Bear Stearns Bailout- Perhaps the Wrong Science?

By: Paul_Petillo

If you have ever taken the time to watch water swirl around a pier, you have seen turbulence. The fixed object creates eddies that are at first large and then, as the turbulence seems to move around and away, they diminish. The late Robert Kraichman, a physicist saw this type of turbulence and wondered if it happened on a larger scale, would the same large to small changes take place.

Because the oceans and upper atmosphere consist of a layered structure, the rules of observable turbulence did not respond the same way. Turbulence he discovered increases when the number of layers that are in play are increased. Our economy is also a multi-layered entity. That said, it would be safe to suggest, since the science of economics has failed to predict the current market situation, to keep in mind that the turbulence we are currently experiencing is bound to continue to grow in size.

We don't need to go back too far in time to examine the possibility. Let's start with Friday. The sudden market shock that Bear Stearns provided was for all intents and purposes unexpected. Who could have guessed that when the investment bank announced that they were about to go bankrupt, losing half their share value in a day, that it would be the New York Fed and JP Morgan sent to the rescue? But then again, why did we not expect it?

We have entertained the idea of late that there is a real disconnect between what is on the “books” is worth the actual stated value at far too many financial firms. One analyst suggested in the ensuing frenzy that morning that the only entity that was not aware of how poorly booked the world's fifth largest broker was, turned out to be the bank of last resort. Once the Fed opened its balance sheet to Bear Stearns, providing a short-term liquidity boost through JP Morgan, those that shorted the broker rejoiced.

And Monday, JP Morgan picked up the beleaguered firm for two dollars a share. But the question remains: should the Fed get involved at all and should they have, as they announced Monday morning, open their discount window to brokerages? The answer to both those questions is no.

First the Federal Reserve, if they were doing their job, would have been ahead of this crisis months ago. But they seem to be trailing the news, reacting in kind with investors who seem to be better informed. Banks are highly regulated entities with transparent balance sheets and bookings that can be easily assessed. Yes, they have faced some difficulties in the current credit crisis and have taken steps to accurately price thinly traded securities. But investment banks or brokers are another story altogether.

When Bear Stearns announced the collapse of two hedge funds last fall, the stock continued to fall from its precipitous high of $171. Investors – not depositors, were reassured even as early as Wednesday of last week that the company was doing just fine. And then the bankruptcy announcement, the Fed bailout and the fire sale that allowed JP Morgan to pick apart the firm for its brokerage business and clearinghouse operations at a price that has made most folks speechless.

Opening the discount window to the possibility that there are other brokers out there with similar problems has the short sharks positively salivating. It may have been that Bear made the biggest bets in these opaque investments and the worst has passed with not much more than a several percentage point drop in the overall stock market value. But this kind of turbulence is multilayered and, if Dr. Kraichman's theories apply, it is far from over.

Now it should be noted that what the Fed did, loaning money to Bear not JP Morgan and assuming the losses or, in the best possible scenario, the profits may create a greater vacuum than would have happened had they let the broker fail. The Wall Street Journal made an excellent comparison when it looked at repo securities as compared to federally insured deposits. They wrote: “ In 1990, securities repo credit, at $372 billion was about 13% the size of federally insured bank deposits, at $2.8 trillion. By last year, securities repo credit had ballooned to $2.6 trillion, 60% of the value of federally insured deposits at $4.3 trillion.”

The mistakes the Fed made were many and financial historians will have a field day speculating how things should have unfolded. But one thing can be said with certainty. The Fed's actions will not shorten the current recession. Main Street is well entrenched in it already and saving a couple of poorly managed investment firms will not ease any of that pain. There are fewer arrows left in the Fed's quiver after this dramatic move.

What happens on Wall Street, more specifically to the financials, is not what the Fed should be focused on. I know that market purists have stepped up and suggested that the Fed should take a hands-off approach to the situation and until this past weekend, I was not so sure that would have been the best reaction. Now, I tend to agree.

By Paul Petillo
Managing Editor
http://bluecollardollar.com

Paul Petillo is the Managing Editor of the http://bluecollardollar.com and the author of several books on personal finance including "Building Wealth in a Paycheck-to-Paycheck World" (McGraw-Hill 2004) and "Investing for the Utterly Confused (McGraw-Hill 2007). He can be reached for comment via: editor@bluecollardollar.com

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