Its not easy to understand as a layperson but the Fed action was not only necessary but it was fairly brilliantly executed.
(For those who want to return to the gold standard and want to argue about whether or not the Fed is constitutional or even really exists, please just continue on since I will only aggravate you.)
Bear Stearns collapse occurred in a matter of hours and not days. Bear Stearns assets were not the problem as much as Bear Stearns was a partner in subprime assets which had OTHER partners who wanted out. In order to prevent the liquidation of these assets, Bear either had to come up with the funds to buy out the departing clients OR get the best deal they could for the assets and then use their cash liquidity to cover the shortfall. This news gets around that some large hedge funds are dumping these subprime assets (no news yet on who first bailed and who then heard about it and then bailed, but that will be very, very interesting to learn). Bear didn’t have depositor clients bailing on them the first day. They had co-creditors who abrupted changed direction on them. They lost $20B in liquidity in about one day.
When news hit big players on the Street about this, they probably started spreading the news and within a matter of hours large accounts at Bear were demanding to be liquidated. Bear ran out of cash to cover these on Friday and that news caused even MORE account holders to demand to be liquidated. The Fed came onto the scene on Thursday when the first liquidity news came from the co-creditor problems. Bear announced to the Fed & SEC that they would have to consider Chap 11 to avoid collapse because their liquidity was depleted and they were starting to stack up requests of account holders to withdraw their funds (which meant liquidated a variety of positions for Bear now that their cash was used up.)
The Fed started looking into how to keep Bear alive until the weekend so they put out word to other large brokerages that Bear was in trouble and needed help (ie, fire sale notice). Had all this occurred on a Monday, Bear would have been in bankrupcty court and the market could have lost 1000 points and consumers watched half a trillion dollars in assets suddenly become valueless in the short term. Fortunately, the weekend came where nobody could act formally. And the Fed assign Bob Steele to work with the NY Fed Governor to arrange access for Bear to the discount window which is normally reserved only for depository banks like Chase, BofA or WAMU.
In order to secure the debt, Steele facilitated the essential takeover/sale of Bear by one of the other big five brokerages to ensure that the taxpayers funds would be managed correctly and repaid timely. It was clear that Bear wouldn’t last a full day on the open market that Monday so something had to happen before then. All of the other firms were able to make offers but JP was apparently best able and most willing to take on the discounted assets and assume the debt. And Jamie Dimon, the new head of JP, is considered almost universally to be incredibly sharp so the Fed, the SEC and Treasury blessed the lending of $29B to Bear if they agreed to a buyout by JP who would then back the funds for taxpayers.
There is an allegation in the WSJ that the Fed actually negotiated the price of the sale. But the Fed, NY Fed Gov and Treasury all deny this occurred (especially since that would be illegal). Whether they did or not, they pulled out some major league M&A within 72 hours and prevent a complete collapse of virtually every asset class that Bear was invested in.
To give a layperson an idea of what would happen if Bear collapsed (and this isn’t a complete list by any stretch so others like businessprofessor could add to the destruction), just think of all the companies, bank, commodies, mutual funds and indexes which Bear held in its $300B in holdings. If they needed to immediately sell the $400M they held in WalMart stock, for instance, the 80,000,000 shared they would need to dump on the market might push the price from $55 down to $30. If you, as an individual investor, owned WMT then you just lost nearly 50% of your stake. Instantly. And if you own a mutual fund or index fund, virtually every one in existence owns at large some WMT stock and those all take a hit.
And when Walmart (WMT) starts going down, hedge funds start pulling out of it as quickly as they start seeing the fall which pushes it down further. And trading desks have automatic trade software which triggers SELL orders as soon as a particular stock they own goes down by a certain percent within a specific amount of time (ie, 10% within 1 hour, which indicates panic selling) and those triggers push the stock price down further and faster which trigger even more people to want to get out before it hits $0.
And the equities are the ones which can take the beating easiest. Consider real estate holdings. You can’t liquidate a home in 24 hours, or even 30 days. So if you have $100M in home mortgages you need to liquidate you either have to find some other financial institution or private investment fund to buy your portfolio of loans. On short notice, you are looking at getting at little as $80M for those mortgages if they are all goldplated. So you just lost another $20M just to turn your loans into cash which is worse than the rate you get at a check cashing store or a loan shark. Even those machines at the supermarkets which count your change for you charge only 9%. And if your loans aren’t gold plated, well....
In the local real estate market where these homes exist, they now have a new owner who is a loan servicer and has no authority or interest in doing any renegotiating if you get into trouble as a homeowner. These loans are then more likely to go from delinquent into foreclosure. And that drives down the average home price in that neighborhood in the tens of percentages in comparable value (ie, your home just lost 10-30% in value when you need to appraise it for a loan or for sale).
Since the entire society is built on credit - the offering of for profit and the borrowing of money, when the assets which collateralize these loans or mortgages become far less valuable it creates essentially a more risky loan. And when existing loans are becoming risky, new loans either don’t get made or the newer loans get made at far higher interest rates or for far more onerous terms. Your mortgage offer gets uglier and your credit card interest rates go up.
So, in short, the Fed just saved your bacon. All of our bacon. And the arguments about Moral Hazard are nice as long as we agree that the collapse of the financial markets is not considered a good outcome just so we can all learn the right lessons from this. I can promise you that no financial firm in existence thinks that Bear Stearns dodged the bullet. Bear Stearns is dead. They were killed last weekend. They ARE the moral hazard for failing to securitize their assets safely. Nobody wants to become the next Bear just so they can get loans from the Fed.
Congress now has the responsibility (God help us) to decide whether the Fed should allow non-depository institutions access to the Fed window as a regular regulating function. I’ll not offer an opinion on that since I’ve said enough already.
Although the unpleasant truth in your scenario is that if a WMT can be taken down 50% by any concatenation of circumstances, it probably deserves to be, though that would require a frank acceptance of just how overpriced the markets have gotten and no one is willing to engage in that.
So you vote for fascism, cronyism, and bailouts by taxpayer dollars ?
We deserve what we get - it’s no wonder our leaders are so corrupt. All the people want is to be given a lollipop and a pat on the head before going back to sleep to get fleeced by the “elite”.
Very interesting, thanks!
So after I panicked when Citi was at its lowest, we decided to keep it. It's coming back up now.
As far as using WAL*Mart as your "example", I don't think they'd dump THAT stock..cuz I fully expect that if we colonize the Moon, the first store on it will be a Wal Mart! :)
sw
well stated.