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Fed Didn't Consider Bear Stearns Bailout Days Before Its Bailout

Stocks in this article: JPM

NEW YORK (TheStreet) -- Transcripts released by the Federal Reserve on Friday indicated that the central bank's Federal Open Market Committee didn't discuss a direct bailout of Bear Stearns just days before it provided the struggling investment bank with a $12.9 billion loan that forestalled its bankruptcy and allowed JPMorgan (JPM) to acquire it. Transcripts also revealed that Bear's struggles caused members at the March 10, 2008, meeting to consider the impact were the central bank to decide to cut its lending to any individual primary dealer.

The Fed effectively bailed out Bear Stearns through its March 13 loan, and a March 17 facility called Maiden Lane that allowed the central bank to purchase $30 billion in assets from the investment bank. Those two liquidity measures allowed for JPMorgan to buy Bear Steans and forestall the investment bank's bankruptcy.

Those same efforts weren't taken just months later when Lehman Brothers, another investment bank, fell into a liquidity crisis in the summer and fall of 2008. On Sept. 15, 2008, Lehman brothers filed for bankruptcy after the Federal Reserve refused to lend to the investment bank as it worked to sell assets, or find an equity investor to forestall its demise.

At an unscheduled March 10 FOMC meeting, Fed officials discussed the implications of their direct lending to primary dealers, many of them standalone investment banks mostly outside of their regulatory purview. Using Bear Stearns struggles as an example, officials also began to contemplate the impact of cutting off lending to any back. Fed officials, however, didn't discuss any of their eventual efforts to lend directly to Bear Stearns as part of its rescue by JPMorgan.

On March 10, the Fed announced an expansion of its securities lending program, which allowed the central bank to lend up to $200 billion in Treasury securities to primary dealers for 28 days, rather than overnight, in exchange for agency residential mortgage-backed securities (RMBS) and non-agency RMBS.

At the time, market participants questioned whether the Fed's expanded lending facility, called the Term Securities Lending Facility, or TSLF, was a direct response to liquidity pressures at Bear Stearns. Transcripts revealed that Bear's liquidity crisis and similar struggles among major financial intermediaries did drive the Fed's decision to create TSLF.

Bill Dudley, manager of the System Open Market Account and a former New York Fed president, led off the March 10 meeting by describing the risks emerging in markets in the spring of 2008. Dudley referenced the failure of Peloton, a major hedge fund, and the problems of Thornburg Mortgage and Carlyle Capital, two vehicles that would later fail after struggling to meet margin calls.

Dudley raised those examples to point out that a vicious circle of liquidity issues, morphing into solvency issues, could cause major financial intermediaries to fail.

"If the vicious circle were to continue unabated, the liquidity issues could become solvency issues, and major financial intermediaries could conceivably fail. I don't want to be alarmist, but even today we saw double-digit stock price declines for Fannie Mae and Freddie Mac. There were rumors today that Bear Stearns was having funding difficulties: At one point today, its stock was down 14% before recovering a bit," Dudley said at the March 10 meeting.

To address those issues, Dudley said the Fed "responded by increasing the size of the TAF program and by implementing a large, term, single-tranche RP program." Dudley also proposed TSLF as a means to swap illiquid mortgage-backed securities for Treasuries with banks, reducing uncertainty between counterparties and allowing them to finance their balance sheets.

The Fed also discussed the implications that it might lend to a financial institution that would later fail.

"Are we aware of any primary dealers who are really in serious condition at this stage and constitute a 'first way out' risk?," Dennis P. Lockhart, a FOMC member, asked at the meeting.

"We have the right to limit our exposure to primary dealers that we have less confidence in. In fact, that is what we would actually do in the implementation of this kind of program," Dudley responded.

Other FOMC officials and Federal Reserve Bank presidents pressed Dudley, Fed Vice Chair Timothy Geithner and Fed Chairman Ben Bernanke on the process by which the Fed would decide not to lend to a primary dealer. Such a decision, Fed officials conceded, would likely cause a firm's demise.

"I noticed in the terms and conditions that it included that the New York Fed reserves the right to reject or declare ineligible any bid entirely at its own discretion. Under the TAF, we require that people be qualified under the primary credit program. Are we planning on using a credit standard equivalent to what is done for the TAF for the broker-dealer community? Do we currently have the capacity to make that determination?," Eric Rosengren, president of the Federal Reserve Bank of Boston, asked.

Dudley, the SOMA administrator, indicated that such decisions would be made on a case-by-case basis and with no hard-and-fast rules. A lack of credit standards ultimately came down to the Fed's lack of visibility into the financial health of primary dealers, many of them standalone investment banks outside of its regulatory purview.

"I think the answer to that question is that we are going to make a determination but we don't have the same level of knowledge about the institution because we are not the primary consolidated supervisor." Dudley said.

At the March meeting, Federal Reserve Bank of Dallas President Richard Fisher even raised the prospect that the Fed choose not to lend to Bear Stearns, as it faced a crisis of confidence that would quickly spin into a liquidity crisis.

"Do we have the capacity, for example, going back to your introductory comments on what happened in the markets, to evaluate Bear Stearns as a participant in this program and to say, "No, you can't participate"? If we did that, what would that do to Bear Stearns?," Fisher asked.

"Well, the first thing is that almost all of these primary dealers have the SEC as their primary consolidated supervisor. So it is important to understand that it is not as though there isn't an entity looking at the financial strength and stability of these institutions. We have the right not to accept collateral from any of the primary dealers, should we decide to do that. It is not going to be public. We are not going to be making a statement. This is just going to be a bilateral arrangement between us and the given primary dealer,' Dudley responded.

"[You] are right; it would be a consequential act for us to say to a primary dealer, '"We are going to restrict you to X' or 'we are not going to consider you eligible any more to bid.' It would not be, we would hope, a visible act. But, of course, in taking the action we would be responsible, in some sense, for contributing to the failure of that institution," Geithner added.

"But not in a legal sense," Bernanke added.

About a half-year later, the Fed would allow Lehman Brothers to fail in the biggest bankruptcy in American corporate history. The firm's failure put financial markets in a freeze and was the precedent for the Fed's actions through the fall of 2008 and the winter of 2009. Some Fed officials raised concerns about the implications were the Federal Reserve to choose not to lend to an individual bank, 
Some Fed officials raised concerns about the implications were the Federal Reserve to choose not to lend to an individual bank, 
Some Fed officials raised concerns about the implications were the Federal Reserve to choose not to lend to an individual bank, 

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