Debate Over Bear Stearns: Hussman vs. Mauldin

Let's take a look at both sides of the Bear Stearns debate. On March 17 John Mauldin wrote Let's Get Real About Bear.

I already have a slew of emails from people upset about what they see as a bailout of a big bank, decrying the lack of "moral hazard." And I can understand the sentiment, as it appears that tax-payer money may have been used to bail out a big Wall Street bank that acted recklessly in the subprime mortgage markets.

But that is not what has happened. This is not a bailout. The shareholders at Bear have been essentially wiped out. Note that a third of the shares of Bear were owned by Bear employees. Many of them have seen a lifetime of work and savings wiped out, and their jobs may be at risk, even if they had no connection with the actual events which caused the crisis at Bear. Don't tell them there was no moral hazard.

For all intents and purposes, Bear would have been bankrupt this morning. The $2 a share offer is simply to keep Bear from having to declare bankruptcy which would mean a long, drawn out process and would have precipitated a crisis of unimaginable proportions. Cue the lawyers.

If it was 2005, Bear would have been allowed to collapse, as the system back then could deal with it, as it did with REFCO. But it is not 2005. We are in a credit crisis, a perfect storm, which is of unprecedented proportions. If Bear had not been put into sounds hands and provided solvency and liquidity, the credit markets would simply have frozen this morning. As in ground to a halt. Hit the wall. The end of the world, impossible to fathom how to get out of it type of event.

The stock market would have crashed by 20% or more, maybe a lot more. It would have made Black Monday in 1987 look like a picnic. We would have seen tens of trillions of dollars wiped out in equity holdings all over the world.

As I have been writing, the Fed gets it. Their action today is actually re-assuring. .... Allowing the boat to sink is not an option. And get this. You are in the boat, whether you realize it or not. You and your friends and neighbors and families. Whether you are in Europe or in Asia, you would have been hurt by a failure to act by the Fed. Everything is connected in a globalized world. Without the actions taken by the Fed, the soft depression that many have thought would be the eventual outcome of the huge build-up of debt would in fact become a reality. And more quickly than you could imagine.

On March 24, John Hussman took the other side of this debate in Why is Bear Stearns Trading at $6 Instead of $2?

Bear Stearns is trading at $6 instead of $2 because unelected bureaucrats went beyond their legal mandates, delivered a windfall to a single private company at public expense, entered agreements that violate the public trust, and created a situation where even if the bureaucratic malfeasance stands, the shareholders of Bear Stearns will either reject the deal or be deprived of their right to determine the fate of the company they own. Very simply, Bear Stearns is still in play. Still, when all is said and done, my own impression is that the ultimate value of the stock will not be $2, but exactly zero.

In effect, the Federal Reserve decided last week to overstep its legal boundaries – going beyond providing liquidity to the banking system and attempting to ensure the solvency of a non-bank entity. Specifically, the Fed agreed to provide a $30 billion “non-recourse loan” to J.P. Morgan, secured only by the worst tranche of Bear Stearns' mortgage debt. But the bank – J.P. Morgan – was in no financial trouble. Instead, it was effectively offered a subsidy by the Fed at public expense. Rick Santelli of CNBC is exactly right. If this is how the U.S. government is going to operate in a democratic, free-market society, “we might as well put a hammer and sickle on the flag.”

The Fed did not act to save a bank, but to enrich one. Congress has the power to appropriate resources for such a deal by the representative will of the people – the Fed does not, even under Depression era banking laws. The “loan” falls outside of Section 13-3 of the Federal Reserve Act, because it is not in fact a loan to either Bear Stearns or J.P. Morgan. Bear Stearns is no longer a business entity under this agreement. And if the fiction that this is a “loan” to J.P. Morgan was true, J.P. Morgan would be obligated to pay it back, period. The only point at which the value of the “collateral” would become an issue would be in the event that J.P. Morgan itself was to fail. No, this is not a loan. It is a put option granted by the Fed to J.P. Morgan on a basket of toxic securities. And it is not legal.

The Fed overstepped and the Treasury overstepped. At the point where unelected bureaucrats pick and choose who to subsidize – who prospers and who perishes – in a free capital market, and use public funds to do it, more is at risk than just $30 billion. Instead, we cross a line, and stumble off a very clear edge down an interminably slippery slope. We speak up now, or forever hold our peace.

This morning JPMorgan Raises Bear Stearns Bid to Woo Shareholders.

JPMorgan Chase & Co. agreed to quadruple its offer for Bear Stearns Cos. in an effort to overcome opposition from shareholders of the crippled securities firm. Bear Stearns stock almost doubled.

The original bid, more than 90 percent lower than the securities firm's market value at the start of the month, drew opposition from shareholders led by U.K. billionaire Joseph Lewis. Dimon met with Bear Stearns employees to seek their support last week.

"Finding a counterbidder is attractive but a lot more difficult," the Sunday Telegraph cited Lewis as saying in a report yesterday. "There are two ways to block the deal: first by a shareholder no vote and second by litigation. We should be able to block the deal by one of these ways."

The Fed adjusted its financial support today, the two firms said. JPMorgan will now be responsible for the first $1 billion of potential losses from the sale of Bear Stearns assets, while the Fed will fund the remaining $29 billion.

How To Get The Needed Votes

There are no ways to block the sale. The above article goes on to say "Bear Stearns will issue 95 million new shares without seeking shareholder approval. Dimon will need only an additional 10 percent of shareholders to approve the takeover."

If management wants to do a deal, it seems there is very little anyone can do to block it. And the key fact remains that this deal still stinks to high heavens whether or not the transaction price is $2 or $10. Not only were existing shareholders deprived of rights to reject the deal, JP Morgan and the bondholders should be the ones taking risk, not the Fed and not taxpayers.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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