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I'm going to avoid using your word "partnership," and certain other terms with specific legal meanings that are not applicable in this context.

The New York Fed created a new and distinct legal entity. They lent $29 billion to this entity, which was used to purchase (and therefore to own) a package of securities from Bear Stearns.

JP Morgan is also a participant in the new entity. Morgan lent $1 billion to it.

Morgan's note is subordinate to the Fed's. That means that Morgan will take the first losses. Morgan gets nothing back on their $1 billion until the Fed has made back all of its $29 billion, plus interest.

After Morgan gets back their $1 billion plus interest, they're out. The Fed gets everything else.

In return for the subordination, Morgan's interest rate is much higher than the Fed's. Fine, that's standard practice.

What I didn't point out in the story is that Morgan, which (unlike the Fed) actually exists to make a profit, was eager to buy into the Bear portfolio on a heavily subordinated basis, after a week's reflection.

That means they saw value in the assets. That's an extremely important point that I should have stressed.

Thanks for answering my questions, I appreciate it. From reading your article, I thought my simplification was correct, overall, but I know my knowledge in this arena is very limited, and wasn't sure.

And I was trying to using the word "partnership", not in its legal sense, but in the more general, "they're working together" sense.

Regarding JP Morgan seeing something of value in Bear Stearns assets, do you think JP Morgan's evaluation was something along the lines of "these assets are so cheap [or maybe undervalued?] this investment is very worthwhile?"

Again, thanks for answering my questions and putting up with my ignorance and newbie-ness

...full of partial differential equations, Greek letters, computer heuristics, and other arcana.

And then someone high up the chain looked at all of that gobbledygook, stuck his finger in the air, and said "Yes, we want in for a billion at discount-plus-450."

A few guys I knew at Caltech, CS and EE guys, ended up at financial firms. My old roommate took a job with PIMCO when he graduated. I didn't understand how this came about.

Now I do.

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"If we want to take this party back, and I think we can someday, let’s get to work." – Barry Goldwater

...math and physics PhDs. They're the ones who created the engineered financial products, that gave rise to the "shadow banking system," that is one of the key causes of the whole problem.

PIMCO, terrific company, by the way. I consulted for them years ago. If your roomie is still there, tell him to stay there.

It's overpriced almost everywhere.

But who knows? If we get a massive inflation (which was the policy response in 1934, and arguably a correct one at the time), then maybe today's land prices will someday look cheap.

I retain the trademark on "St. Patrick's Day Massacre" :-)

I also claim ownership of "Great Depression II," which I coined here at RS. Subsequently Ed Yardeni used the phrase in a research note without asking my permission or paying a royalty.

I retain the trademark on "St. Patrick's Day Massacre"

No problem, but you'll have to put it aside until there's actually a massacre on St. Patrick's Day!

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The deal announcement was timed carefully to take place before Asian markets opened for trading, and they got it in with about an hour to spare. (I was waiting with bated breath the whole afternoon.)

That was Sunday evening in New York. But it was Monday morning in Tokyo, Singapore and Hong Kong.

St. Patrick's Day.

Hillary!!!!

...Monday the 17th was not St. Patrick's Day, are you?

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"If we want to take this party back, and I think we can someday, let’s get to work." – Barry Goldwater

The deal went down in New York, and local time was Sunday evening, 16 March. Nice try, but 16 .ne. 17. Hmm, on second thought, that might appropriate, because that IS the sort of mathematics that got us into this mess in the first place....

Save the empty "St. Patrick's Day Massacre" slot for another year - I'm sure one will come along for you.

Of course, I guess it depends on what your definition of "17" is.... :-O

n/t

so it fits!

But St. Urho drove the grasshoppers out of Finland.

So you can take your pick, except that the deal went down on St. Urho's Day rather than St. Patrick's Day....

Orthodox calendar? :>)

THIS Banf

===
When small men cast long shadows, it is a sign that the sun is setting on the Democrat Party

...(and please don't get me started on this, because I'll talk all day about it), its peculiar structure was chosen precisely because of well-founded fears that Congress would never go for a central bank.

This took place starting in late 1907 (Aldrich-Vreeland Act, National Monetary Commission, all that stuff, leading to the Federal Reserve Act in 1913).

The bad memories of nineteenth century attempts to establish a central bank were still vivid. Until 1913, the US was the only large trading nation without a central monetary authority.

...was done as a stock swap. The purchase of the $30 MBS portfolio was legally a distinct (but contingent) transaction.

Morgan didn't put out any cash to buy Bear Stearns, including the Mad Avenue headquarters building, which is part of the shareholders's equity.

The original acquisition offer was X number of Morgan shares for Y number of Bear shares. (You can look up the actual ratio, 0.025 or something like that.) As of the market close on Friday the 14th, this formula valued Bear at $2/share.

In the next few trading days, two things happened.

First, Morgan's stock rocketed upward, since it was clear from the start that they had made the deal of the century. That effectively increased the valuation of Bear to something above $2/share.

Second, Jamie Dimon got scared that he'd get lynched by all the Bear shareholders out there, so he decided to roughly quadruple the stock-swap ratio. That effectively put a value of $10/share on Bear.

And of course, on the 25th, Jimmy Cayne sold 5+ million Bear shares at $10.68 or something like that.

Now in all this, observe that Bear's bondholders will not lose a penny if the acquisition goes through as currently structured.

There is speculation out there that in the first few days, when Bear stock was trading far above $2, that it was being bought up by bondholders who were perfectly happy to lose money on the stock, but who wanted to vote those shares to ensure approval of the acquisition. (Bondholders don't vote, only shareholders do.)

How's that for financial jujitsu?

It's nice to have someone actually explaining this whole process instead of the normal The Sky Is Falling™

...Treasury Department. From there, it will essentially disappear (cease to exist).

The Fed isn't chartered to make a profit. They really can't anyway, because of the peculiar way that money is accounted for at the Fed.

When the Fed writes a check, it creates brand-new money that didn't exist before. When it cashes a check, it extinguishes money.

That might makes your head spin, and make you want to ask, "Well, doesn't that mean that US dollars aren't really any different from Monopoly money?"

Correct. That's exactly what it means.

... it will essentially disappear (cease to exist)

The Fed isn't chartered to make a profit. They really can't anyway

I'm really not trying to needle you, I like your posts... but given those statements, am I correct in observing that statements from your original post such as "the New York Fed stands to make a significant amount of money here" and "they will make a profit" are completely meaningless? Its seems quite contradictory to stress the potential for significant gain and profit, and then tell me that they can't make a profit and any gain will just vanish anyway - can you explain?

But to the case one might make that the action taken was proper governance, it seems to eliminate a point for the affirmative: that the action had a substantial chance to provide a payback for taxpayers.

That might makes your head spin, and make you want to ask, "Well, doesn't that mean that US dollars aren't really any different from Monopoly money?" Correct. That's exactly what it means.

I admit great ignorance here and have no background in economics, but I believe I get that, more or less. What is troubling is that, the more this action is justified in terms of, well, the money is just created from nothing, it just vanishes afterwards, no taxpayer dollars were used, it's like Monopoly - then it seems to me the more likely we are to be faced with the same argument being made in favor of similar action taken on behalf of any other random special interest, industry, or group of citizens. If it's all just play money and has no positive or negative affect with regards to taxpayer funds, why not throw some play money at everyone else?

Now I suspect that can't be the case and that there actually is some "real" consequence to this action that might make throwing some Monopoly dollars around to some other players ill-advised. And perhaps you could take that up in a future post, where you very clearly describe what the actual effect of a federal bureaucrat typing on a keyboard and creating $29BB is, and why it was required in this case but not in many (or any) other cases where various entities find themselves in extremely dire financial situations.

Thanks, appreciate your efforts!

...when it does happen, it will establish a (higher) market for mortgage-backed securities.

One of the primary reasons that the credit markets as a whole are frozen, is that so many people are holding mortgage-backed paper that has no reliable valuation. So they can't really sell it (there are no buyers) and they can't continue to finance it (no one will lend against it).

Keep in mind that the time horizon here is measured in years.

I've mentioned in several recent posts that one of the policy choices available to the government (not just the Fed) is to start buying up MBS, at some price that could establish a market. The Fed appears to have just waded into the pool.

You're right, there's a larger post to be written about the subject of fiat money in a time of extreme stress. In fact, it's a whole dissertation. Maybe even a Nobel Prize.

One short answer to your question ("there must be real consequences") is that creating money is inflationary.

In a pure macroeconomic sense, fiscal deficits create money just as effectively as the Fed does. That's why Fed chairmen tend to speak out against them.

And the really unknown factor here is the "shadow credit" created by derivatives activity. I have a hunch that the housing bubble will turn out to have been caused by sources of "liquidity" that are not even recognized as such today.

Thanks this is helpful!

... when it does happen, it will establish a (higher) market for mortgage-backed securities.

So if I'm following you, can I restate the purpose of the Fed's intervention as follows:

In this situation, the Fed "invested" in mortgage-backed paper or similar securities, with the expectation that they would make a significant return. They were extremely confident that there would be a profit, not a loss. Even though said profit will essentially vanish, it will at least demonstrate for everyone else that the investment is sound and that will assist the private market in properly valuating similar assets. Once that happens, entities will feel comfortable buying those securities again? Am I close?

The most obvious question seems to be - what did the Fed know about this situation that no other private market entity (company, individual investor) knew such that the Fed saw themselves as the only possible avenue of making the investment and establishing a true value for those assets? This seems to imply that there were no other private market entities with the insight to see that such an investment was extremely low risk and promised significant returns. The Fed evidently didn't believe any other investors were going to move on the opportunity, so they felt obligated to do it themselves?

I'd like to hope that if there were private market entities who saw this opportunity and wanted to take it, that the Fed would have stood aside and let the market correct itself...

How do you explain the fact that the private market, it seems, completely missed what appears to be a rare low risk high return opportunity? This idea goes against every capitalistic bone in my body. It's downright disturbing.

...several kinds of risk that are inherent in holding mortgage-backed securities. The most important one is their ability to finance the purchases with stable funds. They're what bond-market participants sometimes refer to as a "real money" buyer, rather than a buyer that finances with short-term funds from the money markets.

It's a forgone conclusion that many MBS could trade well below their long-term stable value, if it were possible to trade them. And there is a handful of sources of friction in the capital markets that are keeping this from happening.

And this is a global phenomenon, not just a US one.

There are people out there with huge amounts of money, just waiting for the right moment to dash back into this market. Unfortunately, one of the things that are making the market uncertain is the prospect of a federal bailout that will completely distort the market.

I think it's more likely than not, that when the credit crisis resolves, you'll see an explosion of buying in a whole slew of different markets. But there's absolutely no way to predict the timing, nor how much worse things can get beforehand. It could be years from now.

In regard to the Fed's motivations: you're recasting the whole picture in terms of reasoning that senior people at the Fed may have undertaken, and asking my opinion on that.

I stand by the interpretations I presented in the story, which are based on externally-visible data. But I'm not prepared to tell you that I know exactly what the Fed is thinking or how they arrived at the decisions they made.

But I'm not prepared to tell you that I know exactly what the Fed is thinking or how they arrived at the decisions they made.

Well, you shouldn't really have to, and that's part of my problem with this.

My very minimum expectation from government is that they explain the reasons for the actions they take. I'd prefer them to do it before they act, but there's no reason not to do it afterwards, either. What I'm hearing is that they haven't explained why they intervened, they haven't explained what they hoped to gain from the intervention, and at a more detailed level, they haven't explained why they felt the private market couldn't be trusted to see its way through this and take advantage of this great buying opportunity that the Fed evidently saw but no one else could.

And then everyone else is left speculating about the whys and the why-not-the-alternatives. The cynical side of me suspects they don't justify their actions to the taxpayer because that way no one can judge if their execution actually achieved the desired outcome, let alone whether their desired outcome was necessary in the first place.

The unmistakable odor of a bureaucracy looking for ways to sustain itself...

They certainly have bureaucrats, but I wouldn't characterize them as an agency in search of simple power. They're very good at what they do and very serious about it to.

Now if you want to talk about the Health and Human Services Bureau, I'm with you all the way.

Second, the Fed has always been very close to the vest about their decision-making. In fact, they're quite a bit more open now than they ever have been. Up till twenty years ago, they didn't even publish the Fed-funds target rate.

Part of that is a desire to avoid jerking the markets around. Remember during the Greenspan days? When he'd go up to Capitol Hill, and people would literally make trading decisions based on how thick his briefcase was?

"When the Fed writes a check, it creates brand-new money that didn't exist before. When it cashes a check, it extinguishes money."

What this statement says to me is that, in addition to setting a floor to the values of these MBSs, the Fed is looking to reduce the amount of money in circulation by a significant absolute amount (no idea what the rate is) over the next 10 years, thus serving to reduce inflation, or, maybe, if God smiles really, REALLY brightly on them, actually deflate our currency...

Thoughts, blackhedd?

"Guns don't kill people...
"...But they sure help!"
-Paul Giamatti, Shoot 'Em Up

The Fed is chartered by Congress to increase the money supply over time, consistent with a growing economy. I don't believe that they are interested in reducing the money supply, certainly not over a ten-year horizon.

There is an important point to be made here with respect to the enormous and aggressive monetary operations they have undertaken since the beginning of serious market disorder last August:

The Fed's operations have not been inflationary.

It really surprises me how many very intelligent and thoughtful people have been pressing the opposite point. But when the Fed adds reserves to the banking system or enters into repo contracts with broker-dealers, all of these operations are temporary. There's no net change in the permanent money supply as a result of liquidity-enhancing operations.

And in regard to low policy interest-rates: it's not necessarily true that a lower Fed funds rate causes inflation. That would happen if people responded to the availability of cheap money by reducing the quality of their risk-taking activities.

But right now, the problem is that practically no one is taking any risk in the first place. In today's environment, the Fed could run a zero or even negative Fed funds rate, and there would be no incremental inflation.

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"If we want to take this party back, and I think we can someday, let’s get to work." – Barry Goldwater

About your lack of response earlier. Whether I was right or so wrong your head exploded and you weren't able to respond...

"Guns don't kill people...
"...But they sure help!"
-Paul Giamatti, Shoot 'Em Up

Slightly longer answer:

Oh my dear God in Heaven, please make sure they never, ever try to do anything like that!!!

It just happened to be the part that Morgan decided they didn't want any part of. At the time of the acquisition, Bear probably had assets adding up to maybe 1.5 or 2 trillion dollars.

Assuming the obligations (both payment and counterparty) of that large portfolio on two days' notice would have been more than enough to wipe out Bear's equity, all by itself. The fact that they threw in a $1.5 billion building really doesn't mean diddly-squat.

Bear lost in the marketplace. The Fed simply ratified that reality. It was cold, but it was the right thing to do. It would have been far more reminiscent of Japanese-style corruption if they had sat everyone down and said "Now look, Bear's executives need to save face, so let's make sure they get a nice deal."

And if there are any Congressmen or Senators reading this post, you might consider doing the same too...

"Guns don't kill people...
"...But they sure help!"
-Paul Giamatti, Shoot 'Em Up