More on The Federal Reserve's St. Patrick's Day Massacre (The Bear Stearns Takeover)

Two days ago, I wrote here on the widely-reported $30 billion loan that the Federal Reserve made as part of brokering the acquisition of the Bear Stearns Companies by JP Morgan Chase (the "St. Patrick's Day Massacre").

I now have much more information on what this deal is all about. I guessed quite wrong about the deal structure. The $30 billion loan is not a term repo as I originally thought. Nor is it likely to generate monetary losses for taxpayers. (In fact, the opposite is true.)

But it is something bold and different that's worth understanding. In fact, it's a major milestone event in the monetary and financial history of the United States.

Before I launch into this, let me set the context by reminding you why all this financial mumbo-jumbo is important: it's because of politics. Even before the full effects of the credit crisis make themselves felt, we're already deeply into a paroxysm of "the sky is falling! What is the government going to do about it?" I'll be posting as much as I can on this subject in the coming days and weeks, because there is at least as much danger to the real economy from a mad dash toward new regulations and Federal involvement, as there is from the financial-system disorders themselves.

Keep reading...Some of my information comes from this somewhat-cryptic press release by the Federal Reserve Bank of New York, and some from private sources.

During the critical days of March 14, 15, and 16, while Morgan was madly trying to discern the outlines of what they were being asked to buy, they identified a portfolio of assets that they were not willing to finance. They asked for the Fed's help in guaranteeing the value of the portfolio. Several accounts agree that Bear Stearns hurriedly marked this portfolio to market as of March 14, producing a valuation of $30 billion, and the Fed agreed to lend this money to Morgan as a condition of agreeing to the acquisition.

Relatedly, it appears that the Fed (both the Reserve Board in Washington and the New York Fed that directly participated in the negotiations) was involved heavily in setting the lowball price of $2/share offered to Bear Stearns shareholders. (In interviews, Morgan CEO Jamie Dimon will only say that "a lot of factors were involved.") The Fed knew very, very well that the Bear deal would be perceived as a government bailout of a Wall Street firm, so they went out of their way to ensure a smackdown of Bear's shareholders.

How the public sees this is one thing. (The mendacious news media have done nothing to dispel the impression that the fatcats made out like bandits.) Much more importantly, however, the Fed sent Wall Streeters a brutally clear warning not to expect that they will be made whole the next time they get into trouble. The sight of Jimmy Cayne going from near-billionaire to 60-millionaire in just over a year will keep a lot of plutocrats under control for a long time to come.

At any rate, the Fed's $30 billion loan was announced as part of the acquisition on the evening of March 16 in New York. Over the following week, everyone got a chance to catch his breath and re-examine the asset portfolio that was guaranteed by the loan. And as a result, the Fed restructured that transaction. They announced the restructuring on March 24, and this is where things get really interesting.

The New York Fed has created a new limited-liability company, and they hired BlackRock Financial Management to run it. (BlackRock, the division of Merrill Lynch Investment Managers, not BlackStone, the publicly-owned private-equity firm.)

The New York Fed lent $29 billion to the new LLC, for a term of 10 years, which may be renewed at the Fed's option. Morgan put in $1 billion, in the form of a subordinated note. This is a key feature of the re-structured March 24 transaction, since in the original March 16 deal, the Fed was going to speak to the whole $30 billion.

The LLC will use the loan proceeds to acquire the Bear asset portfolio. And they plan to sell out the assets gradually as market conditions improve, over the next ten years or less.

Morgan's $1 billion note will take the first losses on the portfolio, if there are any. In essence, Morgan owns a 10-year call-spread on the deal, long at $29 billion and short at $30 billion. The first people to be paid out (after the LLC's operating expenses) will be the Fed. They get back their $29 billion, plus interest at the discount-window rate.

After the Fed get their money back with interest, Morgan will get back their $1 billion, plus interest at a rate equal to the Fed's discount rate plus 450 basis points (totalling 7% at the moment). That's the most that Morgan can make on the deal. Anything left after the principal and interest payments all goes to the Fed.

Depending on the liquidation value of the portfolio (which in turn depends on the original valuation and future market conditions), the New York Fed stands to make a significant amount of money here, well beyond their $29 billion investment.

Now there is still a big question mark: no one I've corresponded with knows for sure what the composition of the asset portfolio actually is. It appears to be a mixture of residential and commercial mortgage-backed securities, some with agency guarantees and some without.

And here is the key thing that makes this different from anything the Fed has ever done: the deal is essentially a trade. The New York Fed has funded the purchase of assets for a significant amount of time, in the full expectation that they will make a profit.

This is exactly the kind of deal that private actors like Bill Gross and Warren Buffett have been eyeing for months now. We do not know the specifics of the mark-to-market that Bear applied to the portfolio on March 14. It would be exceptionally interesting to know if they valued parts of it at 95 cents on the dollar, 70 cents, or somewhere else. Because the Fed's ratification of that valuation would put a floor under the MBS market as a whole, and potentially go a very long way toward resolving the overall credit crisis.

On the other hand, the New York Fed are very savvy traders. If they intend to make a profit with this vehicle, they don't necessarily want people to know their basis.

The transaction has been described by several of my correspondents as essentially a SIV ("structured investment vehicle"). This description strikes me as only superficially valid. A traditional SIV is dependent on continuous access to short-term repo funding, at low enough interest rates to finance the long-term paper held by the SIV. It therefore faces significant market and liquidity risk as interest rates move up and down.

I don't think the Fed's new LLC faces any risk that they will lose their short-term funding. (Even though there is mysterious language in the Fed's press release about an obligation of the LLC to pay the Fed interest at the current discount rate.) If anything, this is more like a hedge fund or a private equity fund than a SIV. I'd like to know if BlackRock got the standard two-and-twenty compensation structure for managing the vehicle.

To sum up, the New York Fed has entered the market for mortgage-backed securities as a direct participant, going far beyond their traditional role as a lender of last resort. This is a deeply significant and historic change, destined to have major repercussions. I've heard much apprehension and outright fear about the ultimate results, but so far, no one has been able to predict what they might be.

And in addition, many are questioning whether it needed to be done at all. In the days between March 16 and March 24, the Fed opened up its discount window to investment banks and broker-dealers. Some people believe the $30 billion probably could have been funded in the normal repo market after March 17, making the new 10-year LLC unnecessary. I'm not convinced of that.

Much of the general public is still going to react to this story as if the Fed has wantonly and illegally flushed $30 billion in tax money down the toilet. This sweet delusion will continue as long as the media can use it to sell fishwrap.

Forget about that. The real question, and the real danger, is: have the Fed embarked on an eyes-open strategy of direct participation in financial markets that will have extraordinary consequences?

And I’ll repost it, again....though you claim it was posted before.

Face it....you and your buddies lie AND DEFEND EACH OTHERS’ chronic misrepresentations and lies about others that you disagree with.

There is NO post, where I said anything resembling anything like, “The Fed buys bonds every time they want to boost the money supply. According to nic they get the money to do that out of the general tax fund,” AS YOUR BUDDY CLAIMED.

There is NO POST where I ever spoke to the Fed buying bonds.
There is NO post to where I ever stated that the Fed buys bonds to “boost the money supply.”
There is NO post where I ever stated from where the Fed “gets the money to boost the supply of money.”
And there is NO post where I ever made any statement concerning “the general tax fund.”

Face it.....he LIED and you’re defending him for doing so.

*YAWN*

See what I mean? You avoid the simplest of questions--I mean, if you had lied about me in such an egregious fashion that I was still whining about it, I'd at least remember the subject matter. The above is why people don't take you seriously.

I also meant to ask you about that Impeach Bush petition, where did you find it. Were you simply, and frantically, googling Bear+Stearns+bailout+evil? Did you read it before you posted it?

What was your take on that stupid question, the one regarding the taxpayers footing the $29B? Was it his, or did he just post something he found on the 'net?

It's all over the net. Not surprising our own idiots fell for it.

Yes...it's obvious. Your buddy made something up, which I requoted to you in its entirety, and which, despite that fact, you now claim I don't recall the subject matter. FOFLMAO. The very subject matter was the statement I posted to you. And you don't understand why I say that you and your buddies are liars...and defend each other for each other's lies and chronic misrepresentations of others' posts.

I know exactly where I got the information contained about the illegality and bribery...which information did not state "impeach Bush" which I posted in FR...nevertheless, you'd rather comment on what I DIDN'T post...than on something I did post....just like your buddies.

Well, I think it was Petronski who pointed out that it appears to be the meme. The reason I’m asking is because I’m trying to get into the mindset of someone who posts something that is demonstrably false (I’m not the expert on this bailout by a long shot—is it?), and instead of simply acknowledging that fact and proceeding, starting to complain that others are placing words in his mouth. I didn’t even do that as a kid.

And here's another example of your inability to answer a simple question, "I know exactly where I got the information contained about the illegality and bribery . . . ."

I didn't ask you if you knew where you found it. I asked you where you found it. See the difference? I'm afraid not, but I remain an idealist.

You have implied not once but TWICE that the Federal Reserve's open market operations affects the general tax fund. But when we ask you how you claim you never said that and that we are all liars. I don't know how to deal with that.

It's like being up at bat and the pitcher throws the ball behind my back on every pitch but the umpire keeps calling them strikes. What're ya gonna do?

Let the spectators decide.

I don't remember if we've ever really crossed paths on FR, but nic really, really wants me to denounce you as a liar. So please let me take this opportunity to thank you, he's probably on his third or fourth bottle of bourbon by now, and making a complete fool of himself.

That’s because nic has been caught with his tongue in the freezer and he really, really wants to try to save face somehow. Congratulations that he would seek out your approval of his judgement. You must have a profound effect on him - even more so than the bourbon.

One of your latest lies? The following:

You can't post something that you find on the 'net in some Democrat swamp like DU or IndyMedia, such as you did with that petition to impeach, and expect to be taken seriously in any other regard.

What I posted was neither from DU nor IndyMedia, nor any kind of "democrat swamp," and neither did what I post contain the words "petition to impeach"....contrary to your claims.

As far as previous lies that have been made up against me...another occurred just this past week, also by groanup, on a thread to which you posted, and to which you were commented to. You flatter yourself if you truly think any of you are worth the time required saving the voluminous times that you all mischaracterize/misrepresent/or outright lie about things I and/or others state.

I could care less who you denounce.

The fact remains, however, that you are friends with people who lie, mischaracterize, and/or misrepresent other posters’ statements...and defend them for doing so.

And that is why many find you and your kind beneath contempt....and why I could care less what you and your ilk think, on pretty much anything.

You have implied not once but TWICE that the Federal Reserve's open market operations affects the general tax fund.

Um. Wrong.

I've NEVER commented on the Federal Reserve's "general tax fund" EVER...except to repeatedly tell you, I've Never commented on the "general tax fund."

I've NEVER commented on the Federal Reserve's "open market operations" EVER.

I've NEVER commented on how or what "affects" the "Federal Reserve's open market operations" EVER.

Therefore, there can be no IMPLICATIONS NOR INFERENCES made about something I never said.....except that you continue to lie, concoct words and ideas of your own and by your own machinations and attribute them to me.

. . . and why I could care less what you and your ilk think, on pretty much anything.

Sorry, nic . . . but a pet peeve of mine. You meant to type that you could not care less. You just told me that you care, and seeing that you pinged me to this thread to tell me you do not just isn't very intellectually sound.

My pet peeve concerns dishonesty, misrepresentations, and mischaracterizations....not typos.

But, as regards typos and/or grammar errors, that is about the only time I ever see that you and your ilk are consistently genuine about your concern, or its enforcement, valid content or context be damned.

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