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.

12 Responses to “Counterparty of last resort?”

  1. DownSouth writes:

    Really scary, hun?

    I live in Mexico, where lack of governmental transparency is commonplace.

    But in the United States, the “beacon of democracy,” is this supposed to happen?

    George Bush is trying to recreate the United States in the image of Mexico, and so far he’s doing a pretty darned good job.

    Thanks for asking the right questions, Steve.

  2. OrganicGeorge writes:

    Wow the taxpayers now have to suffer the indignity of getting screwed but it’s also high, hard and dry

  3. MRM writes:

    While it is uncharted territory for the FED to engage in a SIV-like structure and I agree broadly that this path should be taken with caution, I would like to comment on the question of ‘contingent liabilities’ that could arise from this structure.

    If indeed it is structured like a SIV (have yet to see/read the docs) and the assets in question are all fully funded, then there should not be any liability beyond the 29bn of loans already extended to the SIV. Apart from the usual legal blurb around gross negligence/wilful misconduct of any of the parties involved, which I assume we can safely ignore for the purpose of this discussion.

    Now could the FED find itself in a situation similar to the other banks in that the SIV fails and it sees itself confronted with having to bail out its own vehicle ? Good question, but I think that is unlikely. The other SIVs got in trouble mainly because the MTM triggers got hit, forcing them into liquidation of assets. Apparently MTM triggers have been removed here.

    The other problem was that the SIVs’ traditional source of funding, the ABCP market, dried up pretty quickly and they ran into difficulties funding their assets. Here it sounds like the FED is providing term funding.

    So what if at maturity of the current FED facility the market has not normalized ? Well, there is obviously a lot of possible scenarios, but one would be that the FED rolls the funding into a new facility and, again, hopes for the best in terms of market recovery. If the liquidation shortfall would be less than JPM’s 1bn investment, it would really be JPM’s problem how to continue funding the portfolio as the FED could have its loan repaid and walk away. Mind you, that is assuming you are in a market where you can unwind a 30bn vehicle without too much disruption – so assuming quite an improvement from today….

    Under most circumstances JPM would be able to take a hit of that magnitude without too much of a problem. If this were not the case though, the FED might see itself ‘forced’ into extending the funding facility for much longer than it had originally envisaged.

    It will be interesting to see how many similar vehicles the will have to sponsor over the coming months.

  4. PrintFaster writes:

    Bear Stearns is counterparty to a large number of CDSs. This would indicate that the Fed is keen to backstop CDS collapse.

    seeking alpha on BSC and CDS

    Nasty business, but what gets me is the possible CDS exposure. Can we use the word “trillion”?

  5. Ryan Glinski writes:


    I’m with Mr. PrintFaster on the CDS problem. The statements from JP and the Fed after the Bear Stearns announcement were clear that JP Morgan had taken on all of Bear Stearns counterparty obligations, that JP Morgan’s credit backed them. I think the $30B investment is more of a way of taking the worst 2% or whatever off Bear Stearns’ ballance sheet, and that the Fed is going to lose big. The announcements seemed designed to imply the Fed would guarantee all the CDS counterparty risk, and maybe they will. Another thing, if the Fed loses say $10B on the deal, that is they put $30B of credit out into the market and only take $20B back, is that any different than dropping $10B out of helicopters?

    Sadly, even with the bennefit of this excelent article and insightful comments, I still don’t quite get it.

    Ryan Glinski

  6. You’re getting it now. Ignore anything Helicopter Ben says. The reality is: the Fed bought about $30 billion of paper no one else wants. At par!

  7. SavvyGuy writes:

    Wait a minute, everybody! The Fed is a private corporation, not the “public purse”. The Treasury is the public purse.

    So if one private corporation (“the Fed”) wants to go ahead and create some kind of screwball financial arrangement to bail out another private corporation (“Bear Stearns”), what the heck is our problem?

    I agree that all of this “may” impact the Treasury at some point, but we’re not quite there yet.

  8. Hubert writes:

    At par?

    As valued March 14 by Bear Stearns is certainly overvalued. That probably means either the super senior stuff really at par and/or the most junior (worth zero) at much above zero.

    From the outside, nobody can have an idea.

    Probably the senior and super senior stuff if BS made the same mistake as MS and Citi.

    LEt´s wait for the hearings. Maybe there is one Senator who gets answers.

  9. wimpie writes:

    Let’s set the record straight on the Fed’s ownership:

    “The Federal Reserve System is not “owned” by anyone and is not a private, profit-making institution. Instead, it is an independent entity within the government, having both public purposes and private aspects.

    As the nation’s central bank, the Federal Reserve derives its authority from the U.S. Congress. It is considered an independent central bank because its decisions do not have to be ratified by the President or anyone else in the executive or legislative branch of government, it does not receive funding appropriated by Congress, and the terms of the members of the Board of Governors span multiple presidential and congressional terms. However, the Federal Reserve is subject to oversight by Congress, which periodically reviews its activities and can alter its responsibilities by statute. Also, the Federal Reserve must work within the framework of the overall objectives of economic and financial policy established by the government. Therefore, the Federal Reserve can be more accurately described as “independent within the government.”

    The twelve regional Federal Reserve Banks, which were established by Congress as the operating arms of the nation’s central banking system, are organized much like private corporations–possibly leading to some confusion about “ownership.” For example, the Reserve Banks issue shares of stock to member banks. However, owning Reserve Bank stock is quite different from owning stock in a private company. The Reserve Banks are not operated for profit, and ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, 6 percent per year.”

  10. UrbanDigs writes:

    I understand that this is a matter of taking the least destructive path, but seriously, when does it end?

    Also, how does the market marks of these assets on Macrh 14th hit the value of holdings across the sector? I assume that because of this we are going to see a whole new round of write downs as everything gets marked down.

    Does this force the fed to do the same thing for the next Bear Stearns?

  11. MRM writes:

    with all the FED/ben bashing going on, let’s just try to stick to some facts:

    – FED did not buy the 30bn at par but at ‘current MTM’. while this would have been inflated as much as possible by BS/JPM, it will certainly be under par and if someone at the FED was smart, they would have got a competitor marking up the portfolio to ensure fairness.

    – another thing I forgot to mention in the SIV comment above is that all potential upside from a recovery of the portfolio seems to accrue to the FED. that is extremely unusual and would not be the case in a SIV. the senior lender does usually get the agreed margin on his loan and nothing beyond that. in a typical SIV/CDO structure, the upside would go to JPM. so arguably, even if it looks unlikely today, the structure provides potential upside to the ‘taxpayer’.

    – i think the concern about the FED having set a precedent is very justified. if another player gets in trouble, it will be difficult not to mount a similar bailout. but will there be another JPM helping out if, say, Lehmans went belly up ?

  12. jck writes:

    It should be noted that the “facility” activates at the closing of the JPM/BS merger and in the meantime financing shows up in “other credit extensions” on the H.4.1, there is no loan outstanding there at this time.

    The “CDO/SIV”: it’s an ultra simple waterfall: first the FED gets its capital back then its interest, then JPM gets its capital back then interest and reidual go to the Fed, so the Fed has 2 positions, one supersenior for capital and interest and another, equity, for the residual that will payoff only if the JPM subordinate notes are made whole. It is not unusual for a deal sponsor to have an X equity tranche with 0 notional to get whatever residual, if any, is left after everybody else is made whole.