A Century of Bailouts
By Vern McKinley
The Independent Institute Copyright © 2011 The Independent Institute
All rights reserved.
Bear Stearns —
The Original Sin (March 2008)
DURING THE FIRST week of March 2008, the U.S. Securities and Exchange Commission (SEC) staff conducted an on-site inspection focused on Bear Stearns's liquidity pool. No significant issues were identified. Bear Stearns's liquidity pool stood at about $18 to $20 billion.
At 1:29 p.m. on Monday, March 10, 2008, Brian Peters of the Federal Reserve Bank of New York (FRBNY) informed staff at the Board of Governors in Washington and the other reserve banks that
Bear's [credit default swap] spreads have blown out to 750 bp, and the stock is down substantially. There are considerable rumors on the Street of dealers and funds pulling away from Bear. We are in contact with the SEC. Please check with your firms to see if they have or are taking any actions (increasing haircuts, refusing assignments to them, or in any other way constraining credit) with respect to Bear.
Meanwhile, that same day the SEC scheduled an on-site visit for Tuesday, March 18, to review Bear Stearns's first quarter financial results in more detail. Bear Stearns started the week with a cash and liquid securities position of $18 billion.
There were also concerns on that Monday afternoon about emerging public reports on Bear Stearns: "Apparently there was some misinformation in the press regarding Bear Stearns that caused the firm[']s [credit default swap] spreads to widen significantly and fueled rumors about potential liquidity problems." Staff at the Office of the Comptroller of the Currency (OCC), which regulates national banks, also reportedly raised questions of their own. On Monday OCC staff became concerned about the potential exposure to Bear Stearns of banks that it regulates, and to that end staff of the agency began to call these banks. The calls were not about general exposures but were specifically about exposure to Bear Stearns. In a recounting of one of these conversations, a targeted banker was told, "Don't tell your traders and don't get out of any counterparty agreements that you have. But what's your exposure to Bear Stearns?" Of course the banker told his traders, bought puts, sold short, and got out of everything he could possibly get out of. Despite these rumors and questions, an unnamed firm "adamantly stressed that it [was] continuing to provide liquidity to Bear Stearns."
By Tuesday, March 11, at 2:36 p.m., a primary focus of FRBNY staff was on the reaction of large financial institutions (LFIs) to the troubles at Bear Stearns: "Several additional LFIs report gradual reduction in various lines to Bear, with most closely reviewing existing positions. LFIs generally seem satisfied with Bear's liquidity. Bear appears to be reducing [short-term] funding and staggering long-term debt, but don't seem interested in financing derivative/repo transactions with longer terms, unique structures, etc. LFIs' management appear [sic] cognizant of exacerbating problems via widespread/dramatic reduction in credit to Bear."
By Wednesday, March 12, 2008, "an increased volume of [Bear Stearns's] customers expressed a desire to withdraw funds from, and certain counterparties expressed increased concern regarding maintaining their ordinary course exposure to, Bear Stearns." This activity prompted Alan Schwartz, chief executive officer of Bear Stearns, to call FRBNY president Geithner that evening to discuss the precarious position of the firm, and the next day the SEC, the Treasury Department, and FRBNY staff discussed the status of Bear Stearns in more detail.
At 2:33 p.m. on Thursday, March 13, 2008, Deborah P. Bailey, deputy director of the Board's Division of Banking Supervision and Regulation, notified members of the Board of Governors and senior staff that
[FRBNY] and Board staffs are monitoring the situation. [FRBNY] staff is in ongoing contact with SEC staff and has asked them to keep the Federal Reserve [informed] as to the firm's liquidity profile including unencumbered cash positions, available secured and unsecured financing sources, and available Fed-eligible and non-eligible collateral. As of noon today, the SEC reported that the holding company has $12.5 billion in cash and has been able to roll "almost all" of its equity repos and all of its U.S. and European bank loans.
Meanwhile, Bailey noted an SEC conclusion that "no notable losses have been sustained and that the capital position of [Bear Stearns] is 'fine.'" That same Thursday "an unusual number of customers withdrew funds from Bear Stearns and a significant number of counterparties and lenders were unwilling to make secured funding available to Bear Stearns on customary terms."
The staff of the Board of Governors and FRBNY was struggling under great time pressure and with questionable information to undertake the required analysis of Bear Stearns in order to understand the firm's operations, as well as the potential broader impact beyond Bear Stearns:
"Coryann Stefansson just called and said that this is the info (still preliminary and probably not super accurate but kind of in the ball park at least) that she has about the exposure of major banks to Bear. ... She also said that [REDACTED] should be on the list, but nobody could confirm it."
"Sorry if my details are sketchy but will try to provide more substance as we get information."
"I must say that I am not that comfortable with the accuracy, but we got the info from the teams."
"We have pulled together the exposure #s of the [large financial institutions] to [Bear Stearns] but the information is from the last monthly reports from the firm that are prepared by the exam teams. Board staff did not go out this week for a request on more current exposure information."
"Here is a report we received where [Bear Stearns] tried to identify the counterparties that they owed money to. The[y] claimed it was inexact (their systems are not set up to run that way), but ordinarily correct.
Looks like it is only derivatives. Will provide more clarity as I can."
"While dated, attached is a spreadsheet folks here pulled together on what each firm had as of year-end 2007 w.r.t. their counterparty credit risk exposure to Bear."
By 5:40 p.m. on Thursday, March 13, numbers were starting to come together on firm level exposure to Bear Stearns for a broad range of institutions as circulated by James Sheerin at the Board of Governors: "Here are exposures to [Bear Stearns] that I have now." These exposures have never been publicly released. By 7:00 p.m. that same evening, Bear Stearns calculated that its liquidity pool was down to $2.0 billion. Although these were not bank depositors that were withdrawing their funds, the impact of the evaporation of funding sources from Bear Stearns had the same impact as a traditional bank run.
At 7:50 p.m. on Thursday, March 13, 2008, FRBNY staff learned of the possibility that Bear Stearns would file for bankruptcy the following day. An email exchanged between FRBNY officials, including FRBNY President Geithner, noted: "SEC just received a call from [Bear Stearns Chief Risk Officer] Mike Alix indicating [that Bear Stearns is] uncertain about [its] ability to operate tomorrow. Likely to call us." Attached to a subsequent email were notes of a telephone conference between FRBNY staff and SEC officials regarding Bear Stearns, but details of the notes have not been publicly disclosed. A FRBNY official forwarded this same email to the Board of Governors' General Counsel, Scott Alvarez, at 8:15 p.m. At 8:26 p.m. Board of Governors Deputy Director Bailey informed the members of the Board of Governors and other senior staff that Bear Stearns's "Chief Risk officer indicated that [Bear Stearns] will likely have 'trouble' opening tomorrow and will be under pressure. A great deal of uncertainty about ability to operate."
That same evening Alan Schwartz, CEO of Bear Stearns called JPMorgan Chase Chief Executive Officer Jamie Dimon to determine if his firm could lend Bear Stearns as much as $30 billion or buy the company. Dimon informed Schwartz that a loan or outright purchase was impossible, but that JPMorgan Chase was willing to assist Bear Stearns in finding a solution to its liquidity problem. During the evening of Thursday, March 13, representatives of JPMorgan Chase and officials from the U.S. Treasury Department, the FRBNY, and the Board of Governors engaged in discussions regarding how to resolve the liquidity deterioration at Bear Stearns. These discussions continued throughout the night. JPMorgan Chase made it clear during these discussions that it could not loan funds to Bear Stearns without some form of assistance provided by the government. JPMorgan Chase and another unnamed bidder were the only firms that expressed meaningful interest in Bear Stearns. Bear Stearns set up a data room for potential bidders to undertake due diligence, the process of reviewing assets of a firm for potential purchase.
At 9:16 p.m. on Thursday, March 13, 2008, Board of Governors Vice Chairman Donald Kohn sent an email to the other board members and other senior staff stating:
[Bear Stearns is] talking to [JPMorgan] but not clear what might happen. Right now it looks like without help holding company likely to file Chapt. 11 tomorrow — broker and other liquid entities should continue to operate, though obviously they wuillbe [sic] subject to runs. SEC has people in the firm and FRBNY likely to send someone over to look at positions.
Elsewhere, between 10 p.m. and 11 p.m. on Thursday, Governor Randall Kroszner, in an online discussion with Vice Chairman Kohn, began to speculate about the indirect impact of Bear Stearns's problems on the broader financial markets: "I think it is not just the direct exposure to [Bear Stearns] but the turmoil that this could cause in the entire [credit default swaps] market. These contracts haven't really been tested and the uncertaintu [sic] generated by a filing by a major player could have extreme consequences." Kroszner did not offer any support for his speculation. By 11:00 p.m. on Thursday, JPMorgan Chase had a team of specialists at Bear Stearns's headquarters reviewing its financial records to determine what action, if any, JPMorgan Chase could and would be willing to take.
At 12:38 a.m. on the morning of Friday, March 14, 2008, Bear Stearns's chief risk officer emailed a FRBNY staffer a spreadsheet of banks and brokers having the largest exposure to Bear Stearns. By 1:03 a.m. this same Bear Stearns spreadsheet had been circulated to other FRBNY staffers and to officials at the Board of Governors. By 2:00 a.m. investigators from the FRBNY joined JPMorgan and SEC staffers already at Bear Stearns's headquarters. One anonymous Federal Reserve staffer's wildly exaggerated take on the situation was as follows: "For the first time in history the entire world was looking at the failure of a major financial institution that could lead to a run on the entire world financial system. It was clear we couldn't let that happen."
At 2:00 a.m. on Friday morning, March 14, 2008, FRBNY President Geithner called Vice Chairman Kohn and told him that he wasn't confident that the fallout from the bankruptcy of Bear Stearns could be contained, and at approximately 4:00 a.m. Geithner called Chairman Bernanke, who reportedly "agreed that the Fed should intervene." Around 5:00 a.m. on Friday, March 14, 2008, FRBNY President Geithner, Chairman Bernanke, Treasury Secretary Paulson, Governor Warsh, Vice Chairman Kohn, Tony Ryan, Bob Steel from Treasury, and Erik Sirri from the SEC participated in a conference call. Jamie Dimon, CEO of JPMorgan, came on the line for a few minutes to provide input on his bank's role as clearing bank for Bear Stearns. He painted a dark picture, emphasizing that a Bear Stearns failure would be disastrous for the markets, and that the key was to get to the weekend.
At 5:48 a.m. and 5:50 a.m., respectively, almost an hour after the conference call had commenced, the members of the Board of Governors and other board officials received, via emails forwarded from the FRBNY, spreadsheets titled "Bear Stearns exposure Mar 14 v1.xls" and "Bear Stearns Counterparty Credit Exposures March 14 Morning Call.xls." These spreadsheets have not been released by the Board of Governors.
Approximately one hour later, around 7:00 a.m., "Geithner laid down the gauntlet. 'We've got to make a call here, because [repo] markets open at seven-thirty,' he said. 'What's it going to be?' The consensus was there. 'Let's do it,' Bernanke said." The "it" was to have the FRBNY offer a short-term nonrecourse loan to JPMorgan, and JPMorgan in turn would extend credit to Bear Stearns.
Chairman Bernanke threw in a caveat to the deal: "I'm prepared to go ahead here only if Treasury is supportive and prepared to protect us from any losses." Paulson admitted that he wasn't sure what legal authority, if any, that Treasury had to indemnify the Federal Reserve in this manner. He stated his position clearly notwithstanding any legal limitations: "I'm prepared to do anything. If there's any chance of avoiding this failure, we need to take it." After all, he later noted, the repo markets would open shortly — around 7:30 a.m. — and he wasn't about to drag in a lot of lawyers and debate any legal fine points. Shortly thereafter, Secretary Paulson called President Bush and informed him of the decision even though the Board of Governors of the Federal Reserve had not yet met to discuss or authorize the transaction.
Despite the fact that the key decisions had been made, the data continued to flow. At 7:39 a.m., Coryann Stefansson, associate director of the Board's Division of Banking Supervision and Regulation, obtained and sent to Governor Kroszner a document setting forth data from the third quarter of 2007 regarding the value of credit default swaps held by the top twenty-five commercial banks. This was apparently a follow-up to the discussion on the fragility of this market.
At 9:13 a.m., just as the meeting of the Board of Governors was about to convene, JPMorgan issued a press release announcing that "in conjunction with [the FRBNY], it has agreed to provide secured funding to Bear Stearns. ... Through its Discount Window, [the FRBNY] will provide non-recourse, back-to-back financing to JPMorgan." At 9:16 a.m., Governor Kevin Warsh sent an email to the heads of the twelve Federal Reserve Banks informing them of the following:
Bear Stearns is proving unable to find (sic) itself. This morning, the Board will vote under [Section] 13(3) to authorize the FRBNY to lend to JPMorgan Chase to on-lend to Bear Stearns. We will announce that action later this morning, following announcements by JPMC and BS. In addition, we will announce the following: 'The Federal Reserve is monitoring market developments closely and will provide liquidity as necessary to promote the orderly functioning of the financial system.'
Around 9:21 a.m., approximately six minutes after the Board of Governors convened, Bear Stearns issued its own press release stating that it had "reached an agreement with JPMorgan ... to provide a secured loan facility." When the stock market opened at 9:30 a.m., the decision to "bail out" Bear Stearns was at least two hours old, and the public had been notified about the FRBNY's emergency financing of Bear Stearns.
At 9:39 a.m., apparently after the Board of Governors had formally authorized the transaction, Dianne Dobbeck of the FRBNY emailed FRBNY staff, board staff, and staff of other Federal Reserve Banks a spreadsheet of "counterparty credit risk exposure to Bear [Stearns]" for year-end 2007. At 11:52 a.m., FRBNY Senior Vice President Jamie McAndrews emailed FRBNY President Geithner and other FRBNY employees a three-page draft memorandum: "I've drafted a set of arguments in favor of today's action for your review. I would appreciate any comments, as these are a first draft." However, the memo was not drafted for use at the board meeting at 9 a.m. In fact, this was two hours after the meeting was completed. Interestingly enough McAndrews, who drafted the memo, did not even attend the Board of Governors' meeting. FRBNY President Geithner forwarded the memorandum to Chairman Bernanke, Vice Chairman Kohn, and Governor Kevin Warsh by email, along with a notation stating, "This is very good." Later that afternoon, at 1:54 p.m., Vice Chairman Kohn emailed a response to McAndrews and FRBNY President Geithner, stating, "Jamie, Nice job; you've made the case about as strongly as it could be made, and it's very helpful to have this spelled out." The email was 'cc-ed' to Chairman Bernanke and Governor Warsh. Four minutes later, McAndrews responded to Vice Chairman Kohn, stating, "Thanks very much Don, I'll work to incorporate your comments, and others I receive in the next day or two from people here." McAndrews "cc-ed" Chairman Bernanke, Governor Warsh, and FRBNY President Geithner. It does not appear that the original or any subsequent version of the document have ever been produced publicly by the Board of Governors. (Continues...)
Excerpted from Financing Failure by Vern McKinley. Copyright © 2011 The Independent Institute. Excerpted by permission of The Independent Institute.
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