Jeremy Siegel, Ph.D. The Future for Investors

"Oh, no! Two dollars!"

So cried investors three weeks ago. The Federal Reserve had just announced that it was lowering the discount rate by a quarter of a point and had arranged for the sale of Bear Stearns to JPMorgan Chase. Stock futures jumped on news of the discount rate cut and Bear sale until investors heard the price.

The market's anxiety was justified. If a legendary Wall Street investment bank that investors valued at over $100 per share just last December was suddenly worth next to nothing, what were the other Wall Street firms, such as Goldman Sachs, Merrill, and particularly, Lehman Brothers really worth? The news sent S&P 500 futures spiraling and set the stage for a tumultuous opening that Monday morning.

Recap on Crisis

Bear Stearns, founded in 1923, has been an aggressive player in the financial markets for many years. One of the pioneers of mortgage-backed securities in the 1980s, Bear was heavily involved in the packaging of sub-prime mortgages during the housing boom. As the prices of these securities slipped last year, Bear bought not only for its own account but also for its hedge funds that it established for its wealthy investors. Bear's purchases were financed with short-term borrowings that were collateralized against these securities. But as the market continued to tumble, lenders demanded more cash to secure their loans. When Bear knew it would not have enough cash to cover the margin, it went to JPMorgan, one of its lenders. Both then turned to the Fed to arrange a $30 billion dollar loan guarantee against Bear's assets to prevent the firm from going bankrupt.

When the Fed guarantee was announced on Friday morning, March 14, Bear stock plunged $27 a share to close at $30, which was what traders thought the company was worth at week's end. That is why the $2 price announced Sunday was such shocker. If Bear management was willing to sell at $2 and there were no other offers (a few hedge funds attended the weekend meetings but declined to bid), investors wondered what the other giant Wall Street investment banks were worth.

A Bailout?

Was the Fed's loan a bailout of a Wall Street firm that had made risky bets and deserved to go under? And how much is the taxpayer going to lose as a result of the Fed deal? Both Barack Obama and Hillary Clinton, contenders for the Democratic presidential nomination, blasted the Fed's action as bailing out Wall Street firms while letting "Main Street" homeowners with mortgages wither on the vine.

The Fed loan probably did prevent Bear from going into insolvency, but it hardly "bailed out" investors. Bear sold for $172 a share last year, once valuing the firm at over $20 billion. The Fed agreed-on price on March 16 was $2, about $250 million, which represents a 98.4% wipeout for investors. Furthermore, Bear as a firm is gone, its assets absorbed by JPMorgan, who will no doubt dismiss a large chunk of its nearly 16,000 employees. And, as I note below, the higher price agreed to a week later actually reduced the Fed's exposure to Bear's troubled assets.

The Details

Here are the details of how the Fed loan will work. The Fed has agreed to effectively lend $29 billion against a portfolio of mostly sub-prime securities that Bear Stearns "marked to market" on March 14. It is important to recognize that this sum does not represent the face value of these securities, which is far higher than $29 billion, but the extremely depressed market prices brought on by the current crisis. JPMorgan, which oversaw the valuation of these securities and also assumed some of the risk, claimed that they were satisfied with the prices that Bear determined.

The higher $10 price that was agreed on a week later required JPMorgan to take a loan against the first $1 billion to Bear's securities, lowering the Fed's guarantee to $29 billion. Given the 120 million shares of Bear Stearns outstanding, the reduction in the Fed's contribution is approximately equal to the $8 increase in the price Bear stockholders will receive.

The $30 billion in assets will be deposited in a newly-created corporation established for the purpose of administrating and selling these securities. The Fed will earn an interest on its portfolio at its ongoing discount rate (currently 2.50%, 25 basis points above the targeted Fed funds rate), and JPMorgan will receive a higher interest rate of the discount rate plus 450 basis points, (currently 7%) on its $1 billion loan.

All proceeds from the sale of Bear's assets will first go to repay the full $29 billion principal and interest due to the New York Fed. Only when all interest and principal is fully paid to the Fed will any further proceeds go to satisfy the $1 billion in subordinated notes due to JPMorgan Chase. Once JPMorgan's note is satisfied, any further proceeds will go entirely to the Fed. In short, unless the default levels soar above the level now anticipated, the Fed will likely recover the entire proceeds of its loan and more.

You may ask if Bear's securities were such a good deal, why didn't the private sector make a bid for the investment bank? Well, $30 billion would be a big chunk for any institution to swallow, and even if a consortium could be established to raise the money, the speed at which Bear's position was deteriorating argued for a rapid merger since no other lender was ready to step forward.

It is my opinion that not only will the Fed get its money back plus interest, but will make a tidy profit on the transaction. As bad as the housing market is, many of these securities are being quoted at prices below most worst-case scenarios. Two years ago, any security that was "asset backed" - and particularly "real estate backed" - was considered golden and priced with almost no risk.

Today any security with the words "real estate" attached is consider toxic and priced at extreme risk. The reality, as usual, is somewhere in between. The Fed did not bail out Bear at taxpayer expense, but enabled - as it is mandated - the financial markets to continue to function. History will call the Fed's action the right move at the right time.