It’s been a long time since I’ve thought about the JP Morgan/Bear Stearns shotgun wedding (see Rescue for Bear? and Rescue Update for background). Back when I wrote those blog entries, I wondered aloud whether, in addition to preventing Bear’s collapse, the Fed also orchestrated a backdoor bailout of JP Morgan in the process.
Anyhow, as part and parcel of the JP Morgan/Bear Stearns deal, the Fed acquired a host of assets that were packaged into what would become known as the Maiden Lane portfolio. The Maiden Lane portfolio housed approximately $30B “worth” of assets, with JP Morgan agreeing to assume the first $1B in losses associated with the portfolio, and the Fed assuming any losses thereafter.
Last week an interesting article in Bloomberg questioned when the Fed knew about the poor quality of the assets it acquired in the Maiden Lane deal, and how it communicated what it knew about those assets (see Fed Made Taxpayers Unwitting Junk-Bond Buyers).
According to Bloomberg:
Federal Reserve Chairman Ben S. Bernanke and then-New York Fed President Timothy Geithner told senators on April 3, 2008, that the tens of billions of dollars in “assets” the government agreed to purchase in the rescue of Bear Stearns Cos. were “investment-grade.” They didn’t share everything the Fed knew about the money.
The so-called assets included collateralized debt obligations and mortgage-backed bonds…that were so distressed, more than $40 million already had been reduced to less than investment-grade by the time the central bankers testified.
At the time Maiden Lane was created, the Fed claims that the assets were solid, credit-worthy, and investment grade.
“As was noted in testimony, all of the cash securities in the Maiden Lane portfolio were investment grade on March 14, 2008, when the deal was agreed to in order to facilitate the acquisition of Bear Stearns and to prevent the systemic consequences of its sudden and disorderly failure,” Michelle Smith, a spokeswoman for the Fed’s Board of Governors, said in an e-mail.
“The Federal Reserve considered not just credit-rating valuations, which have varied some over time based on economic conditions, but also relied on a separate assessment from an independent investment firm, which advised us that over time, we would likely fully recover our principal and interest,” Smith said. “We continue to expect the loan to Maiden Lane to be fully repaid.”
“You’ve got about $30 billion of collateral. And some comments have been made that you feel comfortable because it’s highly rated,” Senator Jack Reed, a Rhode Island Democrat, told Bernanke, according to a transcript. “But a lot of highly rated collateral these days is being subject to questions.”
“Senator, as was mentioned, it is all investment-grade or current performing assets,” Bernanke responded. “We do not know for sure what will transpire,” he said. “But we have engaged an independent investment-advisory firm who gives us reasonable comfort that if we can sell these assets over a period of time that we will recover principal and interest for the American taxpayer.”
That was then. This is now:
More than 88 percent of Maiden Lane’s CDO bonds and 78 percent of its non-agency residential mortgage-backed debt are now speculative grade, according to data compiled by Bloomberg based on holdings as of Jan. 29.
Casablanca moment: I’m shocked, shocked…
Needless to say, I’ve been stewing over that article for the better part of a week now, and several thoughts came to mind:
- The Fed was fleeced. It was in over its head – unable, and unequipped, to properly value extremely complex derivatives – and as a result, was on the wrong side of the Maiden Lane trade.
- The Fed knew best. It was a liquidity problem and not a solvency problem. The Fed bought assets that no other party was willing to buy because potentially interested parties were scared (wrongly pricing Armageddon). The assets still had value and the Fed paid a fair price. To its credit, even the CBO estimates that the Fed will end up realizing a $200 million return on its Maiden Lane investment. So the Fed was on the right side of the trade.
- It doesn’t matter whether the Fed made a good or bad trade. It failed to properly disclose information about the true state of the Maiden Lane assets. That is, the Fed knew that the assets were largely junk but bought the assets anyway in an effort to wind Bear down in an orderly manner and stave off the risk of a systemic collapse.
I hope the answer doesn’t lie behind Door #1. It oughtn’t. There are some pretty sharp minds at the Fed, so I highly doubt they got taken. If the Fed executed a horrible trade, then how could it possibly be seen as a credible central bank, especially in light of the increased regulatory powers that the financial reform bill looks set to grant it? And as Kevin Warsh stressed in a recent speech: “The Fed’s institutional credibility is its most valuable asset…”
I am also skeptical that the answer lies behind Door #2. I keep coming back to the absence of suitors for Bear (and/or those assets). Why was there no market for Bear? Why was nobody interested in what were then largely “investment grade” assets? Did the market really have it that wrong?? As the Bloomberg article notes:
“Why wouldn’t JP Morgan want a bunch of AAA assets?” said Mark Calabria, a former Senate Banking Committee staff member…“The answer is it was all borderline junk.”
The CBO even leaves a wide range for expected returns on Maiden Lane’s assets recognizing in its report that, “the returns realized on asset-backed securities such as those in the Maiden Lane portfolios could deviate significantly from what is expected…”
And so we come to Door #3. Whether the Fed executed a good or bad trade is, in some ways, immaterial. It’s about the way it was handled.
I understand the desire, and the urgency, on the part of the Fed to step in and wind down Bear, much as the FDIC acts as a receiver to failed banks. I am one of those who believes that the alternative (letting Bear fail in a disorderly manner) might have had catastrophic consequences for the global financial system. Of course, we will never know, not having the opportunity to observe the counter factual.
But to me, this is starting to look like a case in which it’s debatable whether the ends justify the means.
As I understand it, the issue is that the Fed did not (at the time) have resolution authority over non-bank financial institutions such as Bear. Therefore, it invoked Section 13(3) of the Federal Reserve Act, which enables it to provide credit to corporations like Bear in extraordinary circumstances, but only in exchange for high quality collateral. Moreover, whereas the FDIC is funded by the premiums collected from member banks and draws upon the Deposit Insurance Fund when winding down a bank, in this case the Fed put taxpayer money directly at risk.
And therein lies what bums me out so. It’s not the kind of assets acquired by the Fed. It’s not the price at which the Fed acquired the assets. It’s not whether the assets will ultimately get paid back, though that’s important (and debatable). It’s not even whether the Fed, through its actions, effectively rescued the financial system from the brink.
In the end, it’s about what the Fed knew about the quality of the assets when it structured the rescue, and the possibility that the Fed put taxpayer money at risk in violation of Section 13(3) of the Federal Reserve Act, perhaps knowing ex ante that it was acquiring collateral of dubious quality.
This is why, in my opinion, Bernanke was so careful with his language in his April testimony. Yes, technically, the assets were investment-grade rated and/or performing assets when Maiden Lane was created. Therefore, at the time, the assets were likely meet the “indorsed or otherwise secured” criteria. Brilliant really, if you think about it.
But did the Fed anticipate that the assets would remain high quality? That’s another story.
If the Fed knew that the Maiden Lane assets were likely to become junk assets irrespective of how they were rated at the time (and we might never find out), it would be eerily reminiscent of a “You can’t handle the truth” kind of moment, …which speaks to a whole different kind of credibility.