Along the lines of the ‘hot potato’ concept, we ask why did the Fed throw Bear Stearns and their shareholders under the bus in a panicky move that insured JP Morgan would benefit from not having to inherit the problem securities?

Consider this: Alex Rodriguez’s contract with the Yankees was worth more than all of Bear Stearns at $2 per share. JPM’s stock rose 25% last week alone, rewarding JPM’s shareholders with a gain of $34 billion, which if you divide by the number of Bear Stearns shares outstanding results in a value of $274 per share. Amazing stuff isn’t it?

In the early days of gloom in Japan following their credit debacle, this solution would be known as a ‘good bank, bad bank’ combination. I guess the Fed felt like it was better to enrich JPM’s shareholders -- and those of many other companies as well -- than to wonder what circumstances would come to pass if Bear would be permitted to fail.

I suspect this will not be the last good bank, bad bank deal. In fact, Bank of America (BAC) absorbing Countrywide (CFC) was this sort of deal. Could it happen to CIT Group (CIT) , Washington Mutual (WM), Lehman Brothers (LEH) and Merrill? Absolutely it can and likely will.

The only question I ask is whether they will be absorbed by domestic or international entities. After all, how many Bear Stearns’ can JPM absorb?

Just How Esoteric?

How can I say that these esoteric securities are a problem when the Fed said it would take in AAA rated agency as well as non-agency securities? They are a problem because many AAA securities aren’t really AAA securities when you tear them apart from the underbelly.

Research by Bloomberg shows that 74 of 80 deals in the AAA-rated ABX Index (measure of various mortgage-backed securities) aren’t even investment grade, let alone AAA (see below). For the full interactive chart on Bloomberg.com click here.


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Since the Fed can just print money -- unlike an investment or commercial bank that must tap public markets for credit -- it's better to pass the hot potato from the balance sheets of Bear, Lehman, Goldman Sachs (GS), Merrill and Citi to the Fed, that doesn’t really have a P&L. It can then simply ask Congress to print more money and expand its balance sheet.

The ultra-talented Jamie Dimon of JPM refused to take the hot potatoes because it would have made the deal a potential mess. Instead, the hot potatoes will make their way to the balance sheet of the Fed.

The Fed just released its weekly balance sheet for the week ended March 20th, 2008, which is depicted below.


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Courtesy of www.federalreserve.org

Note how the balance sheet is slowly moving from marketable Treasuries to ‘other securities.’ In other words, the Fed is slowly taking on the look of a traditional bank or broker/dealer. The Fed is loading up its balance sheet with low grade securities by selling off riskless and liquid Treasuries.

Note also the total size of the balance sheet. It's only one-third the size of Citigroup’s (click here, courtesy of Bloomberg, as of 12/31/07). If the Fed is thought to be the ‘lender of last resort’ and its balance sheet is slowly degrading in an effort to help the system repair itself and avoid counterparty risk, the only option it will have is to drastically increase its balance sheet to accommodate all the hot potatoes.