Setting the Record Straight: Taxpayers Not Funding JP Morgan's Bear Buyout

by: Knockout Analyst July 11, 2008 | about stocks: BSC / JPM    

Knockout Analyst

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Since news of its imminent collapse and the actions of the Federal Reserve to prevent it, much of the criticism heaped upon JP Morgan’s (JPM) takeout of Bear Stearns (BSC) has revolved around whether it amounts to a taxpayer-funded bailout of Wall Street. Countless media reports would have their readers believe that this is indeed the case, but I have yet to read a single compelling explanation of how exactly this is the case. It does not take much effort to stoke the populist fire by quoting anonymous sources or citing vague ‘reports’ supporting this conclusion. To date, not a single account I have read attacks the crux of the matter, which is to explain the mechanisms, or under what circumstances taxpayer funds were, or could be used to fund the transaction.


I’ve scoured information on the Federal Reserve’s website and spoken with respected authorities on the subject, none of which suggest that taxpayers are footing the bill for the transaction. The likelihood that taxpayer funds will every be used at all is slim-to-none. One source I spoke with, a respected Finance Professor (of Markets & Banking, among other subjects) went so far as to say that he doesn’t expect either JPM or the Fed to take any significant loss as a result of the Bear deal when all is said-and-done.


Before anyone jumps down my neck, let me elaborate.


Two weeks ago the Fed released its quarterly update of the collateral pledged against its loan to JPM was marked down to $28.9 Bn from ~$30 bn when the loan was first made. Maturities on the assets pledged extend out 10-20 years or more, according to what I’ve seen, although the Fed is relatively mum on the exact composition of the portfolio.


To illustrate what would happen in an extreme case, lets consider a semi-arbitrary situation in which the default rate on the pledged assets is 100% (which is very unlikely, baring global financial catastrophe or something on that scale), with zero recovery on any assets, spread out evenly over 15 years. In this example, these are not simply mark-to-market accounting losses (how they’ll actually show), but economic losses, just to illustrate the point. In this example, the Fed will have to absorb ~$2bn per year over that 15 year period, a figure which may seem extreme, but as I’ll explain, is relatively insignificant in the grand scheme of things.


In “Purposes & Functions of the Federal Reserve”, pp. 11, it states:

The income of the Federal Reserve System is derived primarily from the interest on U.S. government securities that it has acquired through open market operations. Other major sources of income are the interest on foreign currency investments held by the System; interest on loans to depository institutions; and fees received for services provided to deposi­tory institutions, such as check clearing, funds transfers, and automated clearinghouse operations.

“Ok, BFD, so what?” you say. Relax my young padawan, for the truth shall set you free:

After it pays its expenses, the Federal Reserve turns the rest of its earn­ings over to the U.S. Treasury. About 95 percent of the Reserve Banks’ net earnings have been paid into the Treasury since the Federal Reserve System began operations in 1914. (Income and expenses of the Federal Reserve Banks from 1914 to the present are included in the Annual Report of the Board of Governors.) In 2003, the Federal Reserve paid approxi­mately $22 billion to the Treasury.

In 2007 this number was $38.7bn, up from $29.1bn in 2006 (pp. 360 of the report). Even if we take the low number from 2003, the $2bn annual loss from the above extreme example would only represent less than a 10% hit to the funds contributed to the Treasury by the Fed.


For those who still don’t get it, let me explain. While the Fed is funded and overseen by Congress, it is “private within the Government;” it is effectively a self-funded entity operating as a “private” organization within Government. The loan extended by the Fed to JPM (via Maiden Lane, LLC) was a direct extension of credit from the Fed’s balance sheet, not from an appropriate of taxpayer monies, which so far as I can tell, would have required specific Congressional action.


When this information is taken in its entirety the only possible “hit” to taxpayers would be a budgetary shortfall resulting from poor budgetary planning (e.g. if the budget was based on receiving X dollars from the Fed, only to actually receive X minus whatever “loss” the Fed absorbed from collateral losses in the Bear collateral). Even in this situation, taxpayers still are not actually funding any part of the transaction, only the foregone funds – which were never a certainty to begin with – of the difference between the estimated Fed contribution and its actual contribution in a given year.


May I be missing something (or potentially many things)? Absolutely. But all the research I’ve done suggests that one thing is certain (or at least as certain as anything can be these days): Taxpayers are NOT funding the purchase (“bailout,” whatever) of Bear Stearns.  Until, or unless someone can provide clear, factual support that this is not the case, journalists, pundits, and even those of us on The Street need to resist the urge to propagate the unsubstantiated claims of those who cannot or will not back up such claims.

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This article has 13 comments:

  •  
    Jul 11 09:06 AM
    Pretty artful way of explaining how the taxpayes will never miss getting the $2 Billion a year that they may otherwise get. I can agree that there has been little if any cost yet. And there may end up being a profit. The portfolio should be generating yields greater than the Fed Funds rate in any event so there could actually be a net income from holding these investments. However, trying to say that the taxpayer will not have any costs because any losses will just become "money not paid to the govt. and that is not a real cost" is simply deceptive logic.
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  •  
    Jul 11 09:27 AM
    I agree with Augustus -- FED can spinoff any number of "private" companies within it's governance -- bottomline is Revenue - Expenses equals Contribution to Treasury which is Taxpayers' money.

    And if there is $2billion/year dent into this contribution then It is
    The Taxpayer bailing out Bear...
    Reply | Link to Comment
  •  
    Jul 11 09:32 AM
    test
    Reply | Link to Comment
  •  
    Jul 11 09:32 AM
    test
    Reply | Link to Comment
  •  
    Jul 11 09:35 AM
    sorry for the test results, but my first comment was erased: as follows: this author is a sophist. Clearly, the 29B is a taxpayer liability, of which some, perhaps all, will eventually be realized, making us that much poorer, other things being equal. And if this isn't clear to you, you must be from an academic background, mastering the art of obfuscation. Everyone else sees the Bailout for what it is.
    Reply | Link to Comment
  •  
    Jul 11 09:40 AM
    I agree with prior two posters that revenue not received is a cost to taxpayers. Further, the moral hazard created lets investors ride on the government and taxpayers in charging less for debt instruments in the market for similar firms since there is now "quasi-insurance&... in the form of an expectation that firms with no regulatory mandate within the banking system such as MS, GS, MER, LEH, etc. can expect "help" if needed. While the shareholders of Bear only received $10 all debt holders were fully covered as a result of the help. That is, investors will pay too much for debt of these entities due to the implicit government and, therefore, taxpayer subsidy.
    Reply | Link to Comment
  •  
    Jul 11 01:49 PM
    There is not a Federal goverment or private spinoffs with out being 1st supported by tax payers.

    Why call someone an idiot for stating their opinion.

    IMHO let the chips fall where they may. I hope DOW goes to 10k and stays there for awhile. Let the wheat be seperated from the chaffe.




    Reply | Link to Comment
  •  
    Jul 11 02:14 PM
    The fed is risking 30B of capital by lending it out against some pretty shady The public, through the fed, is taking on the risk of this loan. Meanwhile, the fed has to keep interest rates artificially low so that JPM/BSC can make money on the deal, to the general detriment of the people (inflation, opportunity cost, what have you).

    So, the public takes on the risk and subsidizes the interest rate. Losses can occur at any time. How is this not a bailout, again?
    Reply | Link to Comment
  •  
    Jul 12 08:55 AM
    The academic question is if the government is not bailing out the money center banks or Fanny Mae, or Freddy Mac, who is bailing them out and where does the money come from? Could be the money comes from the same machine that is funding the politicians.....Mafia money laundering.
    Reply | Link to Comment
  •  
    Jul 12 10:32 AM
    Actually, you could argue that the "bailout" actually improved government revenues. The fed may never be required to provide a single dollar to fund the guarantee of Bear Stearns. However, the stability it created likely reduced the amount of losses investors would have incurred -- not just for Bear Stearns investors, but for many investors in the financial sectors. Reducing losses means reduced tax deductions. The result is more money for the federal government, not less. So, in some ways, this "bailout" reduced the potential taxpayer burden.
    Of course, this does not address the costs of "easy money," which has it's own problems. By flooding the economy with easy money, the Fed certainly contributed to the housing crisis / finanicial collapse in the first place. That is where the taxpayers really were hit.
    Reply | Link to Comment
  •  
    Jul 12 02:59 PM
    Ok. I have some baseball cards that won't sell on Ebay. But I SAY they're worth $10B. So how about giving me that much for them and if down the line the Fed can get $10B for them, then that wasn't a bailout, was it?
    Reply | Link to Comment
  •  
    Jul 17 03:08 PM
    Gentlement what you are all forgetting is that the Fed is not OBLIGATED to remit a single dollar to the Treasury. Just because they happen to have done so in the past does not mean that - for whatever reason - they must, or should continue to do so.
    Reply | Link to Comment
  •  
    Jul 30 02:42 PM
    You say that the bulk of the Fed's income come from interest earned on US securities. They then give (if I understand you 95% of what they earn back to the Govt.). I assume this payment is in the form of a Fed Reserve Check. What supports this check? Does it not add to the money supply? Does that not devalue the dollar? Doesn't devaluing the dollar an indirect tax on the public?
    Reply | Link to Comment
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