Government's Bear Stearns Bet Underwater

The portfolio of mortgage-related assets acquired from Bear Stearns by the U.S. government is dropping in value, creating unrealized losses for taxpayers.

The U.S. Treasury has made some big gambles this year on the domestic financial services industry. You can almost picture Matthew McConaughey's bookie character from Two for the Money calling up Secretary Paulson and saying, "Have I got a game for you."

Fed's funny business

Taxpayers are seeing red on the Bear Stearns investment, one of the Treasury's earliest mortgage market bets. Here's a short history of what's happened. In March, the Fed agreed to shore up Bear Stearns' liquidity with an emergency bridge loan that had to be repaid within 28 days. Shortly after it was negotiated, JPMorgan Chase emerged as a potential suitor for the company. The government supported the deal as a way to salvage Bear Stearns' operations, but JPMorgan executives had some deep reservations regarding Bear Stearns' portfolio of risky, mortgage-related assets. The Fed eased those concerns by financing the portfolio with a $29 billion non-recourse loan made to JPMorgan.

In June, the Federal Reserve Bank of New York (FRBNY) formed holding company Maiden Lane LLC, which used a $30 billion loan from FRBNY to purchase those tainted Bear Stearns assets, for the purposes of managing them down over time.

The Federal Reserve recently reported that the portfolio's fair value declined about 9 percent between June 30 and September 30 of this year. The assets are now worth an estimated $26.8 billion. JPMorgan has agreed to absorb the first $1.15 billion of losses, but the rest lies in the hands of taxpayers.

The mark-to-market myth

The 9 percent decline is a function of the Treasury's quarterly assessment of the portfolio's fair market value, which is driven by investors' appetite for the investment, as well as its expected future cash flows. These days, investors are shunning almost any type of mortgage-related security, so it isn't surprising that the market value would decline. This is currently an unrealized loss for taxpayers. Since the Treasury intends to hold this mortgage portfolio for 10 years, the actual performance of the assets could turn out to be quite different.  

Obviously, the Feds are hoping things will turn around, such that the assets pay for themselves over time. Secretary Paulson has staunchly defended the government's involvement in this deal, arguing that it would minimize further economic damage. Unfortunately, Paulson hasn't always been accurate in his economic assessments. Back in April of 2007, for example, he had this to say about the subprime mortgage crisis: "I don't see [subprime mortgage market troubles] imposing a serious problem. I think it's going to be largely contained."

Maybe his bookie told him that. Hopefully, Paulson didn't have any of his own cash riding on that statement.