions whose recklessness and greed helped create the titanic credit mess….” She predicted that such consequences could include a weaker currency, rampant inflation, a continuation of the year-long slow bleed at banks and brokerages firms, or all of the above.
By agreeing to a 28-day credit line to Bear Stearns on Friday, the Federal Reserve Bank of New York all but admitted that its doctrine is “Rescues ‘R’ Us” and that no sizable firms with a book of mortgage securities or loans out to mortgage issuers could or would be allowed to fail.
Morgenson and Krugman both questioned whether Bear Stearns deserved a bailout by the Fed. As Morgenson reminded us, Bear “often operated in the gray areas of Wall Street and with an aggressive, brass-knuckles approach.” Bear cleared trades for notorious bucket shop operators Stratton Oakmont and A.R. Baron. Bear was a major promoter of the most questionable subprime lenders like New Century. Bear’s default rate on Alt-A mortgages is almost double the industry average ? demonstrating lax lending practices. Bear also lost billions for its clients when two hedge funds heavily invested in mortgage securities collapsed. Bear unsuccessfully attempted to dump toxic mortgage securities off its own books and into the IPO of a company called Everquest Financial. Finally, Bear refused to join in the Fed’s rescue effort for Long Term Capital Management in 1998.
Morgenson was not alone, and she quoted others who were also critical of Bear’s bailout. William A. Fleckenstein, the president of Fleckenstein Capital and co-author with Fred Sheehan of Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve, noted, “This is the perfect time to set an example, but they are not interested in setting an example. We are Bailout Nation.”
Josh Rosner, an analyst at Graham Fisher & Company and an expert on mortgage securities, was blunt in his criticism: “The Fed has now crossed the line in a very clear way on ‘moral hazard,’ because they have opened the door to the view that they are required to save almost any institution through non-recourse loans ? except the government doesn’t have the money and it destroys the U.S’s reputation as the broadest, deepest, most transparent and properly regulated capital market in the world.”
The government let Drexel Burnham fail in the late 1980’s. Why was Bear Stearns treated differently? According to Morgenson, because of our policy of not allowing any financial institutions to fail, they have become too big to fail. A failure by Bear Stearns would result in the wholesale dumping of mortgage securities into a frozen market. The fire sale would force other institutions to mark down similar securities on their books, causing more margin calls and more failures.
Morgenson concluded by noting that when the regulators rescue the firms that were the architects of both the markets and their own problems, they undermine the confidence needed to keep the markets open and operating. In the current situation, there is no one with sufficient capital to rescue the next troubled firm except for the ever-suffering American taxpayer.
Krugman was equally critical of the rescue in his column on March 17. In his view, Bear “deserved to be allowed to fail ? both on the merits and to teach Wall Street not to expect someone else to clean up its messes.” The Fed, however, rode to the rescue because it was afraid of panic in the markets that would wreak havoc with the wider economy. They did a bad thing because the alternative was worse. In his view, bailouts will continue because the alternative remains worse.
Krugman argued that how the coming bailout is managed is critical; it is important to bail out the system and not the people who got us into the mess. ” That means cleaning out the shareholders in failed institutions, making bondholders take a haircut, and canceling the stock options of executives who got rich playing head I win, tails you lose.”
The financial markets are in turmoil and need a leader who can figure out how to rescue the system without just opening the coffers of the Federal Reserve System to bail out every bank and brokerage firm with a troubled balance sheet. We just do not have the money to do that. Unfortunately, we are blessed with an overabundance of the financial experts who got us into this mess and a shortage of those who can get us out.
Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. Page Perry’s attorneys are actively involved in counseling institutional and individual investors regarding their subprime investment problems and have brought claims for investors with losses relating to subprimes. For further information, please contact us.