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.
- 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.
|Steve Randy Waldman — Tuesday March 25, 2008 at 1:21am||permalink|