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Jeremy Siegel, Ph.D. The Future for Investors

Jeremy Siegel, Ph.D., The Future for Investors

Did the Fed “Bail Out” Bear Stearns?

by Jeremy Siegel, Ph.D.

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Posted on Friday, April 4, 2008, 12:00AM

"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.

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84 Comments

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  • Bob - Saturday, April 26, 2008, 9:46PM ET  Report Abuse

    • Overall: 2/5

    I agree with the professors remarks, but he changed the subject right after acknowledging the title. The Bear shareholders may not feel bailed out, but the federal government has supported the wealth of wall street far more than main street. The real punch line is that it had no choice.

  • Boo yah - Tuesday, April 22, 2008, 3:54PM ET  Report Abuse

    • Overall: 5/5

    I've heard re-runs of HGTV's popular "Flip This House" program are going to air late night on Comedy Central this summer.

  • Paige - Saturday, April 19, 2008, 8:26PM ET  Report Abuse

    • Overall: 5/5

    I appreciate this detailed description concernng Bear Stearns and the Fed instead of such vague terms as "funny money."

  • Andre - Saturday, April 19, 2008, 3:13PM ET  Report Abuse

    • Overall: 1/5

    I was reading another colomn, so one of comments was to read "this real thing" with all due respect, FED did bail out rich, and rich do not pay for nothing, as well as poor will pay for all of it. by poor it is an ordinary people, who in resent days were branded as poeple of God and Gun , and yes, they will pay for it. Because Fed will continue to creat money from nothing, with backing of tax payers- poor people. and rich will profit. It is realy sad that for the poeple by the poeple does not mean anymore what it was suppose to

  • David - Saturday, April 19, 2008, 7:31AM ET  Report Abuse

    • Overall: 1/5

    Probably most of what Siegel says is true. That said, can we all agree there is no such thing anymore as a free market?

  • Yahoo! Finance User - Thursday, April 17, 2008, 11:05PM ET  Report Abuse

    • Overall: 5/5

    Exactly, it was not a bail-out of anyone who worked for, or owned stock in, Bear Stearns. Dr. Siegel is dead on in his explanation of what actually happened. Anyone who says differently is uninformed, confused, or a populist. It's sad that so many people are having financial trouble with their homes, but why is that anyones fault except their own? No one forced them into buying an overpriced home with an overpriced mortgage. People were being greedy, and not paying attention to the details. That's no one's fault but there own... The mortgage industry should be reformed so that it's easier to understand exactly what the costs of a loan are; however, being the biggest purchase of most people's lives... if you're not sure hire a lawyer for $500 and find out what you're getting into. When people default on a new car b/c their interest rate is 13% is that the car dealerships fault? We need personal responsibility in this country. You signed the paperwork, so it's your responsibility to understand what you're agreeing to.

  • Yahoo! Finance User - Thursday, April 17, 2008, 8:10PM ET  Report Abuse

    • Overall: 1/5

    No, the Fed didn't bail out Bear Stearns. The Fed bailed out Goldman Sachs and their companion organizations. Nothing is ever as simple as it appears.

  • Yahoo! Finance User - Tuesday, April 15, 2008, 7:07PM ET  Report Abuse

    • Overall: 5/5

    Contrast this article to Robert Kiyosaki's views on the "bailout". Dr. Siegel gets my vote on knowing what he's talking about.

  • p - Sunday, April 13, 2008, 2:19PM ET  Report Abuse

    • Overall: 2/5

    This article would make sense if Bear Stearns were a unique case. When this scenario replays several times with other institutions in the next few years, and the dollar is diluted into hyperinflation, I'm not so sure that the Fed "will likely recover the entire proceeds of its loan and more". Even if it did it would be in dollars that will be worth much less than today's dollar.

  • Yahoo! Finance User - Friday, April 11, 2008, 7:22PM ET  Report Abuse

    • Overall: 5/5

    Bear Stearns was to central to the finance world to let it go under. Everyone saying that because no other bank stepped forward that it proves that it's worthless is absolutely out of you mind. Just because you ignorant and have no idea how it works doesn't mean that the fed (and you wrongly assume taxpayers) will lose money. The Fed makes money and very often gives it to the U.S. federal government. They don't want to see the financial system collapse after a credit freezup if they had let Bear Stearns collapse. So instead they decided to help JPM take it over because they unlike most other banks that you say didn't step forward haven't lost money because they didn't make bad loans. Thats why they got the deal. Bernanke also testified before the Houses economic committee and said that this was a rare case and he hopes not to do it again. If you don't know what your talking about go read a book don't just get mad because of you ignorance.

  • Yahoo! Finance User - Friday, April 11, 2008, 6:33PM ET  Report Abuse

    • Overall: 2/5

    This is ridiculous......No wonder the value of the dollar is dropping!! We are throwing dollars away like toilet paper down the drain. When are we going to hold CEO's such as Angelo Mozilo of Countrywide and Alan Schwartz of Bear Sterns responsible for their risky mortgage lending and loans meanwhile their workers get a $600 check which won't even make one mortgage payment. ....................The way we have to rescue the AMERICAN economy is for institutions such Harvard University and Yale to divest half of their endowment from foreign companies and to put it into US Treasuries............That and maybe reduce our federal spending.

  • Yahoo! Finance User - Wednesday, April 9, 2008, 10:13PM ET  Report Abuse

    • Overall: 5/5

    The Fed did what it had to do. If it did not act, and Bear Sterns fell (which it deserved) it would have caused panic and a ripple effect through all the banks. Others such as Lehman may have also fallen, thus creating a greater problem. As far as the Democratic Contenders...... Obama would have the Fed give the money to his "Anti America White Hating" church. Mrs. Clinton would just lie about the whole thing. God help us after this next election.

  • Mark - Wednesday, April 9, 2008, 9:25PM ET  Report Abuse

    • Overall: 1/5

    Wow, what utter garbage. What the author conveniently left out was if there was no deal, Bears would have had to seek protection thus shooting the stock to way below the 2$ initial offer. Thanks comrade Bernanke for making this possible.

  • BernardR - Wednesday, April 9, 2008, 3:07PM ET  Report Abuse

    • Overall: 4/5

    This should be reprinted on the front page of every newspaper to reassure the public.

  • Yahoo! Finance User - Wednesday, April 9, 2008, 2:22PM ET  Report Abuse

    • Overall: 1/5

    The Fed did not bail out Bear. If they did 16k employees would have jobs now. The Fed is trying to shift their mistake of keeping interest rates too low for too long and not pushing for lenders to justify their lending pratices. The Fed is shifting the blame away by acting like a savior. The Fed knew if Bear went solvent Lehman would of went a couple days later, and then some. The Fed knows they came close to a complete financial disaster. Over $300 billion in Fed loans so far is proof of a significant problem. History will show the Fed took no action until they had no other choice. The Fed should push the banking industry to abandon Variable and interest only loans.

  • Yahoo! Finance User - Wednesday, April 9, 2008, 2:20PM ET  Report Abuse

    • Overall: 1/5

    wow, i'm shocked at the "level of ignorance" of those that highly rate this article - if this wasnt a "bail out" then JPM should have bought Bear Stearns WITHOUT FED INTERVENTION. obviously the taxpayer will be losing money since no other financial firm was willing to step in without the government holding its hand. oh wait, maybe the Fed knows these bonds will be much more valuable than JPM thinks they are. NOT!

  • Yahoo! Finance User - Wednesday, April 9, 2008, 1:47PM ET  Report Abuse

    • Overall: 1/5

    The Fed is supposed to be in charge of monetary policy, not brokering deals, valuing securities, turning a tidy profit, or financing buyouts.

  • Yahoo! Finance User - Wednesday, April 9, 2008, 12:27PM ET  Report Abuse

    • Overall: 4/5

    Wow! I never post anything to these forums, but the level of ignorance displayed by those rating this artical 1 and 2 stars is truly amazing. These people have no understanding of economics, the banking system, the Fed, or the tools with which the Fed conducts monetary policy. Siegel is probably right that the Fed's backing of these loans will probably not result in direct cost to taxpayers as they are likely severely undervalued at this point. Nevertheless there is a cost to taxpayers, which is the moral hazard created by the bailout, and it is a bailout because no one in the private sector was willing to provide Bear liquidity without the Feds intervention, even though the Fed may end up making money off of it. The moral hazard cost arises because it sends the message to banks, don't worry you can make risky loans without properly pricing your risk but the Fed will be here to bail you out, which only encourages such irresponsible behavior. So the moral hazard risk needs to be weighed against the systemic risk of an insolvent Bear Stearns. Perhaps a collapse of Bear would have led to a ripple effect and expansion of crisis throughout the financial system, and perhaps. But this is the question that should be debated, and is one that intelligent, well meaning people can discuss and legitimately disagree on. The question of help for homeowners in foreclosure can be debated on much the same terms. Bailing those people out also creates a moral hazard because people should be responsible enough to evaluate real estate values and take on mortgages they understand and can afford. In this case there is little to no systemic risk supporting a government bailout because individuals in foreclosure do not threaten the financial system in same way failure of a major bank does. In this situation the moral hazard and cost to the goverment must be weighed against the social equity concerns implied by a high rate of home foreclosure. These are two separate issues that can not be compared in the way some posts to this thread have tried to do. Each needs to be evaluated on its own merit, and reasonable intelligent people can disagree about the outcome without the vitriol and conspiracy theories. Most of the arguments on this board are complete nonsense.

  • Yahoo! Finance User - Wednesday, April 9, 2008, 10:27AM ET  Report Abuse

    • Overall: 1/5

    Fed does not produce anything, it is a useless regulatory agency, spends taxpayers money by using reserve requirments imposed upon banks, set the interest rate for the country, and most of the decisions are wrong..... They care about "Wall Street" and Ben is a capitalist moron.... Our rogue leaders like the president and v.p.and all under, above, deep within and at the outset and the fake, greedy, always wrong American media machine,,,,,who have imposed upon most Americans artificial, fake and knowingly wrongful news that everything is fine and dandy and please keep on investing in America--no matter what.

  • Nathan - Wednesday, April 9, 2008, 10:21AM ET  Report Abuse

    • Overall: 1/5

    I believe, once again the spin doctors are putting a happy face on BAD NEWS! I counsel homeowners facing foreclosure. I see numerous "middle class" families facing financial disaster, where is the market intervention for them? And I don't believe, for a minute, they made fully informed decisions when they entered those sub-prime loans. If the powers to be want to claim we have a true market economy "let the chips fall where they will". Otherwise, let every party face his/her true risk in the "market".

  • Yahoo! Finance User - Wednesday, April 9, 2008, 10:19AM ET  Report Abuse

    • Overall: 1/5

    Some of these people comments are not very accurate. First of the Feds are not department in this government, the president is picked out by the President(this is the only association). The Feds are made up of multiple banks(that helped get us into this crisis in the first place). I believe(don't quote me on this) that the feds have already overspent thier budget which means they had to print money out of thin air to provide this deal. The tax payers will end up fronting this, if your a phd then you will know that the tax payers get hit with low value of the dollar and the spending of the government. The bill always comes back on the tax payers. I am curious how the banks can bail themselves out with money they don't have. The money they don't have is comes out of nowhere(inflation) or comes from our pocket book for prices on commodities. The Fed is a joke and should have never been invoked. All the fed does is create bubble after bubble after bubble until it keeps getting so big that it is going to hurt really bad when it explodes. Why do people even get payed to write articles like these? This is enough to make baby Jesus cry.

  • Paul - Wednesday, April 9, 2008, 10:18AM ET  Report Abuse

    • Overall: 4/5

    monicas_kleenex, the shares JPM owns do not give it any power over the decisions of the Fed. That's not how these shares work. They can't sell them, lend them or pledge them as security. They can't use them to vote on Fed actions. They can't use them to vote for a hike or cut in the Fed Funds rate.

  • Jim - Wednesday, April 9, 2008, 10:13AM ET  Report Abuse

    • Overall: 5/5

    beefeatervegan, the Federal Reserve does not borrow money from overseas. They have their own and can create more if needed.

  • BradleyD - Wednesday, April 9, 2008, 8:28AM ET  Report Abuse

    • Overall: 5/5

    Jeremy is not perfect, but his alright with me on most accounts. This writing it no exception.

  • Yahoo! Finance User - Wednesday, April 9, 2008, 6:14AM ET  Report Abuse

    • Overall: 1/5

    If you want the truth, see John Hussman's articles at www.hussmanfunds.com. Always a good weekly read. Additionally, I'd recommend Nouriel Roubini at http://www.rgemonitor.com/blog/roubini

  • omar - Wednesday, April 9, 2008, 3:00AM ET  Report Abuse

    • Overall: 1/5

    Readers, please do not trust this author Jeremy Siegel. He is a shill for the Fed and Wall Street. Look at his concluding paragraph. He states, "The Fed did not bail out Bear at taxpayer expense, but enabled - as it is mandated - the financial markets to continue to function." The conclusion of an article is supposed to summarize the body of the article. Where in the article did he explain how the Fed's move "enabled the markets to continue to function"? And another thing, this is NOT the Fed's mandate. If you research the Fed's mandate, it is to provide price stability and to maximize employment (which they are failing on both counts, by the way). If you do more research, you will find that JP Morgan is one of the Fed's largest shareholders. So when you hear that JP Morgan worked with the Fed, you can interpret that as JP Morgan was working with JP Morgan to swallow up a competitor (Bear) for pennies on the dollar. People, please don't take my word for this. It's all out there for anyone smart enough to connect the dots. The Fed is out of control and is acting like a communist or fascist organization, where government and business are one in the same. Please connect the dots, people. The United States of America is quickly becoming the USSA - The Un-united Socialist States of America.

  • ag - Wednesday, April 9, 2008, 12:42AM ET  Report Abuse

    • Overall: 5/5

    On this analysis, the Fed stabilized the market and has a good chance at making a tidy profit. Sounds like a good deal for everyone except the Bear stockholders (maybe them too?!?). Of course, it is a shame that Bear management leveraged up so much without having matched, secure funding in place.

  • sportsfan - Tuesday, April 8, 2008, 10:39PM ET  Report Abuse

    • Overall: 5/5

    I think this guy is one of two guys in the world I would trust to handle every single dollar i have and say "here, invest it". I agree with everything he says. He writes logically and simply, and cuts all the bull away. His books are fantastic. Again, he is right on with Bear Stearns. The government will make money on this deal.

  • beefeatervegan - Tuesday, April 8, 2008, 6:10PM ET  Report Abuse

    • Overall: 1/5

    The good doctor is being somewhat obtuse.The Fed did loan almost 30 billion dollars on this deal,but also had to borrow that money from overseas.The fed loaned it out at 2.75% but borrowed it at a higher percentage.Who pays the spread?All obligations for this deal become the responsibility of the American taxpayer.Thats why its called the public debt, which by the way is around 10 trillion dollars.

  • Steve - Tuesday, April 8, 2008, 6:07PM ET  Report Abuse

    • Overall: 4/5

    I appreciated Siegel's comments. I was pretty dissapointed the Fed stepped in here but when you examine what they did (essentially valued Bear at 5% of prior) and set themselves up to profit on the deal, I don't have the issues anymore. In this whole mess I take greater umbrage with Suzy and Johnny Homeowner who greedily borrowed and lived the good life while foks like me cmahioned living within your means and got dismissed. Smart people (some family members) tried to tell me not to worry. "HELOC's are great emergency money or a source to improve your home" they said. Now all those dolts expect me to pony up (via government bailouts) when I was the one disciplined enough to live within my means. What a bunch of children. There is no excuse for such foolishness. It doesn't take an MBA to realize that if you borrow someone else money you need to understand how it works.

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