The Perils of Being a Bear

The Bear Stearns rescue continues to be a flashpoint in the markets. While the equity holders were hurt, critics say that's a side issue and have focused on the moral hazard of bailing out the Bear Stearns creditors in the midst of a credit bubble.

Today, David Evans, crack investigative reporter for Bloomberg, has an opus on the area many people think will be the next big blowup: Credit default swaps.

In one section of the piece, Evans makes an interesting point. Because Bear was shepherded into the hands of J.P. Morgan — initially for just $2 a share, later raised to $10 — rather than forced into bankruptcy, there was no default event. Evans continues:

"While that's devastating news for Bear shareholders — the stock had traded at $62.30 just a week earlier — it's the best news imaginable for owners of Bear debt. That's because JPMorgan agreed to cover Bear's liabilities, with the Fed pledging $29 billion to cover Bear's loan obligations.

"For traders who sold protection on Bear's debt, the bailout is a godsend. Faced with the prospect of having to hand over untold millions to their counterparties just three days earlier, they now have to pay out nothing.

"For traders who bought protection swaps just a few days earlier — when prices were in the 600s to 800s — the Fed bailout is crushing. Their investments have turned to dust."

In other words, the Fed's rescue of Bear Stearns didn't just help imprudent lenders to an overleveraged investment bank that had overly exposed itself to dodgy mortgage markets, it actually harmed prudent buyers of insurance (and, I should add, the speculators who hoped to profit from Bear's demise).

by Jesse Eisinger