Why I don’t like Mondays
Note: Since last week, interfluidity‘s readership has grown by an order of magnitude. Which, quite frankly, has me terrified. I wonder whether it’s still responsible to post some of my darker provocations. What follows has a very short shelf life, and may or may not capture what’s going on in the suddenly urgent quest to sell off Bear Stearns. It’s speculation and conjecture, but I think worth considering before anything rash is arranged.
On Friday, Alea’s jck pointed us to an SEC press release about Bear Stearns:
According to the information supplied to the SEC by Bear Stearns as of Tuesday, March 11, the holding company had a substantial capital cushion. In addition, as of March 11, the firm had over $17 billion in cash and unencumbered liquid assets.
Beginning on that day, however, and increasingly throughout the week, lenders and customers of Bear Stearns began to remove funds from the firm, despite its stable capital position. As a result, Bear Stearns’ excess liquidity rapidly eroded.
The title of jck’s post was “Bear Raid“.
That’s not just a pun on the troubled firm’s name. “Bear raid” is a term of art for a well-known, usually illegal, strategy. Suppose you know the positions of a heavily leveraged, capital-constrained player, and you’d like to have its assets on the cheap. Rather than trying to buy those assets, sell them short to drive down their prices. At the same time, start rumors that their current owner is insolvent. Soon the target starts getting margin calls it cannot meet, and is forced to liquidate its portfolio to satisfy creditors. This puts even more pressure on the already depressed prices of its holdings. Buy up the dying target’s portfolio, along with the assets you sold short, for a song. Ka-ching!
Cassandra offered some wonderful musings on this kind of strategy in connection with the now quaint Amaranth meltdown.
It’s unlikely that Bear’s little liquidity problem last week was anybody’s secret plot. There is quite enough spontaneous, organic panic in the market to explain how a teensy little rumor might spiral into a life-threatening crisis for a firm with an overstretched and uncertain balance sheet.
But, in light of the circumstances, I was troubled to read this CNBC story (via Calculated Risk):
The discussions indicate that potential bidders for Bear have been narrowed to [J.C. Flowers and JPMorgan Chase], although other last minute contenders could still weigh in… time has become a major issue for the investment bank… S&P lowered its long-term counterparty credit rating on Bear to “BBB” from “A,” and it placed long-and short term ratings on credit watch with negative implications… Because of that S&P downgrade, bankers have now come to the conclusion that a deal must be done by Monday morning because no one on the street will trade or lend to Bear Stearns, which is rated a notch above junk bond levels… If there’s no deal Bear Stearns will have to file for bankruptcy, executives said.
A quick sale, on its face, is an attractive option. It’s a “market solution”. Bear stockholders wouldn’t be completely wiped out, and Bear’s counterparties would be relieved to have a stronger player on the other side of their deals.
But a quick sale is likely to be a fire sale, and it’s impossible for a transaction of this complexity to be adequately vetted in 72 hours. With all the world trying to get a deal done, whoever “buys” Bear might end up getting the firm’s good assets cheaply without fully assuming Bear’s potentially unknowable liabilities. (Recall the uncertainty still surrounding Bank of America’s purchase of Countrywide.) In the very worst case, to make the crisis go away, the Fed might be asked to backstop some or all of Bear’s obligations while a “buyer” cherrypicks the assets.
Viewed as a one-shot affair, this might seem like the best that can be done in a bad situation. But, alas, there are always those unanticipated consequences to consider. Bear Stearns probably was not the victim of an intentional bear raid. But, set the right precedent and the next bank to fall very well could be.
Bear Stearns has already been nationalized all but in name. Executives hinting that the firm will file for bankruptcy unless an immediate sale is arranged are playing a game of chicken with the Federal Reserve, trying to get paid now for stock that may be much worse than worthless when all the books are tallied. They suppose they have leverage, since the Fed has made clear that an abrupt bankruptcy would be too harmful to permit (probably because of Bear’s role as a derivative counterparty, see Michael Shedlock).
Suppose that Monday morning, Ben Bernanke is presented with a deal, under which a buyer gets Bear assets on the cheap, Bear stockholders get paid out, and the Fed (implicitly or explicitly) bears residual risk. If the Fed doesn’t approve, executives say, Bear will file for bankruptcy. Dr. Bernanke will then have an unappetizing choice. He can say yes, and hope that there aren’t any more rumors out there about any other firms. Or he can say no, and make it very clear that if Bear Stearns files for bankruptcy despite the Fed’s continuing provision of liquidity, he will do everything in his power to hold Bear executives personally responsible for the crisis that results.
A man who by all accounts is a very nice guy may be forced to play some very hard ball.
Update: Very short shelf life indeed, Monday came on Sunday this week. So, what was the deal? Buyer (J. P. Morgan) does get Bear on the cheap. Bear stockholders get paid a token amount, but really next to nothing. The Fed does bear residual risk, both explicitly via a $30B “+/-” nonrecourse financing arrangement and implicitly since J.P Morgan is even too bigger to fail now. The most important bit, though, is here:
[T]he Federal Reserve Board voted unanimously to authorize the Federal Reserve Bank of New York to create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets. This facility will be available for business on Monday, March 17. It will be in place for at least six months and may be extended as conditions warrant. Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities. The interest rate charged on such credit will be the same as the primary credit rate, or discount rate, at the Federal Reserve Bank of New York [which is simultaneously reduced to 3.25%, or the Federal Funds Rate + 25 basis points].
You might call this the “anti-Bear-raid” provision. If this had been in force last week, Bear Stearns would still be a proud Wall Street titan, and we wouldn’t have heard a thing. This should be sufficient to head off a round of competitive consolidation by rumor and guile.
Overall, it looks like J.P. Morgan comes out a big winner, Bear stockholders are the losers, and Bernanke & Co. did better than they might have. If, as I speculated, the bankruptcy rumors were BSC execs playing chicken with the Fed, the Fed won. Whether JPM’s windfall was luck or craft, we may never know, but parsimony and good sportsmanship suggest we call it fortune, absent evidence to the contrary. At least this deal is makes some effort to think about incentives. An important player has finally been allowed to fail, and a set of perverse incentives was carefully eliminated. Still, this arrangement is very, very generous to everyone other than Bear. One was sacrificed that all might survive. (Was it karma, coincidence, or something else that the one firm that refused to participate in the LTCM bailout would be the only firm not bailed out during the Great Credit Crunch of 2008?)
It’s worth noting that the Fed has now committed yet more of its dwindling balance sheet to stabilization, and on easier terms than ever before. Keep a close watch on H.4.1. There’s no doubt that the Fed is taking on a lot of credit risk, and is providing a lifeline to other firms no more or less worthy of being made an example of than Bear.
A few puzzling details: The Fed has provided roughly $30B nonrecourse financing (meaning that the Fed absorbs the credit risk) for “largely mortgage-related” assets, but according the J.P. Morgan’s presentation of the deal (hat tip Calculated Risk), mortgage-related assets will account for only $20B. What’s the other 10B “+/-” about? No mention is made of Bear’s role as derivative counterparty, although “JPM will guarantee the trading obligations of BSC and its subsidiaries effective immediately”.
Perhaps some of this was discussed in this evening’s conference call. I haven’t had a chance yet to listen or read a transcript.
Update II: Yves Smith and Calculated Risk both point to signs that Lehman Brothers may be in trouble as well. Given the Fed’s new facility, if you think (as I do think) that the Fed would lend taking a 15% haircut from par on Monopoly money to prevent another major firm from falling, I have a hard time seeing Lehman going under.
- 16-Mar-2008, 10:10 p.m. EST: Added update re Monday coming early.
- 16-Mar-2008, 10:30 p.m. EST: Changed update, embedding my comments on the deal rather than putting them in a separate post. Added Update II re Lehman as well.
- 17-Mar-2008, 3:05 a.m. EST: Cleaned up some wording in Update II.
Your old readership is here too!
And I think I understood up to 15-20% of your post this time. ;-)
March 16th, 2008 at 3:26 pm PDT
link
“That’s not just a pun on the troubled firm’s name. “Bear raid” is a term of art for a well-known, usually illegal, strategy.”
Cornering the market ala Hunt bros silver play(not succesfull) or Soros’ breaking the pound play(succesfull)are examples of players gaming the system. The PPT also games the system when they have ibanks buy futures at key support levels, cut irates in response to asset price movements and talk their book counter to reality.
At the end of the day, you can’t hold back the tide. The music has stopped and Bear finds itself one chair short.
March 16th, 2008 at 6:07 pm PDT
link
The ABX-HE-AAA 07-02 now values Triple A MBS at 53 percent of face value. Allowing Bear Sterns and other banks to borrow 100% of face value will generate a race to the TSLF window that depletes the Feds balance sheet without restoring confidence. Why can’t the FRB do what J.P. Morgan did in 1907–offer to buy or lend against Triple A MBS securities at a fixed discount (that could vary with verified characteristics of the MBS) from face value. This would set a floor to the mark-to market write downs, ease fears of further balance sheet erosion and signal to the vulture funds currently on the side lines that bottom has been reached and its time to jump in. If the offer gets no takers and does not restart the market for MBSs, the FRB could consider raising its offer. If the government ends up owning lots of MBS paper, the 30% or so discount gives it a chance to break even or possibly come out ahead as it did in the Chrysler rescue.
March 16th, 2008 at 7:02 pm PDT
link
Ok, I’ve only read the first paragraph so far, but here’s my idea:
Since you’ve grown my an order of magnitude in a week, you’re clearly going to grow by an order of magnitude every week forever. So, I’d start making letting people borrow against your future earnings. If it works, you’ll be rich. Worst case, the Fed bails you out…
March 16th, 2008 at 7:09 pm PDT
link
This is like a child who KNOWS he is in big trouble but hides from his punishment.All the while KNOWING the longer he waits the more severe the consequences are going to be.
Sometimes you have to trim the branches so the tree can grow stronger.
March 16th, 2008 at 7:09 pm PDT
link
The Man and the Monkeys: A Wall Street Fable
Once upon a time in a village a man appeared and announced to the villagers that he would buy monkeys for $10 each.
The villagers knew that there were many monkeys in their forest. They left their farms on the plains and went into the forest to catch them. The man bought thousands at $10.
As the supply of monkeys started to diminish the villagers stopped looking. Finding and catching monkeys was soon no longer worth the effort for $10. They started to return to their farms to plant the spring crop.
The man then announced that he would buy monkeys for $20 each. This new higher price renewed the effort of the villagers and they headed back into the forest to find and catch monkeys again to sell.
When the monkey supply diminished even further that summer and the people started to return to their farms, worried they had not made enough money selling monkeys to buy all the food they needed but had not planted any crops yet either, the man raised the price he’d pay for monkeys to $25 each. The hunt was on again.
Soon the supply of monkeys became so small that a villager didn’t see a monkey in a day of hunting let alone catch one. Even at $25 each the effort was not profitable so the villagers finally headed back to their farms that fall. After nine month’s absence from their farms they knew the time had passed to produce enough food for the coming winter, but at least now they had enough money from selling monkeys to buy food to eat.
But the man wasn’t finished. He announced that he would buy monkeys for $50 each! The villagers became very excited. He also explained that he had to go to the city on business and that his assistant was to stay behind to buy monkeys on his behalf.
As soon as the man left the assistant told the villagers, “So you think you have made a lot of money selling monkeys, don’t you? But do you want to really get rich?”
“Yes, yes!” said the villagers.
The man’s assistant went on. “I have a gigantic, enormous cage filled with monkeys. I will sell them to you for only $35 each and when the man returns from the city you can sell them to him for $50 each and make a fat profit. You don’t even have to work to find monkeys at all. Then you can not only buy all the food you need for this winter you call all buy flat panel TVs, too.”
The villagers were thrilled. They collected all of their savings together and bought all the monkeys in the assistant’s cage then awaited the man’s return.
They never saw the man nor his assistant again. All the monkeys that were once in the woods were now in the village. All of the villager’s savings were gone.
Moral: Substitute housing for monkeys. As the winter of the US economy arrives, you still have the house you had before the price was bid up. Now that prices are falling back down, who has your savings?
Now you know how Wall Street works an asset bubble racket.
(Original by Anonymous, improvements by metalman.)
March 16th, 2008 at 7:10 pm PDT
link
Well, Steve Randy Waldman, it now looks like Monday morning arrives in the U.S. at 8:00 p.m. Sunday evening. As the NYT informs us: “Bankers and policy makers raced to complete the deal (Morgan Stanley purchase of Bear Sterns) before financial markets in Asia opened on Monday…”
The most disturbing part of the deal is that it looks like the Fed (as you and me as taxpayers?) is on the hook for $30 billion.
And Alan Greenmonkey–sounds like another tulip bubble to me. A web page I visited says a “good trader could earn up to 60,000 florins in a month– approximately $61,710 adjusted to current U.S. dollars. With profits like those to be had, nothing local governments could do stopped the frenzy of trading.” Has anyone else noticed that the modern-day investment banker is getting to look more and more like a bookie every day? He could care less if his investors win or lose, just so long as he gets his juice.
March 16th, 2008 at 9:53 pm PDT
link
I am not, unfortunately, terribly fluent in the finer points of financial accounting. Given this character flaw, I have two questions: first, at the end of its November quarter, BSC had notional/contract amounts of $13.4 and $8.74 trillion of derivative financial instruments on its books. The Fed has apparently offered to “guarantee” $30 billion of this amount in order to facilitate the orderly unwinding of these positions. What are we to make of the tiny, $13.6 trillion or so, of derivatives that Bernanke &Co. have neither the will nor, more importantly, the wallet, to back stop? Is JPM on the hook for part of this sum? Second, given the current configuration of the Fed’s balance sheet, how seriously should we take its new, six month commitment to lend potentially unlimited sums to the major i-banks? Are there practical limits to the Fed’s ability to prop up the primary dealers given the current structure of its balance sheet? More than two questions, I guess — I was never very good at basic arithmetic either.
March 16th, 2008 at 10:56 pm PDT
link
Keep up the good work. Interfluidity turned out to be a well-informed, sober news hub. There aren’t many.
March 16th, 2008 at 11:26 pm PDT
link
Thank you for your Work,I followed the Link at Calculated Risk here,and am favorably impressed by the clarity of your writing and analysis.
March 16th, 2008 at 11:57 pm PDT
link
“Note: Since last week, interfluidity’s readership has grown by an order of magnitude. Which, quite frankly, has me terrified. I wonder whether it’s still responsible to post some of my darker provocations.”
Col. Steve R Waldman: You want answers?
Lt. John Q Public : I think I’m entitled.
Col. Steve R Waldman: You want answers?!
Lt. John Q Public: I want the truth!
Col. Steve R Waldman: You can’t handle the truth!
“The last duty of a central banker is to tell the public the truth.”
Alan Blinder, Vice Chairman of the Federal Reserve
stated on PBS’s Nightly Business Report
Steve, contrary to policy maker perceptions and wishful thinking we can handle the truth….keep it coming.
March 17th, 2008 at 8:57 am PDT
link
“HIV, the infectious agent of AIDS, is thought to have originated in non-human primates in sub-Saharan Africa and transferred to humans during the 20th century.”
hmmm, I wonder if AIDs is an “unintended consequence” of Alan Greenmonkey’s monkey business? Probably not, but “the law of unitended consequences” always shows up after every CB irate manipulation.
March 17th, 2008 at 9:35 am PDT
link
“(Was it karma, coincidence, or something else that the one firm that refused to participate in the LTCM bailout would be the only firm not bailed out during the Great Credit Crunch of 2008?)”
Steve, I see your “darker provocations” are still with us. Of course, truth is stranger than fiction, so who knows(or is willing to tell)?
OT
“Cheney’s itinerary will take him to Saudi Arabia, Turkey and Israel. High on the agenda will be a discussion of oil prices with Saudi Arabia’s King Abdullah. High crude oil prices are “damaging” the markets of Saudi Arabia’s biggest customers and encouraging the development of “alternative forms of energy,” Bush said in a Public Broadcasting System interview last week when asked about Cheney’s trip.”
Looks like Cheney is trying to nip the “dollar crisis” in the bud. Too late Dick! Not enough oil in the ME to backstop the dollars value. If the EU holds together, the Euro will quickly become the reserve currency of choice.
March 17th, 2008 at 10:16 am PDT
link
Help!!!
Can someone answer some questions?
1. It is my understanding that the Fed only has about $800 billion in assets (of which it had already spent $400 billion before this latest round of largesse announced Sunday evening). I read this morning that several analysts are predicting the problem may be much bigger than that, that banks may need to raise in excess of $1 trillion in new capital. For instance, in a Fortune interview with Paul Krugman this morning and his column this morning in the NYTs, he implys, using Japan as a comparison, that the bailout could cost $3 trillion.
I also read this morning that sovereign funds (like China’s)are sitting on the sidelines. So all the heavy lifting will fall on the shoulders of the Fed, no?
Question: When and if the Fed runs through its $800 billion, what happens then?
2. I also read this morning that all the Fed’s historic, precedent-setting actions are being taken by fiat, with absolutely no public debate or discussion. If the Fed runs out of money, will there then have to be a public debate?
March 17th, 2008 at 11:36 am PDT
link
This credit crunch is a missile aimed at the centre of the US economy. The US, with a massive current account deficit, finds itself in a position where its main export (debt) is shunned by foreigners. This sends the dollar plunging, which makes their imports soar (oil f.e.) and increases the demand on their other exports (corn f.e.). Inflation all around, the virtuous circle in reverse gear. As Paul Krugman envisions, the markets are forcing a government bailout, since it’s only public debt that will be trusted by all investors. (How long will it be before GSE’s are nationalized?) But this can only lead to more inflation since the government won’t be willing to pay for the mess at their expenses. It’s no wonder the commodities are going to the moon. They take the place of money when the CBs relinquish their role as guardians of the currency, the only one they shoud have.
Groucho hits the nail when he says:
“Think about “price inflation” for a minute. To get an INCREASE in prices the govt has to devalue, on average, the currency enough to wipe out(on average) ALL efficiency that the system is able to generate. On top of that you must further devalue the exchange unit enough to get the govt’s required inflation tax to keep the treadmill in motion and make it hard for most workers to take a break..”
March 17th, 2008 at 12:35 pm PDT
link
Steve,
No corollary seems to be made between the position that JP Morgan has in the derivatives market (apparently, they’re party to half the notional outstanding in the market before they bought another $10-odd trillion), including 1/4 of the CDS market, and hence their very serious hope to avoid the triggers that will set off further defaults, and their purchase of BS, especially considering that counterparty resolution in the $45.5 trillion dollar CDS market is very poor:
The 45 trillion dollar question: can we consolidate our way around an imminent tsunami of default events?
March 17th, 2008 at 12:43 pm PDT
link
Here’s a question I don’t hear asked: With the dollar “in free fall,” how does that impact the validity of the DJIA as a measure of economic health? Some musings on that here:
http://www.xanga.com/Beloved_Spear
March 17th, 2008 at 4:05 pm PDT
link