Counterparty of last resort? Yes, but…
It’s official. The LLC that the Fed and J.P. Morgan recently formed to manage $30B Bear Stearns assets has taken over a portfolio of derivative positions along with those assets. Those positions involve both rights to receive and obligations to pay whose value may depend upon both circumstance and counterparty quality. Of course, if liabilities associated with those positions ever exceed the value of the LLCs assets, the limited liablity company could declare bankruptcy, so in theory, the Fed’s maximum exposure is $29B. But, if, out of reputational concern or to promote systemic stability, the Fed would inject capital rather than let the LLC default, then the Fed has indeed become a counterparty of last resort. However, the derivative positions are all claimed to be hedges related to the LLC’s “cash assets”. So, I guess the word of the day is basis risk.
Timothy Geithner’s speech yesterday amounts to the clearest narrative and strongest defense we’ve seen from an insider regarding the Fed’s management of the Bear Stearns crisis. (Hat tip Felix Salmon, Calculated Risk.) We learn that the assets effectively acquired by the Fed from Bear Stearns are
investment grade securities (i.e. securities rated BBB- or higher by at least one of the three principal credit rating agencies and no lower than that by the others) and residential or commercial mortgage loans classified as ‘performing’. All of the assets are current as to principal and interest (as of March 14, 2008).
However, these “cash assets” are bundled with “related hedges”. What are these hedges? It’s not stated explicitly, but the “Summary of Terms and Conditions” regarding the formation of the LLC, published with the speech, includes the following language:
[Bear Stearns] will sell to [the new LLC]… the assets identified by JPMC, the NY Fed and the Asset Manager as described on Schedule A hereto (the “Scheduled Collateral Pool”), together with the hedges identified by JPMC, the NY Fed and the Asset Manager [BlackRock] as described on Schedule B hereto (the “Related Hedges”) and including the Pre-Closing Date Proceeds Amount. For the avoidance of doubt, the Related Hedges include the amount that the Borrower [the new LLC] would have to pay to, or the amount that the Borrower would receive from, the applicable counterparty if the Borrower had entered into an identical transaction on March 14, 2008 based on the Bear Stearns marks as of such date (the “Transfer Value”), as well as all accumulated mark to market gains or losses thereafter and any cash proceeds as a result of Related Hedges’ being unwound.
…
[The new LLC] will assume as an economic matter the obligations under the Related Hedges and receive the benefits thereof by entering into a total return swap with the [Bear Stearns], such total return swap having an initial fair value as of the Closing Date equal to the fair value of the Related Hedges as of the Closing Date. The Controlling Party (as defined below) [the NY Fed] shall have the right to make all determinations related to the underlying hedges (e.g., whether and when to terminate) that are subject to the total return swap. At the request of the NY Fed, the Seller will use its commercially reasonable efforts to replace the total return swap with direct hedges with underlying counterparties through novation.
In English, Bear Stearns is selling various securities to an LLC controlled and largely financed by the Fed, but it is also transferring (“as an economic matter”) a portfolio of derivatives that are characterized as hedges of those assets. (In practice, these derivatives may be bilateral contracts not easily transferable to the Fed’s LLC, so the LLC and Bear are establishing a new contract, a total return swap, under which the LLC reimburses Bear for whatever is owed, and Bear forwards to the LLC whatever is earned, on positions that can’t be replaced with direct contracts.)
Specific information about the securities and the portfolio of derivatives has not been revealed. The schedules on which they are listed are not public. They could be credit default swaps on which the Bear Stearns had acted solely as protection buyer, which would be pretty benign. (These are like insurance contracts — the very worst that could happen is the LLC pays a regular premium, but when some of its bonds catch fire and disappear the insurer fails to pay up.) But lots of instruments could arguably qualify as a “related hedge”, some of which would be much riskier.
I would like to know general types and notional values of the LLC’s contracts, as well as the current exposures, gross and net. I know. I’d like a pony, too. Still I can’t see why the Fed should withhold this information other than potentially “bad optics”. Is this really a set of well tailored hedges to the cash assets described? How much counterparty risk has the Fed taken on?
There are some other interesting tidbits in Geithner’s speech. Geithner claims that, when the Bear crisis broke on Thursday, March 13, the Fed agreed to “extend an overnight non-recourse loan through the discount window to JPMorgan Chase, so that JPMorgan Chase could then ‘on-lend’ that money to Bear Stearns.” That differs from contemporaneous statements, which announced “a secured loan facility for an initial period of up to 28 days allowing Bear Stearns to access liquidity as needed.” The difference is important, as one of the big puzzles of the Bear collapse was why the firm, which had survived its public brush with bankruptcy by end-of-day March 14, suddenly had to be sold by Sunday evening. Most of us thought the crisis had been stabilized and the firm had 28 days to resolve it. (Bear insiders too: “We thought they gave us 28 days. Then they gave us 24 hours.”)
Another curiosity is this:
The assets [to be taken over by the Fed’s LLC] were reviewed by the Federal Reserve and its advisor, BlackRock Financial Management. The assets were not individually selected by JPMorgan Chase or Bear Stearns.Does this give you any comfort? I guess it depends what you think the Fed wanted to do here, and what you think it ought to have done. Did the Fed cherry-pick relatively good assets and hedges, to protect taxpayers? Or did it knowingly take the riskiest assets that it could within its broad-outline criteria, intentionally making itself a risk absorber of last resort to forestall future crises? It may be a while before we know, if ever.
- 4-Apr-2008, 12:50 a.m. EDT: Removed a superfluous “that”, changed a “could” to a “would”.
I, as a tax payer, am totally stoked to take on this debt for bear sterns. Being of the mind that the rich should get richer, I totally support this move…not.
April 3rd, 2008 at 10:58 pm PDT
link
None of this gives me any comfort. Who picked the assets to go into the collateral pool? Surely it wasn’t random.
A CMO support bond purchased at a premium can lead to significant losses when prepyaments go up — so who cares if the bond is current as to interest and principal?
Also,the derviatives trades must be toxic waste as JPM goes through a RubeGoldberg TRS facility to transfer the risk to the taxpayer.
Why doesn’t the FED come clean and just disclose the ‘assets’ in the Delaware SIV?
April 4th, 2008 at 12:27 am PDT
link
I think the issue of the day is whether the US has taken on (on behalf of the American taxpayer) significant exposure to sub-prime losses. It’s one thing to be holding sub-prime mortgages, but if you’re in the business of leveraging these assets on a basis of 3:1 over the next quarter things get a lot more risky fast ( link )
Socializing risks and privatizing rewards does nothing to improve the situation of the average citizen, and in the face of a declining dollar it does significant damage.
It is simply not in our best interests. It is however in the best interest of a fed trying to subsidize debt (since Sterns is one of the 3 major buyers). JP Morgan is heavily leveraged in similar markets to Bear Sterns, so regardless of the bailout there is in effect, another shoe to drop.
April 4th, 2008 at 5:41 am PDT
link
“The difference is important, as one of the big puzzles of the Bear collapse was why the firm, which had survived its public brush with bankruptcy by end-of-day March 14, suddenly had to be sold by Sunday evening. Most of us thought the crisis had been stabilized and the firm had 28 days to resolve it. (Bear insiders too: “We thought they gave us 28 days. Then they gave us 24 hours.”
From Bloomberg:
“Bear Stearns executives thought they had at least 28 days to consider options, including finding a buyer, CEO Alan Schwartz told the committee. By Saturday, the Fed insisted the situation would have to be resolved over the weekend, surprising Schwartz, he said. Officials expected panic selling when Asian markets opened, according to Geithner.
“The sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and would have severely shaken confidence,” Bernanke said. ”
April 4th, 2008 at 8:45 am PDT
link
“Geithner claims that, when the Bear crisis broke on Thursday, March 13, the Fed agreed to “extend an overnight non-recourse loan through the discount window to JPMorgan Chase, so that JPMorgan Chase could then ‘on-lend’ that money to Bear Stearns.” That differs from contemporaneous statements, which announced “a secured loan facility for an initial period of up to 28 days allowing Bear Stearns to access liquidity as needed.” The difference is important,….”
Steve, there is no difference. BS had an overnight loan from the Fed to cover thursday 13th to friday 14th and the “up” to 28 day loan was announced on the morning of friday the 14th running from the 14th.
April 4th, 2008 at 9:33 am PDT
link
Without knowing exactly what the assets are it is impossible to determine if this is a good deal for the Fed or not. If I had to guess I would say it is good for the Fed, on average MBS are incredibly cheap to their fundamental value due to the enormous technical pressures in the market. Until we know what they are, however, we can’t say if they were cheap or even if the Fed paid the market price for them.
April 4th, 2008 at 10:04 am PDT
link
Dr. Steve – Forgive me if you would for being the dumb guy in the mix again, but I understand (probably incorrectly) that one of the significant objectives of the transaction as done was indeed to forestall disclosure, prevent actual portfolio contents from being revealed. Many features of the proceedings make me think so, including some of the “what might have happened…’ statements made by various principals and some of the explanations why other workout processes were not acceptable. It is not hard to imagine other ways (other than the Blackrock LLC etc.) to manage BSC positions while liquidating and providing counterparty payments for the sake of system “stability,” but most of them would involve more description/discussion of what is being done. An actual bankruptcy, of course, is one of the the fuller cases of disclosure (with filings and trustees and creditors committees and all the stuff) and appears to have been unacceptable not just for the use of the word “bankruptcy”, but for the extent of required public disclosure.
April 4th, 2008 at 10:20 am PDT
link
jck — yeah… i should have made that clearer. so sure, there’s no contradiction between overnight financing Mar 13 – Mar 14, plus a commitment for a 28 day loan beginning the 14th. but geithner’s comment erases the latter from history. but immediately after what i quoted, geithner states “This action was designed to allow us to get to the weekend, and to enable us to pursue work along two tracks…”, as though the intention were to provide only one night’s financing. the 28-day facility, which seemed crucial to Bear investors on Fri Mar 14, is nowhere in geithner’s narrative. it’s a big unanswered question, why they were not given 28 days.
br — i hain’t no dr., probably a bit of a dumb guy in the mix meself. to what degree avoiding “sausage-factory” disclosures about Bear was a motivation in how the crisis was handled is something about which we can only speculate.
general — whether this and the fed’s strategy as a whole turns out to be a good deal for taxpayers in nominal or real dollar terms net of opportunity costs, or in overall terms given the risks associated with alternative course of actions and the costs financial and otherwise associated with the path chosen, are all unknowable for now (and may be unknowable forever). i’m fairly cynical about the approach, but there is a reasonable case that the hazards being avoided are worth every taxpayer penny put at risk. i wouldn’t make that case, not because i’m so worried about the medium dollar liabilities to taxpayers, but because i think so many bad precedents are being set that it will be hard to get a financial system to work properly with incentives distorted as badly as they will be after all this. the more “moral hazard” we create to avoid risks, the more radically the ex-post financial system will have to be regulated or changed in order for it to have any hope of doing a reasonable job of allocating capital properly. if we maintain basically the same system ex post, these interventions have created tremendous incentives to game, unless we can plausibly commit that we wouldn’t do the same during the next crisis.
April 4th, 2008 at 12:13 pm PDT
link
Steve:
just like the bank of england didn’t expect their “rescue” of northern rock to trigger a bank run, the Fed crew didn’t expect the “run” on BS to get worse on friday after they announced their package so they had to do something quick. By the way I still think that this mess is the result of the fed action paticularly the annoucement of the TSLF which started the whole run on primary dealers. So many thanks to Ben and Tim for rescuing us from their own stupidity. These guys should be in jail, not pontificate in Congress.
April 4th, 2008 at 12:28 pm PDT
link
Steve:
Have been reading for a few weeks and very much appreciate your English translations of FinSpeak. I notice in Geithner’s speech the following:
“And at the request of and with the full cooperation of the SEC, examiners from the New York Fed were sent into the major investment banks to give the Federal Reserve the direct capacity to assess the financial condition of these institutions.”
Is this how the Fed wants to limit the ability to game as they create/maintain the “incentives to game”?
April 4th, 2008 at 5:32 pm PDT
link
jck — Wow. Ouch. I guess you don’t mince words.
I do buy that the announcement of support for Bear might have been sufficient to trigger a broader run, a la Northern Rock. But, the BoE stood fast in its support, until the substance of the support overwhelmed the panic it had provoked. Britain decided the final disposition of Norther Rock at leisure rather than in haste. The Fed had the same option. It announced 28-days of support, and its balance sheet was perfectly capable of delivering that support until market participants believed. That’s what a reasonable Bear investor would have anticipated given the announcements on Mar 14. A run is not enough to explain the change of heart (nor does it explain the odd absence of the original 28 day support in Geithner’s otherwise detailed account). My guess (of course it is only a guess) is that the hasty marriage between Bear Stearns and JPM announced on Sunday was not the result of any post-Friday exigency, but was the result of a choice, right or wrong, that Bear should be sacrificed on the alter of appearances, specifically the appearance that the consequences of bad risks have not been socialized, that market discipline is in play among the high and mighty. Of course, there is nothing resembling market discipline in a planned execution by the central bank, but wiping out equityholders (of Bear, while delivering a windfall to JPM) did look like capitalism red in tooth and claw, at least for the moment that it lasted.
djk987 — That may be what the Fed hopes to do, but we’ve just witnessed the results of a system that creates huge incentives for people to do foolish things, and relies on the monitoring of schoolmarms to prevent those foolish things from being done. It’s just not a good model.
April 5th, 2008 at 5:27 pm PDT
link
Hooray. In looking at the JPMorgan bailout, not Bear bailout, I thought of William Jennings Bryan’s (WJB) 1896 “Cross of Gold” speech. Yes, Bear was “sacrificed” for the good of the rest of Wall Street. If Hank Paulson and Helicopter Ben have any brains at all, they will see to it that the rest of Wall Street keeps Bear’s employees employed as “protection money” to shut them up. Welcome aboard Steve! With apologies to WJB, “Thou shalt crucify Bear Stearns on a cross of JP Morgan”. I also feel Countrywide was similarly sacrificed.
April 6th, 2008 at 9:30 am PDT
link