U.S. Fed action comes too late to save Bear Stearns

I’m starting to get the sense that U.S. Federal Reserve Chairman Ben Bernanke’s job is harder than any of us can comprehend.

And a component of that Triple Black Diamond difficulty comes in the need for people in his position to have a sense of what problems are coming down the pike, and getting ahead of them.

Last fall, “Helicopter” Ben was chastized by many market observers for missing the signs in the weakening subprime mortgage market. Mr. Bernanke’s critics are going to have a field day after this week.

On Monday morning, rumours about liquidity issues at Bear Stearns (BSC:NYSE) became very insistent (see prior post “Bear rumour speaks volumes“, March 10-08). Despite having made the rounds for the prior couple of weeks, with little impact on the stock, the rumour seemed different this time. Bear’s shares started to crumple, falling 13% in the first 150 minutes of the trading day, and speculators were buying $58 dollar puts even though BSC was trading in the mid $60s. Unusually out-of-the-money.

Around midday on Monday, Bear Stearns boss Alan Greenberg called in to CNBC to say the rumours (posted here, thanks to a great tip, before Bloomberg and Reuters filed their initial stories; back pat) “were ridiculous”.

Not true.

The very people that provide credit to each other hundreds of times a day – the banks and brokerage firms – knew what they knew. Clearly, many of them were starting to get less comfortable advancing sums to BSC as of Monday. And perhaps Bear Stearns was no longer providing as much leverage to its “prime brokerage” clients as it had been in prior weeks. With less cash on hand, Bear wouldn’t be as able to provide as much credit to its hedge fund clients. Who better to ascertain the financial health of a business than the customers and counterparties?

These are but two of the many ways the Bear rumour might have been started, and I’m pretty sure – in hindsight – that it wasn’t a “rumour”.

It was a tremour. Like those hints you get from the tectonic plates shortly before a large earthquake is about to happen.

In an effort to help shore up firms such as Bear Stears, the U.S. Federal Reserve announced on Tuesday (undermining Mr. Greenberg’s earlier protestations), that it would now accept AAA mortgage-backed securities as collateral. A move clearly designed to help Bear Stearns, the #2 U.S. underwriter of mortgage-backed securities, among other large independents (think Lehman Brothers).

Here’s one take on the move by the CIBC World Markets’ Economics & Strategy Department:

Last Tuesday’s surprise Fed announcement that it would set up a new securities lending program to trade Treasuries for select mortgage-backed securities was greeted enthusiastically by financial markets. But despite the initial high hopes of investors, this measure, like the ones before it, will not be a cure-all. It will not fix the underlying credit issues that gave birth to the current financial crisis, nor will it keep home prices from continuing to fall, and it is unlikely to keep real GDP growth from sliding into negative territory during the first half of the year.

This latest creative policy action by the Fed is not intended to be a substitute for further
monetary easing over the next few months. Rather, it is designed to help ensure that rate cuts translate into lower effective borrowing costs for banks’ customers. Just as the Fed’s mid-December decision to temporarily set up a Term Auction Facility was largely motivated by the desire to control term borrowing costs for deposit-taking institutions, this latest Fed initiative is designed to help securities dealers boost the liquidity of their MBS holdings in order to increase their lending capacity.

In the end, this was too little, too late.

The news of the US$200 billion Term Auction facility drove North American financial shares higher on Tuesday, and Bear Stears recovered ~$6 of its Monday swoon. It didn’t last.

The very firms that do business with Bear didn’t change their view between Monday and Wednesday, and the ducks began to quack once again. By Thursday, the very reasons why the financial community had been starting to pull back their counterparty risk from Bear Stearns took hold. Overnight, the Federal Reserve stepped in, using J.P. Morgan (with assets of US$1.6 trillion) as the funding conduit.

The moral is this. When it comes to financial stocks, there are no secrets (see prior post “‘Panic’ sets in to the debt markets“, July 29-07). If a business is in trouble, it is very hard to hide it from the folks across the street. The industry is just too intertwined.

The very people yakking about funding issues at Bear Stearns were the very ones who should have known there was trouble brewing – they are, after all, the people that trade with them all day. If they were nervous, it didn’t take a leap of faith to expect them to calm their own nerves…and yank the funding relationships.

The Fed underestimated the subprime crisis. Now it has raced unto the scene on its white horse, only to find out that market confidence in Bear Stearns may well be past the point of propping up. It’s not as though the signs weren’t there. As a result, a sale of BSC over this coming weekend is not out of the question.

One thing’s for sure. Helicopter Ben’s critics will be at it again tomorrow.

MRM