Helicopter Ben To The Rescue

There's something really weird on the radio tonight: sounds like Holst meets Gershwin....

Anyway, there's obviously a lot of news about the bail-out of Bear Stearns, and I'd like to chime into the chorus with a view that'll be anathema to some and gospel to others -- it wasn't a bail-out.

I repeat: it wasn't a bail-out.

This time last week Bear Stearns's stock price was $75/sh -- today it spiked up to $6. Shareholders and employees of B.S. (my, what an unfortunate set of initials!) have taken it in the shorts -- we're talking about livelihoods lost, retirements ruined, portfolios smashed. No-one with an interest in Bear Stearns's success was helped one iota by the Fed's actions. We'll see if their CEO keeps his shirt when the civil suits are finished with him, but anyway....

The phrase to keep in mind is "counterparty risk". I'll circle back to that in a second, but basically we should regard the derivative markets (literally: where an asset is created that derives its value from the value of some other asset according to fixed rules) as a ticking time-bomb, and Helicopter Ben's trying like mad to cut the right wires. There are all kinds of examples that one could give, like options, futures, options on futures, etc. all the way up to 6th-level arcana like convexity-swaps, but the point can be made via garden-variety short-selling. When you sell a stock short, you borrow the instrument in question and sell it, creating an IOU to the holder of the stock that you have to make good on, hopefully by buying the stock back at a lower price. Nowadays the exchanges make short-sales very easy (depending on which exchange and under what rules, they may not even have to borrow the stock any more, but let's pretend they still do). If we had to enter into these stock-lending arrangements on our own, very few short-sales would happen, because let's face it: good intentions don't count when you're talking about seriously real amounts of moolah. The reason that any short-sales actually happen is because someone takes the role of a "market maker", which they do not only by having a big building and lots of account numbers, but also by assuming the counterparty risk of the market's participants. So if you loan me 5,000 shares of Microsloth so I can sell them short, but it turns out that Vista SP2 is such a rampaging success that Richard Stallman does a public-service TV commercial for them, you don't have to worry that I've just lost my shirt and can't get you your shares back -- the market maker will make you whole and then will send guys with violin cases to collect from me.

Although Bear Stearns was a smaller player among "the big guys" on Wall Street, it held bazillions of financial instruments, all of which had "in case of bozo, see Bear Stearns to be made whole" metaphorically stencilled upon the back of them. We all know how much "bozo" there has been to go around in so far as exposure to the sub-prime lending debacle goes -- it's been sorely straining market-makers to the point that the Fed has had to reinvent its product-line to keep banks upright. But Bear Stearns was not only a market-maker for a lot of those instruments, but also took highly-leveraged positions in this toxic-waste market itself! In its greed it nuked itself ... and their shareholders have gotten creamed for it; wham-bam-thank-you-ma'am, they're outta there.

What Bernanke just engineered was not merely a face-saving gesture so that the Wall Street Journal didn't have "BEAR STEARNS BANKRUPT!" plastered across its front page; Bernanke in fact just saved the commercial banking system from a run on it that would have made Black Monday (which was when Russia said "you know all those pesky bond-things y'all are holding that you think we're going to pay back, uh, I wouldn't go using them as collateral for any assets you care about") look like a walk in the park by comparison. All of those we-owe-you's that Bear Stearns has floating around would have had their status's changed from "it's Bear Stearns, of course they're good" to "I wonder how much I'll have left once the bankruptcy judge's finished with 'em". You and I don't normally pay too much attention to the solvency of our local banks, because unless we've got an account with over $100,000 in it (Mother May I?), the FDIC will make us whole in case our bank goes bozo. But most of the modern banking system isn't part of the FDIC, so if Bear Stearns had been allowed to go toes-up, there would have been tens of thousands of people with big smoking craters where there wallets had just been, and the rest of the already-skiddish commercial-banking customers would have gone "holy fucking shit on a horseshoe, Jack, I'm cashing out my account like mucho-pronto". This would have not only have led to the complete destruction of what reserves the banking system has left, but would have killed the extension of credit to anyone, no matter how good their FICO score. Imagine most of the world trying to cash out their dollar-based derivatives -- most of them being highly leveraged affairs. Next to "bloodbath" in the OED would be the phrase "300 trillion notional dollars in assets cutting their prices in competition for 1.4 trillion dollars of hard currency". Total nightmare -- you'd be able to buy a Lexus for a thousand dollars, but you'd be too shit-scared to take anyone up on the deal. Normally a bank won't call (demand immediate repayment) a mortgage with a loan-to-value ration less than 80%, but under that kind of scenario, what do you think your house would be worth? With all of its creditors suddenly turned into jackals, how long would your employer keep the lights on? Bad. Bad bad bad.

Instead, J.P. Morgan has "bought" Bear Stearns for a price so ridiculously low that you might as well consider it an administration-fee, and the Federal Reserve has guaranteed all $30B of Bear Stearns's outstanding obligations.

Bailout? Nah, I call it salvation.