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Bob Reich, whom I knew vaguely long ago, writes a demagogic column for the <a href="http://www.prospect.org/cs/articles?article=rewards_without_ris

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Reich and numerous others have been trying to do Monday morning quarterbacking on Bernanke’s decision re: B/S.  If Bernanke had done nothing and we had seen a financial meltdown that crippled a significant number of financial institutions, they would have been doing the same thing saying “why did he just stand there and wait!”

Unfortunately though Reich is shrill and Cox is measured and calm does not answer who is correct.

If you want to gauge how much of the assets of these institutions are ripe for a write down look at the Level 3 Assets.  Last November Citibank had $134 billion in Level 3.

These are assets that cannot be readily valued in the market and these institutions have been using Mark-to-Model rather than Mark-to-Market to set a value.  A lot of this is worth less, far less, than the listed numbers imply as we just saw this week with the big European group UBS - Now with $37 billion in write-downs.

NET: The assets on the books and thus the sufficiency of the levels of capitalization is very suspect.  But the day before any of these big revaluations if you went to look at the books the capital is sufficient ASSUMING you accept the values of the assets.

What I think Reich is referring to is the guarantee made by the Fed backed by a letter from the Treasury in the JP Morgan buyout of Bear Stearns.  When the acquisition has closed and JPM starts cleaning up JPM absorbs the first $1 billion of losses and the Fed (read US Treasury per the letter from Paulson to Tim Geithner of the NY Fed) takes the next $29 billion of losses.  That means taxpayers just the way the cost of all the government eventually might be paid by taxpayers.

There’s no denying that the BSC action was an emergency response that averted a much more serious calamity, but the folks at the Fed have only to look in the mirror for the root cause. The Fed has been pumping money into the system since 1991. That has been their solution to every problem--pump up M3 some more. Bernanke has picked up the baton from ‘maestro’ and continued to prime the pump.

As a result, the dollar has collapsed, REAL inflation has crept back up north of 6-7%, and so many cockamamie financial instruments were devised that it is now impossible for even the creators of the mess to figure it out. And it isn’t over yet. To quote Churchill, we’re at the end of the beginning.

So, while what’s-his-name’s piece got a lot wrong, it also got more than a little bit right: we are all going to be paying for this for a long time. If the GSE’s aren’t outright nationalized--putting all their liabilities on the nation’s balance sheet--then there are still the $400 billion in treasuries that have been pledged in exchange for Level 3 (unpriceable) assets on the books of Lehman, GS and any others who care to belly up to the Fed’s hangover bar for some hair of the dog.

All that debt backed by people who didn’t even have to prove income, paid nothing down, and who now are walking away from their homes in record numbers? We haven’t even scratched the surface yet. BSC’s $30 billion and UBS’s additional $19 billion writedown (for a total of $40B) is all money that could well end up coming right out of the Fed’s (USG’s) coffers. Every dollar printed and pumped into the system brings us another dollar closer to the rest of the world bidding sayonara to the dollar. The falling dollar may help exports, but imports cost more correspondingly--and we buy a lot more than we sell nowadays.

Ben Bernanke and crew may have dogged a bullet on March 17, but it is the slug has the ballistic signature of their own weapon. And next time they might not be so lucky: they might miss their foot and get the American public right between the eyes.

I do not understand why the Fed did not let Bear Stearns fail. There are hundreds of banks, brokerage houses, private equity firms, investment banks, etc. How can the failure of one of them, even a big one, bring down our multi-trillion dollar financial system? If it can truly happen, something is wrong with our financial system. And more regulation will not solve it.

Well, there are three different issues, and it is possible to demagogue on all three. It is also possible to ask legitimate questions on all three.

(1) Should the Federal Reserve exercise its judgment to prevent systemic collapse of financial markets? The “Austrian” answer (or at least the answer of von Mises) is that central banks are pernicious and that their very existence creates the crises that they purport to rescue us from. (OK I am oversimplifying his argument a bit.) The traditional answer, going back at least to “Lombard Street” but probably to the 18th century, is that financial markets require a “lender of last resort.” It is absolutely obvious that the only way a lender of last resort can prevent systemic failure is to act before such a failure occurs. Acting so as to prevent a future event requires making a necessarily uncertain judgment of the future and is always open to cheap second guessing. There are only two legitimate positions: dispense with a central bank or expect a central bank to act on its best judgment during a crisis. If Reich is in favor of the first position, then it is only honest to say so rather than carp about whether the judgment was correct. If you give people discretion, you have to expect them to be wrong sometimes.

(2) Was taxpayer money put at risk? The Federal Reserve is the one directly at risk for the amount of its loan secured by the BS assets (intentional pun here,) and prior to the renegotiation, it was at risk from the first dollar on. Now that can be considered taxpayer money in either one of two senses. The Fed pays over its profits in excess of what it needs for capital to the Treasury. If the Fed takes a loss, then the government’s deficit goes up. Alternatively, the Fed’s profits can themselves be considered a tax on the commercial banking system (and so indirectly on the general public.) Now the only justification for that tax is to give the Fed the wherewithal to act as lender of last resort. Apparently Mr. Reich believes that the taxpayers have a right to expect the Fed never to take a loss in the exercise of its duties as a central bank. Interesting, a lender that never takes a loss. I’ve been a banker for over thirty years and never seen such a bank. The legitimate question is whether BS, which was exempt from the “reserve” tax and the numerous regulations imposed on commercial banking, was a proper recipient of funds from the lender of last resort. To put it another way, the only justification for the Fed’s rescue of BS is that it was “too big to fail,” and anything that is “too big to fail” is by definition outside the scope of being regulated by the market and so must be regulated by the state on at least terms as stringent as those imposed on the entities that pay the tax. BS got the benefit of a system for which it never paid.

(3) Was it a bailout? Of course it was. The relevant question, however, is whether it was a justifiable bailout. That the BS shareholders took a bath is true enough, but if BS had entered bankruptcy, the BS shareholders would have got nothing. So the shareholders were bailed out, meagerly but actually. More importantly, BS creditors were bailed out at 100 cents on the dollar. That will do nothing to reduce moral hazard in the future. It is silly, I think, to support the idea of a lender of last resort (as I do and as I presume Mr. Reich does) and to carp that the lender of last resort will sometimes take losses like any other lender or that the lender of last resort has acted in situations that may not have required action. I for one will not try to second guess the Fed on whether it was prudent to rescue BS. What I will and do question is whether the Fed did a good job in making the loan. It certainly should have (and probably could have) required either that some of BS’s creditors take a haircut or that its loan to BS be well enough over-collateralized that JP Morgan was at significant risk.

clarity,

The assets pledged for the Fed Reserve loan are a “stand alone” deal.  JPM puts up $1 bln. the Fed puts up $29 Bln.  The both own part of the $30 Bln - with JPM suffering the first losses.  The Fed’s $29 bln is not a fund for JPM to “draw against” to offset any losses on the rest of the assets acquired in the deal.  In statements made immediately after the takeover, JPM stated that they had no problem with the Bear Sterns valuations of assets that they were carrying.  In the Congressional testimoney, JPM stated that there was not any cherry picking of assets, and I believe the statement was that the assets pledged with the Fed were GSE insured assets.  The Congressional testimony was that Bear met the “net equity” standards at the time of the take over.

Now, as to whether anyone on this board has ever “loaned any money to Bear Sterns”, well yes you may have indirectly.  The assets carried by Bear were being funded on a daily basis through the use of repos.  Bear pledges the collateral at a mark to market value and gets short term funding - very short term.  And those repos are typically done with either banks or money market funds.  So, if you have money in a money market fund you may have been making loans to Bear.  But, the money fund also had access to the collateral and would have had little problem in the event of a bankruptcy - no particular bail out benefit.

The real reason for the Fed to take action is that Bear was one of the hubs for the Credit Default Swaps market.  The trades were between the buyer or seller and Bear.  So, if Bear takes the cure, all of the Credit default swaps are then suspect.  The buyers and sellers did not do the trades directly with each other but with Bear as principal.  And it is the secondary market for these swaps that has bee establishing a value for much of the CMO / CDO / MBS market.  If that market freeqes up, no more liquidity in the system.  Loans get called from all over - no renewals and it would not have anything to do with the borrowers credit quality.

So the action of the Fed was taken to keep that market orderly.  It had very little to do with any asset quality or valuation issues.  Sure, Bear was over leveraged.  However, look at the balance sheet for your bank.  Deduct the goodwill and the office equiptment from the equity number.  Divide the liabilities by the resulting approximate equity value.  Probably near 15.

As Bear has related, if they had had access to the Fed as a funding source they would have been able to staunch the run on the bank.  And that is why the Fed is there for the Commercial banks.  However, note that the Fed only covers you up to the insured deposit limit of $100,000.

Reich is a true demagogue.  I expect that he does know better as he does not strike me as that dumb.