Leveraged Liquidity: Bear Raids and Junk Loans in the New Credit Market

I. INTRODUCTION By now, we have all noticed the turbulence in our credit market. Defaults on residential mortgages have climbed, prices for structured credit products have fallen, and banks have tightened lending standards. To counter some of this, the Federal Reserve (Fed) has been adding "liquidity" to the credit system by lending banks cash (or financial resources that act like cash) against collateral pledged by the banks.1 Liquidity injections reassure nervous banks and, it is hoped, coax them into making loans of their own to consumers and businesses, that way jump-starting confidence in the economy. One such liquidity tool is the Fed's discount window, which lets a bank pledge its own loans to bank customers (or securities from the bank's own portfolio) in exchange for a cash loan from the Fed.2 Think of it as the Fed's pawnshop for commercial banks facing short-term liquidity problems. During the discount window's near-century of operations, only depository institutions like commercial banks could use it, with the exception of some nonbank firms that got emergency loans in the Great Depression.3 But in March 2008, the New York Federal Reserve Bank agreed to use discount window liquidity for the benefit of Bear Stearns (Bear), an investment bank, using JPMorgan Chase & Co. (JP Morgan), a depository institution that is a member of the Fed, as a financing conduit.4 The loan was used to fund JP Morgan's acquisition of Bear, for which JP Morgan put in $1 billion and the Fed lent $29 billion through the discount window at terms that are much more borrower-friendly than typical discount window lending.5 In the words of the New York Fed, the action was being taken "with the support of the [U.S.] Treasury Department, to bolster market liquidity and promote orderly market functioning."6 JP Morgan finalized the acquisition of Bear in a stock-for-stock merger that became effective in May 2008.7 Legal authority for the deal with Bear (aptly named since "bear" means downward price pressure) came from a section of the Federal Reserve Act that lets a majority of Fed governors extend emergency credit to individuals and firms in "unusual and exigent circumstances," as they had in the 1930s.8 The use of Fed liquidity to keep an investment bank viable is significant, as noted by the senior Fed official in charge of the loan when testifying about it to the Senate Banking Committee.9 No isolated transaction, the Bear deal is part of an evolving response on the part of regulators to a new credit market. Just two weeks after the deal, the U.S. Department of the Treasury proposed a new approach to financial market regulation-the Treasury Blueprint for a Modernized Financial Regulatory Structure (Treasury Blueprint).10 By recommending that the Federal Reserve had a legitimate interest in providing emergency financing to institutions other than depository institutions, the Treasury Blueprint blessed the Bear deal and endorsed access to the discount window for financial firms other than banks.11 This too is noteworthy. The Bear deal is a watershed in U.S. banking and finance because it marks the official recognition that new liquidity dynamics in our credit markets merit attention. Indeed, liquidity is the financial dimension of the hour. As the Chairman of the U.S. Securities and Exchange Commission (SEC) emphasized about Bear, it was "a loss of liquidity-not inadequate capital-[that] caused Bear's demise."12 Liquidity "feeds fantasies that risk has evaporated. . . . Just as inflation shaped psychologies a generation ago, liquidity determines our behavior in a world of short-term performance."13 Unfortunately, our understanding of liquidity has not kept pace with the credit market, hence much discussion of the issue is imprecise or incomplete.14 These liquidity dynamics are here to stay, so the sooner regulators and traders face up to them, the better. Luckily, financial academics and regulators concerned with liquidity are working on new conceptual tools, including this Article. …