Bear Stearns in a nutshell: How taxpayers came to bail out a bank

[COMMENTARY] Congratulations! You and your fellow American citizens just bought a failed investment bank at a fire-sale price overnight!

Well, almost. The Federal Reserve agreed to guarantee losses by Bear Stearns if the healthiest U.S. investment bank, J.P. Morgan, would buy Bear Stearns and in turn guarantee its financial contracts. The amount that the Federal Reserve has offered for underlying guarantees is $30 billion of taxpayer money.

The Federal Reserve took this step in order to stop what looked like a run on Bear Stearns (BSC), which as an investment bank was a buyer and seller of equity and debt securities for customers like large corporations; other financial institutions; and governments, whether domestic or foreign. Many investors were pulling their money out of BSC because they’d lost confidence in the bank due to the amount of mortgage-based business BSC held, much of which has been impacted negatively by the subprime crisis and poor oversight of the mortgage industry.

There was a lot of concern that this loss of confidence could spread across the banking industry, pushing the Federal Reserve to offer the financial bailout as well as a quarter-point reduction in the lending rate to financial institutions last night, from 3.5 percent to 3.25.

But this fire sale didn’t begin overnight, no matter how shocked the breathless talking heads on television and radio sound this morning. For more than five years, credit has been too cheap and too easy, and financial firms have not faced much scrutiny for lending this cheap, easy money. There were far too many so-called NINJA loans (folks with no income, no job or assets were able to get loans).

Continued -You probably saw some iffy loans advertised on television, where one could borrow a large sum to buy a home with no money down, and without having to pay down the principal, making payments only on the interest. The folks who most frequently pursued these kinds of loans also agreed to adjustable interest rates that fluctuated with the market for money. These borrowers assumed that interest rates would remain low or that their situation would improve and allow them to manage payments that increased in size over time.

The easy credit encouraged consumption, propping up our economy; it also encouraged the churn of real estate at the same time since people could buy more and bigger properties. Renters bought homes; home owners traded up to larger properties. Many buyers simply bought homes as an investment; there were new television shows on Home and Garden Television that focused on “flipping” properties as investments. The aggregate demand drove up housing prices, creating a classic bubble.

And now the bubble has popped, just like the dot-com bubble of the late ’90s. Bad NINJA loans have hit banks’ books hard. The changes in recent years to bankruptcy laws in the U.S. shifted the priority of debt repayment to credit cards rather than mortgages, so borrowers are more likely to walk away from homes and home loans where they may have no equity at risk (or staying in the adjustable-rate mortgage costs more than losing the equity).

Factor in the 60+ percent increase in fuel costs over the last year and the corresponding increase in cost of living, both of which decreased cash available for home buyers for mortgage payments, and bingo: There’s a glut of homes on the market, collapsing the value of the entire housing market, and banks and other financial institutions now hold worthless mortgages. 

Businesses like BSC were heavily invested in a lot of financial instruments, the value of which was supported by mortgages that are believed to be bad. Their holdings were viewed as worthless, and quite possibly worthless to the point of being negative. Investors pulled out of BSC last week, and that’s where we stepped in.

J.P. Morgan bought BSC for $2 a share, or roughly $236 million. BSC stock closed on Friday last week at $30 a share; it closed Thursday at $57 a share. Quite a fall for a stock that traded last year at $170 a share, or a total value of $20 billion. BSC’s office building in New York City is valued at roughly $1.5 billion; this means the business itself was valued negatively.

The market will likely not tank on Monday, but it’s going to be grim. The Nikkei dropped more than 3 percent when the Japanese market opened, and the Hong Kong market lost 5 percent of its value during its trading day. European markets are already looking equally depressed, presaging a very dark day on Wall Street if not a Black Monday.

We’re only beginning what will be a grim week, though. If BSC is virtually worthless, what is the real value of all banks on Wall Street? What’s the value of regional banks like Wells Fargo, or those here in our own state? We taxpayers may bbu more than one failed bank before this is all done, as well as paying higher interest rates to cover our state’s budget obligations.

And while many of us may feel the sting through losses in our investments in a floundering market, or through likely increases in taxes to cover the BSC bailout and other bailouts to come, pity the folks arriving at their desks this morning at BSC. Employees owned approximately 30 percent of BSC stock — now worthless — and are now facing likely mass layoffs and the loss of retirement income they may have expected.

It might feel just a bit like living in Michigan for those BSC folks on Wall Street, as there will likely be few jobs welcoming them once layoffs begin. At least we Michiganders are used to the feeling.