Bear Stearns...Not A Bailout

Unless you have been living under a rock for the past week, you have undoubtedly heard about the mess at Bear Stearns: their CEO proclaiming things were fine on CNBC, experiencing a liquidity crunch/good old-fashioned bank run on their assets, and finally the Fed-orchestrated JP Morgan Chase buyout for the princely sum of...$2...down from $170 a year ago and around $60 at Thursday's close. The important thing to understand here though is that, despite the non-recourse loan given to JPM by the Fed, this was not a "bailout."

Consider the following: Bear was counterparty to $13 trillion in various derivative contracts. To put this number into perspective, the GDP of the United States is approximately $13 trillion. So what does this mean? If you were a hedge fund, or really any kind of brokerage client of Bear Stearns, and you chose to to purchase/write some kind of derivative, Bear would take the other side of your desired trade as a service to you, and in attempt to make money. If Bear Stearns were to go bankrupt, any derivative trades that were held in your name would then no longer be valid. This would mean that $13 trillion in assets would be wiped to slightly below the stock price of Bear. This would undoubtedly lead to a wave of bankruptcies and destroyed wealth, as worthless investments on hundreds, even thousands, of leveraged balance sheets are wont to do.

But wouldn't SIPC (Securities Investment Protections Corporation) help? They only cover up to $500,000 worth of cash and investments in the case of a brokerage failure. Also, to my knowledge, this would not include the more exotic derivatives such as swaps. I'm not sure about more vanilla derivatives such as simple put/call options.

But how was Fed involvement, namely the $30 billion non-recourse financing to JPM, not a bailout of Bear Stearns? Because it was more like an orderly liquidation, whereby JPM was given an incentive to bring Bear's liabilities onto their own balance sheet, ensuring that a wave of panic and bankruptcies would not submerge Wall Street. Despite the objections by BSC shareholders that the company should go bankrupt so that they have a chance at more than the measly $2 of JPM stock, the reality is that preventing collapse of the U.S., perhaps even global, financial markets takes precedence, not to mention the fact that shareholders are last in a long line of creditors to receive anything in the event of a bankruptcy (read: be glad you are even getting $2).

While some might say that free market economics, of which I consider myself a follower, dictates that failures should be allowed to fail, and that the markets will deal with the aftermath, I believe that no one would benefit from the markets trying to deal with such a massive amount of vaporized assets. There are some occasions where the government, or a goverment entity, must act in order to prevent chaos. I believe this is one of those rare times. By orchestrating the takeover of Bear Stearns, I think the Fed has rightly avoided a potential catastrophe.