...Archive for March 2008

Don’t regulate, rationalize

I know it’s mostly bull, the hippie management bromide that “in Chinese, the word for crisis is danger plus opportunity!” I don’t care. We’re gonna go with it here. I see the current financial crisis as dangerous, but also a tremendous opportunity to fix a lot of things that have been broken for a very long time.

The “sophisticated” banking systems and capital markets that we’re always flogging to developing countries are like nuclear reactors of the Chernobyl design. Sure, they are very powerful, very sexy. When they work they can light up whole cities, and that’s gotta be attractive if you’re sitting in the dark. But they have deep weaknesses, structural flaws, inconsistencies that are resolved only with generous applications of duct tape. Everything seems to work most of the time, but they are an accident waiting to happen. When an accident does happen, there is a story, perhaps a true story, about the particular screw-ups that were proximate cause. But focusing on those misses the point. We ought to get the engineering right before trying to operate the plant.

Financial systems are much more massive enterprises than nuclear power plants, and much more important. We need to redesign our financial system not only to be more robust, but to be more effective. Lost in the flamboyant pain of the current crisis is a quieter tragedy. We have misallocated natural and human resources on a vast scale over the past few years, and it won’t have been the first time. The real economic meaning of financial losses in the housing sector is that hands and minds were squandered bulding houses when they should have done much better things. Timber was felled and oil wells pumped dry, and what we made turned out to be of less value than what we destroyed. We could have predicted and avoided that. A reasonable financial system would have predicted and avoided that.

Treasury Secretary Henry Paulson has mooted a variety of reforms in response to the present financial crisis. Reading through, those proposals amount to a rationalization of the hodge-podge institutions that regulate financial markets. That’s not unwelcome, but it’s not what’s needed. It’s like responding to the Chernobyl meltdown by issuing three-ringed binders filled with better procedures about how to manage the plant. Regulation can compensate for minor flaws. But it can’t overcome a design that is structurally unsound. Our financial architecture is structurally unsound, so our task is not to rationalize the regulatory regime, but the financial system itself.

That will require changes far more challenging to incumbent firms than what Mr. Paulson proposes. Institutions that are too big to fail and/or capable of moving market prices unilaterally don’t sit well with the theory of financial markets. Financial firms can be regulated utilities that handle essential plumbing but bear little risk, or they can be aggressive risk-seekers looking to play every angle and milk every opportunity. They cannot be both. The gentlemen at Mr. Paulson’s alma mater may not like the implications of that, but the principle is correct regardless, and we ought insist that it not be fudged. The “Nationally Recognized Statistical Rating Organizations”, and the constellation of professional norms and judicial safe-harbors that link their opinions to the behavior of institutional money are an abomination, a legal discouragement of the independence of judgment upon which accurate prices and market stability are based. Their special status simply has to go the way of the dodo. This has to go a lot farther than merging the SEC and the CFTC. Rather than placing our faith in the Fed as an ever-watchful superhero, saving us all when financial catastrophe strikes from outer space, we can and should better manage our affairs here on Earth to avoid those catastrophes in the first place.

These have been great times to be a cynic. But, at long last, appropriate cynicism is finally getting priced into the market. There’s not much intellectual alpha left there. When this all washes out, we do want an informationally efficient, market-based financial system. It’s time to start talking specifics about what we need to do to get there. Before very long, all options may be on the table. Let’s have some good ones ready to go.

Counterparty of last resort?

MacroMan has a nice find, in a post aptly entitled Timmy Geithner, SIV Manager!?. He points us to details of the “loan” being arranged by the Fed to support J.P. Morgan’s purchase of Bear Stearns.

It is not a loan at all. The Fed and J.P. Morgan are creating an investment fund, to be managed by BlackRock.

The New York Fed will take, through a limited liability company formed for this purpose, control of a portfolio of assets valued at $30 billion as of March 14, 2008. The assets will be pledged as security for $29 billion in term financing from the New York Fed at its primary credit rate.

JPMorgan Chase will bear the first $1 billion of any losses associated with the portfolio and any realized gains will accrue to the New York Fed.

The money that the Fed and J.P. Morgan will provide is startup capital for the fund. All of it is referred to as “loans”, but that’s facile. Obviously, somebody will own these assets, bear the risk of carrying them, and realize any gains on the fund’s portfolio.

Specifically, J.P. Morgan is offering financing of $1 billion dollars that is loan-like in one sense — the maximum it will be repaid is its initial investment plus interest (“the primary credit rate plus 475 450 basis points”, currently 7.25 7 percent) — but equity-like in another sense — J.P. Morgan’s billion bears the first loss.

The Fed’s ownership stake will be $29 billion, ostensibly in the form of loans at “the primary credit rate, which currently is 2.5 percent and fluctuates with the discount rate”. But, that is largely meaningless. If the investment company’s assets turn out to be worth less than the principal and interest due the Fed, then the Fed’s loan won’t be repaid. If its assets appreciate, J.P. Morgan gets paid out, and the rest belongs to the Fed. The only significance of the “interest rate” would be if, as the fund unwinds, asset values are high enough to make only a partial payment to J.P. Morgan. In this case, the interest rate would help determine the split between the Fed and JPM.

Essentially, the Fed will own this investment fund and the Bear portfolio outright. JPM’s position is basically a call option on the fund’s assets at $29B plus time-value whose value is capped at $1B plus time-value. (JPM is long a call option and short the same option at a higher strike price.) The Fed can deny all it wants that it is considering purchasing mortgage-backed securities. That is the economic effect of this arrangement. The Fed is buying up mortgage-backed securities and other unspecified assets at “the value of the portfolio as marked to market by Bear Stearns on March 14, 2008.”

But we already knew that.

I remain interested in precisely what sort of assets besides mortgage-backed securities this fund will hold. I think that MacroMan used the term “SIV” advisedly. The signal fact about SIVs is that, though they were formally off-balance sheet, limited-liability entities, in reality SIV sponsors bore downside risk beyond their legal obligations to the funds. Reputationally, the banks who sponsored these “independent” entities could not just let them fail.

I have a simple question, one to which I think taxpayers deserve a simple answer. Will this new “limited liability company” have contingent liabilities to any parties other than the Fed, J.P. Morgan, and BlackRock for ordinary management fees? Will its portfolio consist of any positions that would make the fund a counterparty, potentially with obligations to pay, not merely rights to receive, future cash?

If the answer is no, a plain statement of that would be nice. If the answer is yes, then don’t count on the “limited liability” of this investment company to provide taxpayers much protection. It’s strikes me as implausible that a fund backed by the Fed would default on obligations to third parties. We’ve had central banks touted as lenders of last resort, market-makers of last resort, and fools of last resort. We’d better think very carefully before letting the Fed become a derivatives counterparty of last resort. The very idea represents a subsidy to those we may not wish to subsidize. There’s never been such a thing as a risk-free derivatives counterparty. Every holder of a derivatives position has an implicit option to declare bankruptcy and not pay should circumstances move decisively against them. Parties who retain an option to default while the other side of the contract is taken by someone who cannot are gaining something of value, something I’m not sure we want to give. Should counterparty risk move from a theoretical bogeyman to an actual crisis, the scale of sums at risk could be large, even on a portfolio whose current net value is only a few billion dollars, as those owing the Fed refuse to pay while Fed is obliged to cover “offsetting” positions from the public purse.

Update: The Fed has corrected the rate of interest to be paid on J.P. Morgan’s $1B stake. It’ll be 4.5%, not 4.75% as originally reported. (Hat tip Alea, WSJ) Original values are struck and corrected in the text above.

Update History:
  • 25-Mar-2008, 4:20 a.m. EDT: Originally had a confused explanation of JPM’s implicit option. I’d written it was long a call and short a put, but that’s not right at all. JPM is long a call and short a call at a higher strike. I just changed it to long a call with a capped value. That’s much easier, I think.
  • 25-Mar-2008, 4:55 a.m. EDT: Put the corrected version of JPM’s option position as a parenthetical in the text.
  • 27-Mar-2008, 2:35 p.m. EDT: Modified the rate reported on JPM’s loan to be consistent with the Fed’s recent correction. Added explicit update re the change.

Could flight to safety in credits help boost equity prices?

Treasury securities are trading at bizarrely low yields, and Yves Smith offers an intriguing thought:

Since bill prices are used as the input into other pricing models (most notably the Black-Scholes option pricing model), the distortions in the [Treasury] market have the potential to feed into other markets (we’ve already seen problems with new issue bond pricing due to sharp increases in spreads and blow-ups of correlation models in the credit default swaps market).

The word “model” conjures fancy, expensive things tended to by rocket scientists. But for “value” oriented stock investors, simple discounted cash flow valuation still occupies a place of honor. DCF valuation models require two inputs: an expected stream of cash flows (projected dividends, free-cash-flow-to-equity, whatever) and a required rate of return.

One of the lovely aspects of fundamental stock valuation is that it lacks hubris. Everyone knows that stock prices fluctuate unpredictably, so trying to estimate anything to twelve decimal places is just dumb. Value investors look to get a ballpark estimate of a stock’s worth, and buy only if there’s a large margin of safety. If you have to call in the quants, it ain’t worth the risk. The required rate of return is often chosen in the simplest way you can imagine: Check the Wall Street Journal for a current Treasury yield, and call that the “risk-free rate”. Ask yourself how much more you’d need to earn for it to be worth your while to hold the stock, and call that a “risk premium”. Add the two together, and voila! You’ve got a required return by which to value the shares.

One of the channels by which Fed interest rate cuts affect the economy is to boost stock prices by reducing the “risk free rate”, and therefore investors’ required rate of return. But terror and turmoil in credit markets has goosed demand for safe Treasuries, driving yields well below what the Fed would expect given its current rate stance. In January of 2005, the Federal Funds rate was targeted at 2.25%, same as now, and a 3-month T-bill paid 2.21%. Today, we have the same Federal Funds rate, but the 3-month T-bill yields 0.34%. The 5-year Treasury paid 3.61% in Jan 2005. Today the rate is 2.37%. On any of the common proxies for a risk-free rate, flight to safety in the credit market has introduced a rate cut of between roughly 120 and 190 basis points beyond what Bernanke & Co would have expected based on the 2005 experience. If the marginal value investor hasn’t increased the premium she demands for holding equities by the same amount, then all the gnashing of teeth about a financial meltdown may actually be net supportive of equity values!

Now this is weird, since equity is supposed to be the high risk, first-loss side of investment universe. But a recurring theme in the current crisis is that whatever you always thought was safe is not safe. The familiar risks of stock investing might seem like a warm campfire compared to the blizzard of uncertainty on the fixed-income side. It’s not obvious that investors would demand an unusually high premium for holding equities right now.

The Fed is working hard to restore some semblance of normalcy to Treasury markets. It would be ironic if that were to inadvertantly remove an important prop from beneath stock prices. If there’s anything to our little valuation speculation (it is only speculation!), the Fed may wish to mingle some rate cutting with its efforts to satisfy market demand for Treasuries, in order to hold roughly constant the effective risk-free-rate for equity valuation.

Credit Crisis for Kindergarteners

David Leonhardt notes that it’s pretty hard to explain what’s going on in the financial world these days (ht Felix). Here’s how I’d tell the tale to a child:

Alice, Bob, and Sue have ten marbles between them. Whenever one kid wants another kid to take over a chore, she promises a marble in exchange. Alice doesn’t like setting the table, so she promises Bob a marble if he will do it for her. Bob hates mowing the lawn, but Sue will do it for a marble. Sue doesn’t like broccoli, but if she says pretty please and promises a marble, Bob will eat it off her plate when Mom isn’t looking.

One day, the kids get together to brag about all the marbles they soon will have. It turns out that, between them, they are promised 40 marbles! Now that is pretty exciting. They’ve each promised to give away some marbles too, but they don’t think about that, they can keep their promises later, after they’ve had time to play with what’s coming. For now, each is eager to hold all the marbles they’ve been promised in their own hands, and to show off their collections to friends.

But then Alice, who is smart and foolish all at the same time, points out a curious fact. There are only 10 marbles! Sue says, “That cannot be. I have earned 20 marbles, and I have only promised to give away three! There must be 17 just for me.”

But there are still only 10 marbles.

Suddenly, when Bob doesn’t want to mow the lawn, no one will do it for him, even if he promises two marbles for the job. No one will eat Sue’s broccoli for her, even though everyone knows she is promised the most marbles of anyone, because no one believes she will ever see those 17 marbles she is always going on about. In fact, dinnertime is mayhem. Spoons are placed where forks should be, and saucers used for dinner plates, because Alice really is hopeless in the kitchen. Mom is cross. Dad is cross. Everyone is cross. “But you promised,” is heard over and over among the children, amidst lots of stomping and fighting. Until recently, theirs was such a happy home, but now the lawn is overgrown, broccoli rots on mismatched saucers, and no one trusts anyone at all. It’s all a bit mysterious to Dad, who points out that nothing has changed, really, so why on Earth is everything falling apart?

Perhaps Mom and Dad will decide that the best thing to do is just buy some more marbles, so that all the children can make good on their promises. But that would mean giving Alice 19 marbles, because she was laziest and made the most promises she couldn’t keep, and that hardly seems like a good lesson. Plus, marbles are expensive, and everyone in the family would have to skip lunch for a week to settle Alice’s debt. Perhaps the children could get together and decide that an unmet promise should be worth only a quarter some fraction of a marble, so that everyone is able to keep their promises after all. But then Sue, the hardest working, would feel really ripped off, as she ends up with a much more modest collection of marbles than she had expected. Perhaps Bob, the strongest, will simply take all the marbles from Alice and Sue, and make it clear than none will be given in return, and that will be that. Or, perhaps Alice and Bob could do Sue’s chores for a while in addition to their own, extinguishing one promise per chore. But that’s an awful lot of work, what if they just don’t want to, who’s gonna force them? What if they’d have to be in servitude to Sue for years?

Almost whatever happens, the trading of chores, so crucial to the family’s tidy lawns and pleasant dinners, will be curtailed for some time. Perhaps some trading will occur via exchange of actual marbles, but this will not be common, as even kids see the folly of giving rare glass to people known to welch on their promises. It makes more sense to horde.

A credit crisis arises when many more promises are made than can possibly be kept, and disputes emerge about how and to whom promises will be broken. It’s less a matter of SIVs than ABCs.


Update: Mark Thoma offers characteristically thoughtful comments. I also liked this, by Alex Whalen. (BTW, I don’t have children, though my wife is urging we remedy that soon.) In the comments, Arun Garg is reminded of Paul Krugman‘s Baby-sitting Co-op, whose influence I’m happy to acknowledge. Krugman is a master of this sort of parable, see also hot dogs and buns.

Update 2: (Not for kindergarteners!) There’ve been comments here and elsewhere suggesting that the numbers in this story can’t be made to work. They can. Note that the 40 marbles the children think they have is before netting. As the piece says, “They’ve each promised to give away some marbles too, but they don’t think about that, they can keep their promises later, after they’ve had time to play with what’s coming.” That’s realistic. It’s why people who borrow from banks think they have cash, even though, if you net it out, that cash is offset by a liability to the bank. On idealized balance sheets, the promises made to us are represented as assets. The promises we’ve made are our liabilities, and the promises that can’t be kept show up as negative equity. On net, across people, all promises sum to zero, and all equity sums to the real value of all the stuff. It’s the distribution of gross numbers that gives rise to a credit crisis. It’s an accounting identity that, on net, everything balances. But that doesn’t help anybody.

For the very geeky among you, click the link below to reveal balance sheets that comport with this tale.

Update 3: (Only for very neurotic grownups!) The balance sheets posted in “Update 2″ miss a constraint implied by the tale. It is claimed that, if promises were devalued to a quarter marble, everyone would be solvent. But given the posted balance sheets,, Alice would still be underwater. One can come up with balance sheets consistent with the constraint, but in doing so one runs afoul of another implication of the text, that Bob owes Sue more than Sue owes Bob. I don’t think that both constraints can be satisfied. So, I’m changing the text, from “a quarter” to “some fraction”, because it’s the right thing to do. I think everything works out now, and the balance sheets previously posted are fine.

Update History:
  • 20-Mar-2008, 1:30 p.m. EDT: Added update re Thoma, Whalen, and Garg comments, Krugman acknowledgement.
  • 20-Mar-2008, 6:40 p.m. EDT: Added update 2 with balance sheets.
  • 20-Mar-2008, 6:40 p.m. EDT: Added sentence about bank loans to update 2. Changes a “the” to an “a” and added “not for kindergarteners” to same update.
  • 24-Mar-2008, 2:05 p.m. EDT: Added update 3, struck “a quarter” and replaced it with “some fraction”.

Bear raid in plain sight?

jck at Alea, the first to hint that Bear Stearns might be the victim of a bear raid, now reports that the SEC is on the case, investigating whether the liquidity crisis that brought down Bear Stearns was the product of an orchestrated whisper campaign.

That struck me as ironic, in light of Felix Salmon’s digging into why Bear Stearns stock is trading at roughly triple what it will be worth if the merger with J.P. Morgan goes through. He points to David Neubert. Neubert heard that

…the reason Bear Stearns (BSC – $7.90) is trading so far above the deal price with JP Morgan (JPM – $41.00) is that bond holders who NEED the deal to go through are buying millions in equity to save their billions in debt.

These buyers, obviously, will vote their shares in favor of the merger with J.P. Morgan.

Let’s speculate a bit.

Who else might want to see the deal go through? A firm called J.P. Morgan saw its market cap increase by more than 10 billion on speculation that the deal would go off as announced. Perhaps buying millions of shares at even $4, or $8 dollars, a share to ensure that it did would be in that firm’s interest. If JPM paid $8 for every share of Bear, that would represent only a small fraction of the value the market ascribed to the merger, and a small fraction of the book value of the assets JPM stands to acquire.

Putting it all together, what’s happened over the past week? A mysterious, still unexplained, loss of confidence led to a run on Bear, bringing the firm to the brink of bankruptcy. Rather than providing liquidity sufficient to see the firm through the panic (as expected Friday), Bear management, the Fed, and J.P. Morgan effectively ratified those rumors, by placing a value of $2 per share on Bear equity. No information was released to the public that would reconcile so low a valuation for Bear with the valuation of similar financial firms, especially with much of the Bear’s risk offloaded to the Fed.

Despite the palpable anger of Bear shareholders, Morgan execs asserted their confidence that eventually owners of Bear stock would see the light and approve the deal. With a share price anchored around $2 rather than Friday’s close of $30, sudden demand appeared for Bear equity. Today’s trading volume was more than BSC’s entire float, and 9 times the firm’s average daily volume. Perhaps Morgan execs anticipated the possibility that there would be new shareholders with a deeper appreciation of the virtues of the merger?

If the SEC is out to find people who hoped to gain by spreading information that would tank Bear’s share price so that they and their allies could gain control of firm assets on the cheap, the front page of the Wall Street Journal might be a good place to start.

I’m not alleging that anything illegal here — a deal was inked, that was news, not rumor. It may well be that the deal was wise and necessary and for the greater good, and it’d be hard to prove that it was worse for shareholders than the alternative of bankruptcy. Besides, everyone knows this smells funny, that’s why J.P. Morgan is reserving $6 billion for “transaction-related costs”, first bullet point: litigation.

The Bear Stearns crisis might or might not have been brought on by a bear raid against the firm. But the cure sure resembles one. As Paul Krugman put it, hair of the dog.

More questions than answers on Bear

I’ve just read through last night’s conference call on J.P. Morgan’s purchase of Bear (ht Calculated Risk). Overall, I’ve many more questions than answers.

  1. Sure, executives always talk up their deals. But really, this sounds like a fantastic coup for J.P. Morgan. They get Bear, which as a going concern was worth roughly $10B not long ago, for next to nothing. According to JPM execs, Bear was being candid when it insisted its books were fundamentally sound, and the crisis was just a liquidity issue. Much of the risk JPM might not have been comfortable with has been laid off on the Fed. jck at Alea notes that the markets, skittish about financials though they may be, have rewarded JPM with roughly $11B in excess market capitalization today. The market clearly views the deal as a windfall for J.P. Morgan. If a Fed-guaranteed Bear was a $10 billion bill just waiting for someone to pick up off the floor, why were there no so few bidders this weekend for the firm? Why was J.P. Morgan able to name its price? Alternatively, why didn’t the Fed itself purchase the firm for $2 a ticket and then negotiate at leisure a value-maximizing sale for the benefit of taxpayers?

  2. Why were Bear’s shares worth $30 Friday at 4 p.m. and close to $0 by Saturday evening? (Charlie Gasparino announced on Saturday that the firm would likely file for bankruptcy if a deal wasn’t done over the weekend.) Pointing to rating agency downgrades isn’t helpful. S&P and Moody’s have clearly tempered their pace of downgrading the monoline insurers and some AAA structured credits in order to mitigate systemic risk. I think it implausible that they would have downgraded Bear so quickly without some consultations. After all, as of Friday, Bear was perfectly liquid (thanks to the Fed’s special credit line), and it’s overall position looks to have been pretty solid. Somehow, something happened over a period of 24 hours that changed Bear from a slightly tarnished name that yet sell itself for a decent price to an urgently distressed asset. I’ve yet to hear a convincing account of how that went down. (Lawyers have already been called to look into this, and JPM has set aside funds for litigation.)

  3. The Fed is financing, and bearing the downside risk, on roughly $30B of Bear assets. About $20B of those are mortgage-backed securities, the rest are unaccounted for. Many of us — perhaps reasonably, perhaps hysterically — view Bear’s derivative portfolio rather than its mortgage-backed securities as the greatest concentration of risk. Is it possible (and I am asking here, I really don’t know!) that an “in-the-money” derivatives portfolio could be viewed as an asset, and pledged to the Fed? After all, synthetic credits include CDS positions, and we wouldn’t be surprised to learn that the Fed accepts highly-rated synthetic bonds as collateral. Very specifically, is the Fed’s downside risk on the $30B it has financed limited to $30B (the Fed gets stuck with worthless assets), or has it assumed a role as a guarantor of assets that could become outright liabilities under adverse conditions? I do not think this is likely, it would be too radical, too weird. But it would be nice to have explicit assurance that the portfolio whose losses the Fed has taken responsibility for includes only “limited liability” securities.

  4. In my previous post, I feared that Bear execs would use the threat of a destabilizing bankruptcy to try to extract an undue payout to shareholders. Now that the deal is done, and it is Bear shareholders who seem to be shafted, Andrew Clavell asks very pointedly why Bear did not use its bargaining power at least a bit more effectively. Why couldn’t Bear hold out for $4 per share instead of $2? Just how hard ball did J.P. Morgan and/or the Fed end up playing? Andrew points out that the option value of a share in bankrupt Bear might be more than the $2 consolation prize on offer. Why should Bear shareholders accept this deal (they must vote to approve it)? The possibility that Bear shareholders would not approve the deal was the risk Morgan executives seemed least capable of addressing during the conference call. They think shareholders will approve, but things will clearly get complicated if they don’t.

I want to reiterate, I think the outcome of all this is better than it could have been. I feel some sympathy for Bear stockholders, since fundamentally the firm may have been no less sound than its competitors. But managing liquidity risk was the Bear’s responsibility, and it failed to do so. From a “moral hazard” perspective, I’m glad an important player was allowed very publicly to fail. However, any salutary effect on incentives may be counterbalanced by the new funding facility for investment banks, which looks like a commitment by the Fed to bail-out any other firm in similar straits. I’m also a bit uncomfortable with J.P. Morgan’s windfall, which isn’t really a “market outcome”, and strikes me as a massive case of “private the gain, socialize the risk”.

I’m glad the Fed removed any incentive to try to bring down other firms via “bear raids”. But, as a correspondent of Yves Smith points out, investment banks may be safe, but hedge funds are suddenly vulnerable. I’d guess that the Fed is privately suggesting aggressive margin calls on hedge funds would be unwise right now. The Fed’s bully pulpit is in good shape, as a firm excluded from the Fed’s new liquidity facility would be one whisper campaign away from roadkill. The impaled carcass of a bear sits at the gate of Dr. Bernanke’s castle as a reminder to all of the price of being disliked.

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.

Update History:
  • 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.

Character and Capitalism

Via the indefatigable Mark Thoma, our attention is drawn to an odd piece by Robert Skidelsky. I was left mostly bewildered by the article, but I was intrigued by the author’s discussion of the virtues that are and are not inculcated by market capitalism:

Consider character. It has often been claimed that capitalism rewards the qualities of self-restraint, hard-work, inventiveness, thrift, and prudence. On the other hand, it crowds out virtues that have no economic utility, like heroism, honor, generosity, and pity. (Heroism survives, in part, in the romanticized idea of the “heroic entrepreneur.”)

The problem is not just the moral inadequacy of the economic virtues, but their disappearance. Hard work and inventiveness are still rewarded, but self-restraint, thrift, and prudence surely started to vanish with the first credit card. In the affluent West, everyone borrows to consume as much as possible. America and Britain are drowning in debt.

One thing to remember is that there is no such thing as “capitalism”. In the real world, there are actual practices and institutions, the details of which bear consequentially on both moral and economic outcomes. There are infinity of possible capitalisms, and at any given moment we are living just one. A stylized graph of supply and demand always hides more than it reveals.

The capitalism we are living right now is rather a nightmare, due to a credit, um, event. So it seems a propos to remember that credit analysis traditionally includes an explicitly moral component. Remember the “5 Cs of Credit“? Character, capacity, capital, collateral, and conditions. Character.

Here’s a famous bit of financial history, as recounted by Jean Strouse in the New York Times:

Asked by the lawyer for a congressional investigating committee in 1912 whether bankers issued commercial credit only to people who already had money or property, [J. P. Morgan] said, “No sir; the first thing is character.” The skeptical lawyer repeated his question and Morgan, in Victorian terminology, elaborated on his answer — “because a man I do not trust could not get money from me on all the bonds in Christendom.”

If you think Morgan, the arch plutocrat, was just telling a nice sounding, self-serving lie, think again. Think about a world in which there was no SEC, FDIC, or Federal Reserve; in which there was no technology sufficient to prevent a person from simply disappearing, changing his name, starting over somewhere else. Morgan invested vast sums, and though he was a powerful man, he could always be taken. When parting with a dollar, he could not be so lazy as to presume a courtroom would ensure its repayment. Morgan had to trust.

Since Morgan’s day, in pursuit of efficiency and safety, we’ve built up institutions designed to automate and certify the evaluation of character. When we lend money, we don’t ask to meet the person who promises to repay us. We look for a nod by a regulator, the AAA brand provided by S&P or Moody’s or Fitch, perhaps a FICO score. But those are not markers of character at all. We don’t take them to be. We understand that banks engage in regulatory arbitrage, finding ways to stretch their balance sheet as far as possible for yield despite whatever regulatory regime is in place. We know that credit issuers (and bond insurers) do what they need to and no more for their rating, that perfectly dishonorable individuals attend to their FICO scores to maintain access to credit. Actual character is completely washed out of these proxies. The capitalism we have is one that presumes that all actors are sharks, that business is business, and that it is irrational to take any less than you can get away with unless you will “incur costs” from decertification. I’m not sure that J.P. Morgan would be willing to lend to any of us, and it’s not because we’re worse people. We just live in different times, a different world.

We shouldn’t go back to the world as it was at the turn of the century. When character evaluation was a personal exercise, it necessarily depended upon social connections, whether someone you know and trust can vouch for someone you don’t yet know, whether you can be sure that disgrace and dishonor would be costly. And we definitely should not adopt a moralistic attitude towards debt nonrepayment right now, just when a throng of irresponsible lenders are demanding “responsibility” from borrowers whose calls they would not even take a year ago. (For the record, I think that “jingle mail” is perfectly acceptable under present circumstances, and that the recent “bankruptcy reform” was a cruel mistake.)

But I do think that it’s an interesting technical question, going forward, whether we couldn’t set things up so that the criteria by which investors decide where to put their money map more closely to what we would recognize as trustworthiness or character. “Abolish the SEC and the Fed and the ratings agencies!” is not a sufficient proposal. Crises due to misplaced trust long predate those institutions, and are a large part of why they came to be in the first place. Morgan was successful not because he did what everybody did, but because he did what almost nobody did, despite the lack of ratings by S&P to stand-in for due diligence. Investors have always been hopeful and lazy in good times.

T.S. Eliot once wrote, “It is impossible to design a system so perfect that no one needs to be good.” Perhaps the art is to come up with a system, however imperfect, under which being good is the best way to succeed.

28 Days Later

When the TAF program was first announced, it was billed as a temporary facility. The announcement was in December, and some suggested it was intended to help banks meet end-of-year balance sheet needs. Four auctions were announced, two auctions of 20B in December, and two January auctions for an amounts that has not yet determined. An important question at the time was what would happen 28 days later, when loans made via two December auctions expired. Would the amounts of the January auctions be the same as the December auctions, effectively rolling over the TAF loans (not necessarily to individual borrowers, but to the consolidated banking system)? Would the January loans be smaller, indicating a gradual phase-out consistent the temporary nature of the program? Or would the loans be expanded, suggesting an ongoing intervention of indeterminate scale? Since then, the size of the program has more than doubled, and the Fed has announced explicitly that it intends to continue the program “for as long as necessary to address elevated pressures in short-term funding markets”.

In the past few days, the Fed has announced two new programs, and again, we are left to wonder what happens 28 days later. This weekend, I argued that since the Fed cannot retire loans made via TAF and its repo program without adding to those “elevated pressures”, the loans should be considered an equity infusion, because they’ll be repaid at the convenience of the borrower rather than on a schedule agreed with the lender. Does the same argument apply to the new Term Securities Lending Facility (TSLF)? On face, it’s harder to view TSLF as an equity infusion, since the Fed is giving no one any cash. (In fact, the Fed will withdraw some cash as interest.). Eyes unprotected by green shades will glaze over at descriptions of a kind of asset swap, where some obscure assets are “pledged” to the Fed while other boring securities are lent to firms.

But to firms holding illiquid securities that the Fed is accepting as collateral, the program is equivalent to a not-so-efficient cash infusion, because the Treasuries the Fed is lending are liquid and can be converted to cash easily in private markets. From a cash-strapped firm’s perspective, borrowing a treasury, then borrowing cash against that Treasury in ordinary repo markets, is equivalent to borrowing cash directly from the Fed, except that there’ll be an extra middleman to pay. So, this new facility might well be a form of equity, if the Fed is willing to roll it over indefinitely and require payment only at the convenience of borrowers. We’ll have to wait and see what happens, 28 days later.


As a sidenote on the debt vs equity question, Yves Smith points out that S&P and Moody’s have not cut the AAA ratings of many securities that no longer meet their usual guidelines for that rating. TSLF specifically allows the pledging of “non-agency AAA/Aaa-rated private-label residential MBS” as collateral. (Only Treasuries, agencies, and agency MBS can be pledged for the Fed’s repo program. Non AAA debt can be accepted as TAF collateral, at the discretion of the Fed and at reduced valuations. Fed discount window guidelines apply.) To the extent Fed loans (in cash or securities) are genuinely overcollateralized, they are more “debt-like”, as equity is “risk capital” and the Fed bears little risk of nonrepayment. To the extent that the true value of the collateral is less than the value of the loans, either initially or due to decay over time without new collateral being posted, the facilities appear more like equity.

Update: Yves Smith and Barry Ritholtz both question the quality of TSLF collateral. Barry Ritholtz also tries to quantify the proportion of AAA MBS whose ratings might be questionable, but his analysis is based on the ABX indices, which jck at Alea warns us may not be a fair sample.

Update History:
  • 11-Mar-2008, 1:30 p.m. EST: Added update re Yves Smith and Barry Ritholz comments on collateral quality.

Comment Hoists, 2008-03-10

There’s been some good conversation in the comments. I thought I’d pull out a few of my favorite bits.


The Fed’s Balance Sheet Constraint

jh writes

The interesting point that no one has commented on is the existence of a Fed balance sheet constraint on limits to the outstanding TAF.

The Fed is limited by the size of the liability side. It doesn’t ‘force feed’ currency note into the system beyond the demand of the banks and the public for currency. And it has no room to expand bank reserve balances in aggregate of it wants to maintain control over the level of the funds rate. That’s why it’s ‘sterilizing’ now.

So the upper limit to TAF is essentially the size of the Fed balance sheet now, allowing for natural growth in currency demands of the banks and the public.

Beyond that, the Fed couldn’t ‘sterilize’ by selling other assets. It would have to start issuing its own liabilities, such as the sterilization bonds issued by the PBOC used to offset their foreign exchange purchases.

Looking at the March 6 Factors Affecting Reserve Balances, in addition to the already announced TAF and repo programs, the Fed could initiate somewhere between $500 and $600B more in “sterilized interventions” (as Paul Krugman first pointed out these are) before it would have to issue bonds rather than selling existing assets.

There’s more discussion of this point over at Brad Setser’s (in the comments section).

Update: The Fed announced this morning that it will use up $200B more of that capacity via a “Term Securities Lending Facility“. After the FAF expansion, repo program, and TSLF, the Fed will have between $300B and $400B in remaining sterilization capacity, unless it issues bonds directly. Paul Krugman, John Jansen, jck at Alea, Yves Smith, Michael Shedlock, Free Exchange, Justin Fox, Zero Beta (and see this!) comment.


Why the special repo program?

Why did the Fed announced the new repo program rather than just more dramatically expand TAF?

livingston guy offers an explanation:

The new repo line… is nothing more than the TAF for the brokers who dont have access to the TAF. Essentially, a Merrill wants to have the same access to liquidity as JPMorgan but doesn’t have it in the current framework of TAF which is only available to depositories. The new repo line just makes the same facility available to Merrill.

So the repo program can be looked at as a partial implementation of what Thomas Palley suggests. (In a pinch, apparently the Fed can lend directly to whomever it deems necessary, but that power has never been used. See David Wessel, “Analysts: Rate Cuts May Not Be Enough“, ht Mark Thoma.)

Update: Livingston Guy wrote on Sunday, and was referring to the expanded repo program announced Friday, not the TSLF program announced Tuesday. However, both the expanded repo program and TSLF are available to primary dealers, whereas TAF is accessible only to depository institutions.


The /Price Spiral

Len writes

[Regarding] a widely held misconception; namely that “inflation is the debtors friend”. That IS kind of the way it worked during the Carter inflation as unions, now largely powerless due globalization, were largely able negotiate wage hikes rapidly enough to stay more or less even with inflation, creating the famous wage/price spiral which made debt an ever shrinking entity to the detriment of lenders. Nowadays we have just the /price part of that spiral, wages have been flat to negative in real terms for years. Without a means of increasing his income along with the inflating currency, the debtors debts in fact, instead of looking smaller, look ever larger as his required spending for necessities crowds out available funds for debt service, hastening insolvency.

Compare to a recent speech by Janet Yellen, President of the San Francisco Fed (via WSJ Real Time Economics):

Even so, I expect both total and core inflation to moderate over the next few years… This… assumes that inflation expectations will remain well-anchored, as they have been, and also that workers will not through their bargaining offset the real losses resulting from higher food and energy prices.

Things look different if you’re a central banker.

Update History:
  • 11-Mar-2008, 10:45 a.m. EDT: Added update re “Term Securities Lending Facility”. Attributed observation that these are sterilized interventions to Paul Krugman directly, rather than only implicitly via a link.
  • 11-Mar-2008, 10:55 a.m. EDT: Cleaned up awkward wording introduced by reattribution in previous update.
  • 11-Mar-2008, 11:05 a.m. EDT: Removed a redundant “in the comments”. Sheesh.
  • 11-Mar-2008, 1:05 p.m. EDT: Added Yves Smith to list of TSLF commenters.
  • 11-Mar-2008, 2:55 p.m. EDT: Added Michael Shedlock to list of TSLF commenters.
  • 11-Mar-2008, 3:55 p.m. EDT: Added update explaining that LG’s comments were wrt repos, not TSLF. Added Free Exchange, Justin Fox, and Zero Beta to list of TSLF commenters.