When mentioning the 2008 Credit Crunch, few still could not believe the speed and severity with which Bear Stearns, one of the world largest investment banks, collapsed. The bailout of Bear Stearns, arranged by the Federal Reserve (Fed) in the form of a shotgun marriage with JPMorgan Chase at the price of $10 per share, seemed to be a legitimate action from the Fed to prevent the crisis from spreading its impact further. Yet, controversies and opposing viewpoints kept stirring up regarding whether the bailout might have been an act manipulated by the Fed through insider trading. In this paper, I will summarize the Bear Stearns case from the viewpoint of the Fed, as well as discussing the case from the standpoint of those who opposed to the way the bailout was executed. I will then use Michael Walzer’s theory of complex equality to answer the question of whether or not the actions of the Federal Reserve and JPMorgan should be justified from the standpoint of those who opposed to the bailout.
A – Case study: Bear Stearns, JPMorgan Chase & the Federal Reserve
Bear Stearns – Victim of the mortgage crisis
In the wake of the mortgage meltdown, Bear Stearns’ business model, which contained lots of mortgage-backed securities trading and collateralized debt obligations, collapsed. Things started going down in December 2007, when Bear announced the loss of $854 in the fourth quarter, along with $1.9 billion write-down of bad mortgage-backed securities. The crises of market confidence had also made thousands of the firm’s clients hastily hoard all their cash out of the firm in fear of its inability to pay out. Having run through approximately $15 billions in cash reserves, Bear Stearns plunged even deeper into a liquidity crisis. The situation became worse as other banks refused to do any business with Bear, while even customers from its prime brokerage arms – Bear’s most valuable business at that point, started pulling out. Bear’s CEO Alan Schwartz turned to JPMorgan for help, and the big bank agreed to give emergency funds for 28 days. Yet, the Fed pressured Bear Stearns, giving it two days to finalize a deal. On March 16th, two days after the announcement of the emergency funding, Bear Stearns’ board was left with two choices: either agreed to be sold to the gigantic JPMorgan Chase at the price of $2 per share, or declared bankruptcy. Below is a graph that depicts Bear Stearns stock price trends up until the point when the firm was sold at $2/share
The firm eventually succumbed to its rescuer, JPMorgan, while the Fed agreed to grease the deal, lending JPMorgan $30 billions to fund Bear’s less liquid assets that would potentially damage JPMorgan’s balance sheet.
The Federal Reserve – Rationale behind the bailout
The Fed’s heavy involvement in the deal should not be taken lightly. For the first time since the bailout of Long-Term Capital Management, the Fed was forced to confront a possible collapse of a Wall Street firm that might leave the US financial market in tremor. How did the Fed’s explain the rationale for its actions? First, the US financial system, within which Bear Stearns’ involvement was particularly substantial, was extremely interrelated and complex. As borrower and lender, Bear Stearns was tightly interconnected and had business relationships with numerous Wall Street firms. Thus, allowing Bear Stearns to go under would have been brought extreme amount of risk to those firms. In addition, Bear’s fall would lead to further dramatic decreases in market confidence, as well as threatening the stability of the global financial system. Its collapse could also spread its impacts across the whole economy system. The potential damages from the bankruptcy were too severe to measure and cover. With all that being said, the rationale for the Fed’s actions seemed perfectly valid.
JPMorgan Chase – Benefits from saving the troubled
A bank with multiple business relationships with Bear Stearns, JPMorgan Chase apparently came to save the day. The firm was said to be chosen for being in a much better position to come to Bear’s aid than other big banks such as Citigroup or Bank of America who were occupied in dealing with their own subprime mortgage distress. Why did JPMorgan agree to buy Bear Stearns? If Bear Stearns had gone bankrupt, it would have created huge pressure on its counterparties, including JPMorgan itself – one of the biggest credit – default swap players. The consequence would also have made Bear more likely to call in collateral from these counterparties; the credit crunch would have been exacerbated even further. What did JPMorgan get out of this? With the original price of $2 per share, JPMorgan, for the most part, could have acquired Bear Stearns’ prime brokerage service and clearing business for free. The business, which involved providing loans and back office service to hedge funds and brokerages, was worth around $1 billion and was well respected. In fact, many of Bear’s prime brokerage and clearing service clients were relieved when the bailout announcement came out JPMorgan later admitted that it was indeed great time for the firm to acquire Bear’s prime brokerage business.
How did the deal turn out?
Bear Stearns’ shareholders and employees were enraged with the $2 per share deal and threatened to file lawsuits. Meanwhile, Treasury Secretary Henry Paulson worried that the failure of the deal would be likely to bring Wall Street down to its knee, and decided to intervene. With just a phone call from Paulson to JPMorgan CEO, Jamie Dimon, the price was eventually brought up to $10 per share to soothe Bears’ investors. As an enticement, the Fed had to agree to loan JPMorgan $29 billions. As collateral, JPMorgan agreed to put up $30 billions worth of “time bomb” mortgage-backed securities. However, it was later revealed that aside from the $30 billion loan, the Fed actually lent $25 billions to Bear Stearns; the bailout turned out to cost $55 billions, not 30 billions.
Suspicion rose: Was Bear Stearns really rescued?
On the surface, the bailout seemed a legitimate action from the Fed. Yet, Ellen Brown, a writer from the Center for Research on Globalization, bore lots of suspicion on the purchase of Bear Stearns. The bailout was said to be triggered by false rumors that undermined the confidence in Bear Stearns, despite its adequate liquidity days before. Even though JPMorgan was glorified as the “hero”, Brown asserted that JPMorgan was not the rescuer; and Bear Stearns, which “wound up being eaten alive”, was definitely not the one rescued. Brown used evidences of suspicious events presented by John Olagues – a known expert in options trading, suggesting that far from rescuing Bear Stearns, JPMorgan was actually its nemesis: Bear Stearns was brought down by a plan of insider trading drawn up by the Fed and JPMorgan. Its collapse was artificially created so that JPMorgan could gain billions of taxpayers’ money to cover its own insolvency and “eat alive” its rival Bear Stearns; at the same time, insiders could gain massive profits by taking large “short” positions in Bear Stearns stocks.
Who sold the unusual, “lottery-like” put options?
The suspicion started with a series of requests for put options made on March 10th, 2008, with an exercise price of 25 and 8 days left of expiration. The stock was $70 on that day, meaning for put-buyers to gain, the stock would have to drop to $45 in 8 days. It was a risky bet, unless insider trading was involved. After the series opened, massive purchases of put options were made. Later on, more requests to open March and April put series were made, with very low exercise prices and only few days of expiration; these were also followed by massive purchases of put options. As Olagues alleged, “for anyone in his right mind to buy puts with five days of life remaining with strike prices far below the market price”, there must have been pre-arrangements involved. Someone must have prepared the collapse beforehand, or manipulated the market to make it look like Bear Stearns needed to be bailed out immediately. There were also some suspicions that JPMorgan, not Bear Stearns, was the one going bankrupt and needed bailout by the Fed. Evidences included the massive losses from derivatives on its books. Ellen Brown then maintained that “naked short selling” – selling stock short without actually owning the stock, must have been the reason. Naked short selling is considered illegal if the intention is to drive down the price of a stock, which was clearly the outcome in Bear Stearn’s case.
The Fed’s plan for expansion of power
Looking back to the April 4th Congressional Hearing on Bear Stearns bailout, both Brown and Olagues maintained suspicions. Most people present at the hearing agreed that the collapse was triggered by false rumors of Bear Stearns’ insolvency that cause a run on the bank. Yet, evidences of trade data from the Options Exchange suggested that the collapse was obviously prepared for. The suspicion was that Bear Stearns’ collapse was used to “justify a proposal giving vast new powers to the Federal Reserve to promote financial market stability”. Coincidently, 2 weeks after Bear Stearns’ collapse, Treasury Secretary Henry Paulson announced a plan of consolidating the state regulators and the SEC under the Fed, meaning most regulations would not be under the Fed. Calling the bailout “privatization of profit and socialization of risks”, Brown asserted that the deal was extremely beneficial for JPMorgan and the Fed, while incredibly bad for both Bear Stearns’ shareholders and US taxpayers. Indeed, JPMorgan got the all the money, and the Fed got all the power.
B- Michael Walzer’s complex equality theory
As the Bear Stearns collapse involved with dominant forces within the US financial sector and the economy as a whole, I would like to discuss the case with respect to Michael Walzer’s complex equality. In a society in which there is complex equality, small inequalities will exist, but they will not be multiplied through conversion process. Instead, they simply cancel each other out by being restricted from transferring from one sphere into another, so that overall, people are still equal even though they are unequal in certain aspects. Basically, Walzer argued that what is unjust about capitalist society is not the unfair distribution of social goods and the dominance in one sector, but the fact that dominance in one sector can lead to dominances in other sectors through conversion. He stressed: “I want to argue that we should focus on the reduction of dominance…we should consider what it might mean to narrow the range within which particular goods are convertible and to vindicate the autonomy of distributive spheres.” Therefore, JPMorgan’s action of using the bailout to gain billions of money would not be justified under Walzer’s theory. As one of the giant banks and dominating forces in the financial sector, JPMorgan had exploited its possession of power in the financial sector and converted it into wealth; and this wealth in the financial sphere would likely and unjustly lead to wealth in other spheres of the economy as well.
To minimize the convertibility of power into wealth and prevent banks like JPMorgan from exploiting their power, Walzer would suggest more regulations within the financial sector. This brings up another question of how the power to regulate should be distributed. Again, the bottom line to Walzer’s argument is that in a just society, dominance cannot be transferred between spheres. If what Ellen Brown and John Olagues contended was the truth, the Bear Stearns bailout would pose a big question regarding distribution of power. The fact that the Fed might have manipulated Bear Stearns’ collapse, and used it to gain more control by consolidating the power of the state regulators and the SEC under itself would be considered unjustifiable by Walzer’s theory. The financial sector is massive and consists of many small spheres in which different actors exercise dominance; it includes the spheres of the 50 states regulated by the state regulators, the federal government regulated by the SEC, and the banks regulated by the Fed. As an authority in charge of regulating the banks’ activities, the Fed should not assume all the power in the spheres that are regulated by the SEC and the state regulators. The power of regulation should instead be distributed to different authorities across multiple spheres of the financial sector. The rationale for this distribution of power is that the Fed’s increasingly monopolistic power in the financial sphere might unjustly be converted into increasing power in the political sphere. If the Fed’s growing possession of power in the sphere of politics enabled the Fed’s authorities to convert that power into wealth that is distributed in a separate sphere, then equality would not be preserved. In fact, it is still unclear whether the Fed’s power in the political sphere would be converted into wealth in another separate sphere in the long run. However, Walzer’s theory clearly would not validate the fact that the Fed might have manipulated the bailout in order to gain power in other spheres in which the SEC and the state regulators were the dominating forces.
C – Conclusion
All in all, Walzer’s complex equality theory was not against the idea of increasing regulations, but it clearly opposed to the idea of the Fed controlling all the regulations. Anyhow, it was still difficult to conclude which side was telling the truth, and whether Bear Stearns was the scapegoat or the rescued one. After all, Brown and Olagues’s version of the Bear Stearns bailout was mostly speculations based on trade data from the Options Exchange that suggested evidences of insider trading. None of these speculations has ever been confirmed as being the truth. However, the evidences were certainly compelling enough for us to say that they must suggest a certain degree of truth. The Fed could have pursed other options such as removing some of the less liquid assets on Bear’s portfolio, or directly lending money to Bear Stearns. Instead, the Fed chose a solution that made it difficult for Bear’s shareholders and employees as well as US taxpayers. Of course, US taxpayers would have to take the blow either ways, but why chose the option that would further bring outrage from Bear Stearns’ side as well? These will certainly remain open for even more speculation in the future.
D – Works Cited
Bernanke, Ben. “Testimony- Developments in the Financial Market.” Board of Governors of the Federal Reserve System. The Federal Reserve, 03/04/2012. Web. 16 Apr 2012.
Brown, Ellen. “The Secret Bailout of J. P. Morgan: How Insider Trading Looted Bear Stearns and the American Taxpayer.” http://www.globalresearch.ca. Center for Research on Globalization, 16/04/2012. Web. 16 Apr 2012.
Goldstein, . “Bear Stearns’ Big Bailout.” Bloomberg Businessweek. Bloomberg Businessweek, 16/04/2012. Web. 16 Apr 2012. <http://www.businessweek.com>. <http://www.globalresearch.ca/index.php?context=va&aid=8974>.
Smith, Steven. “Who Traded 55,000 Bear $30 Puts Tuesday?.” The Street. N.p., 13/04/2008. Web. 16 Apr 2012. <http://www.thestreet.com/>.
Walzer, Michael. Spheres of Justice: A Defense of Pluralism and Equality. United States of America: Basic Books, Inc. , 1983. 220.