Thanks for your response re my ‘devil’s advocate’ comments. Re the Fed’s ‘exposure’ and your related comments, I was referring more to the Fed’s credit exposure as a function of Bear’s liquidity exposure, not the Fed’s own liquidity exposure. Without a weekend deal, the Fed would have faced a decision on Monday on whether or not to continue or even expand the size of the JPM conduit loan to Bear. The decision would have been a choice between bankruptcy for Bear, or extending the JPM conduit facility while Bear was still on its own and while JPM was still prepared to act as a conduit. In extending it, the Fed would have been exposed to continuing liquidity pressures on Bear, and therefore having to increase the size of the conduit facility in order to sustain Bear even temporarily. In other words, without a deal, the Fed would have been exposed to Bear’s liquidity risk in the sense of an increased JPM conduit requirement.

This would have exposed the Fed’s own balance sheet to credit risk via the increased size of the collateral it might have taken on. The primary concern for the Fed was not its own liquidity risk (as you point out), but its own credit risk as a function of Bear’s liquidity risk in the absence of a deal. It was very interesting also that Geithner responded to one question about all this by saying that if a deal had not been structured over the weekend, and assuming that the Fed had still announced a newly expanded discount window facility on Monday, he would have been very reluctant to allow Bear to use the discount window directly on Monday, due to its liquidity problems, and the fact that the Fed still has the last call on whether to allow an institution “in trouble” to use the discount window. This is because, given Bear’s liquidity problems, its use of the discount window directly (just as its use of the JPM conduit) would have created an open-ended credit risk exposure for the Fed. The discount window, while providing last resort funding for situations that have some prospect of containment, is not intended to be the final funding source for financial institutions that have absolutely no hope of survival due to a complete collapse in confidence. That’s when other measures must be taken, as they were here. (I didn’t follow Dimon’s comment closely regarding JPM’s lack of risk due to the Bear deal, but I think it was ill advised.)

I’m inclined to agree with your point that BSC faced a _liquidity_ crisis, not quite yet a capital solvency crisis on 13-14 Mar; thanks for making that point of important distinction explicit. If true, this would explain why Bear didn’t draw down its big credit lines in Japan, even after purportedly losing $10B on Thursday, 13 Mar; they were still solvent as of that day. Thus, one might assume that Schwartz of Bear called Geithner of NYFed on Thursday, 13 Mar not because he was ‘bankrupt’ or about to be as stated for public consumption, but because he was in a severe squeeze, and begging for 28-day liquidity to get his mismatches realigned.

Why then was Bear in a squeeze on Thursday? One assumes broadly with Tom Riccardi posting above that a bunch o’ folks called back their collateral all at once, and at bad marks which tore great chunks of capital from Bear’s hide. But effectively, Bear was done in when the other ibanks slammed down their interbank lending windows on Thursday as rumored (though this is only _rumored_; not reported, and certainly not announced by anyone under oath). At that point BSC was effectively out of business whether or not they were technically solvent since if the ibanks won’t counterparty, either from prudence or for less charitable reasons, a bank-broker is soooo gone. From that perspective, BSC was attacked by a horde of flesh-eating zombies and then had the portcullis banged down in its greedhead face: cut out, cut up, cut off . . . cut dead. That might also, spinning inferences, explain why Bear’s management ‘had no other options’ per Schwartz’s testimony and the failure of management to kick at JPM’s terms on Monday, 17 Mar; as a stand-alone business, the industry had declared them dead.

On another point, though, the MAIN point, the contention that the Fed ‘had to’ work via JPM ‘to protect itself from liquidity exposure’ from BSC makes no sense whatsoever, to me. The Fed is vastly larger than JPM, has far fewer constraints on how it acts, and despite all the repos it has out is vastly more liquid. If said ‘liquidity risk’ from Bear was so great that the Fed ‘needed protection’ that would seem to put JPM at risk in the deal—Morgan agreed to guarantee the exact same positions even in just keeping BSC alive before acquiring them—thus jeopardizing this much larger *cough* white knight [sic]. Yes, the ibanks may feel more comfortable with Morgan’s capital than with Bear’s, thus easing the liquidity squeeze which Bear could not accomplish if they themselves got public liquidity guarantees. —And then the Fed turns around and (again rumored) says it will lend ‘whatever it takes’ to Lehman’s to halt a similar run? Nah, I don’t buy that the Fed cut in Morgan to limit _it’s own_ liquidity exposure.

Furthermore, after getting a measly $30B in backstop liquidity against said ‘uncertain’ liquidity exposure incoming with BSC, Dimon at JPM announces that he sees _NO EXPOSURE_ to Morgan in the deal; he could be wrong, but that’s what he said. Further yet, Dimon went through a great deal of personal embarassment and trouble from Monday, 17 Mar over the following week to get Bear’s shareholders to take the hemlock, even re-negotiating the highly unorthodox, not to say extra-legal, financial terms with the Fed to do so while accepting $1B of further expense to Morgan. Yes, Dimon got in the battered junker once called Bear Stearns and drove it home gladly to his garage, as if that dead weight in the boot was a footlocker of ingots rather than a dogpile of radioactive alien corpses. (Quick: what’s the film reference? —That’s right.) Not the act of a man taking on a liquidity risk _too great for the Fed_, say what you will.

One could postulate many reasons why the Fed refused to either provide, or having provided refused to honor, a liquidity guarantee to BSC while most swiftly doing the same to JPM—who promptly acquired the exact same liquidity risks in guaranteeing BSC’s trades. I’m not a fan of conspiracy theories, at all; it’s just that this whole thing reeks. (Don’t bother dialing Rent-A-Rumor, I’ll lend you one: Paulson nixed Thursday’s liquidity promise to Bear and said “Kill ‘em” on Friday. He’s supposed to have personally insisted on a negligible price for BSC’s equity, and is the guy who didn’t show for the hearings. “Who wasn’t there?” as they said in a different movie about, as in this instance, gangsters opening fire in public spaces.) The real problem to me in all this is that we still don’t know why the Fed decided to kill Bear and save or backstop the others. Just forcing a bad actor ouf of the game? That’s certainly the end result, yes. Simple ineptitude?? Don’t let’s, as Yves says, rule out _that_ potentiality. Genius, nefarious or otherwise, is in the tail end of the distribution, while incompetence bulges the middle out; ergo . . . .

‘Twas an ill-death, done badly. I don’t cry for Bear’s stakeholders, they got more than they deserve. But we all remain exposed to whatever reasons and agendas went down with this deal—and that’s what put’s a frission in my brisket on this pigsticking.

Bear Stearns got caught up in a few dynamics of the market for sure, but that was not the core of the problem. Their inability to police themselves and manage “fairly” their responsibility to stockholders, employees, counterparties and the public, became increasingly out of reach as their “lifestyle” and business model kept pulling them in other directions, out of moral scope.

Take a look at the upcoming meeting next week of ISDA in Vienna – the International Swaps Dealers Asssociation. Take a look at the Board Members and the Vision charter. Ask yourself exactly what these guys and this organization were doing for the past 15-20 years. Giving themselves awards and having lavish parties and golf outings at taxpayer expense. Watching the problem escalate for years with no corrective influence or industry value. These guys should be brought before a “Financial Crimes” judicial panel and sentenced harshly.

Bear Stearns simply followed the rules in place at that time. One unit came in every morning, and sought to “fund” the firm by repoing out securities. They identified sources of funding who wanted certain types of collateral, and they phoned JPMorgan Chase and “borrowed that collateral”, putting up either cash at 102% or other securities collateral at 105% or more. They did this with other Custodian Lenders like State Street Bank, and Northern Trust, and others until they “locked in” a rate that was their basis point profit every hour until conditions in the market changed that model. Someone called the securities back, the interest rate changed, the securities became premium, or other factors. JPMorgan Chase was very prominent in the Bear Stearns resolution, since a failure of Bear Stearns would have devasting effect on JPMorgan Chase, and resolving Bear Stearns solvency was a prime driver for JPMC.

Another unit of Bear Stearns came in every day and needed to borrow securities to covering trading shorts by counterparties, and they needed money or securities to back their collateral requirements.

Another unit came in every morning for years and made a fat living and wined and dined their way into individual personal breakthroughs in earnings and income through their packaging of securitized ABS, CDOs, and CMOs, while using these “financially engineered and complex intruments as their “collateral” in the market. When that collateral started to become too expensive to insure, the counterparty began demanding different collateral or proposing to return it to Bear Stearns for their cash. In order to come up with the cash to make the first guy happy, BSC had to “liquidate” its holdings of some of these derivative securities at less than the current “fictitious” market value or mark, or in situations where lack of liquidity pushed the price downward. This set off a chain reaction of activity that worked at unwinding Bear Stearns faster than there was adequate liquidity in the market to get their cash at a reasonable price.

Certain counterparties began refusing to take Bear’s collateral, or wanted their good collateral back and wanted to give Bear back its cash at a reduced Mark. In other words, the market started to gang up on Bear, not as a “gang”, but as individual counterparties protecting their vested interests. Schwartz didn’t discuss the “development” of the problem, just the ramifications.

Bear Stearns pioneered the start of Prime Brokerage services, and was one of the leading firms in the industry along with Citicorp Services (The old Salomon, Smith Barney unit), Morgan Stanley, Lehman Brothers, and others like UBS, Credit Suisse. As Hedge Funds proliferated, Prime Brokerage services were in a windfall situation. As more and more Asset Managers sought to realize Hedge Fund profit models, they formed new Hedge Funds, giving rise to more need for Prime Brokerage services,more trading and more borrowing and lending activity.

Bear Stearns was at the lead of this Prime Brokerage services sector, and kept financially engineering its product portfolio to support demand for collateral to borrow money to fund its Hedge Fund clients, and its own operation.

Knowing that it was creating more and more risk and fragility in its highly leverage instruments and securitized packages and trenches used for funding collateral, Bear continued to swim in shark infested waters. Leveraging the business further everyday on a distant gap mismatch that could never catch up with itself. Alan Schwartz never spoke about the “digging of the hole” and what he and his management team were doing to surveil and police this exposure and contingency risk.

Schwartz called it a “run on the bank”, but failed to rspond to why this run on the bank occurred. He advanced the notion that it was “a few firms” taking short positions in Bear and this gave rise to “rumor”. But he failed to dig in and accept responsibility for the cause of the problem – unbridled greed, and willingness to ransom the firm for market share in Prime Brokerage and to continue to sponsor and encourage banks to let Bear Stearns “package up their mortgages”, giving rise to the banks looking for more sources of raw material- the Mortgage Brokers, and the ugly food chain that started with Bear being the principal market maker.

Schwartz stated that a “few Hedge Funds” went short on Bear stock, giving rise to uncertainty and rumor. But those Hedge Funds’ Prime Brokers all receive reports of trades done away from the main Prime Broker so Bear would have had to become aware of this growing basis of problem, even if it was substantial enough to challenge Bear’s credibility and ability to remain out of default.

The real problem, not the Schwartz “blame it on them” thesis, is the market activity and behavior that caused the problem. More investigation needs to be initiated in to Securities Lending, Repo, Prime Brokerage, Gap Duration Mismatching, leverage in OTC markets, and risk-weighted equivalency of a portfolio. When was the last time that anyone saw a price ticker on a Securities Loan? When did you last see any trading ticker of securities loans and borrows volumes? The push to collateralize with non-cash to keep items off the balance sheet, and therefore reduce capital adequacy and also to allow trading desks to be unrestricted in bringing in new volumes of business that don’t need to be on the balance sheet. Investigation into the work and “non-work” of ISDA would be a good peripheral examination, and taking a look at the complicity of these board members in their firms’ failure to manage “leverage” more judiciously and safely for the benefit of their employees and stockholders.

Tom Ricciardi
Bangkok, Thailand

Average assets are the denom for the Tier 1 Capital Ratio (not risk weighted assets)

Private ownership should also bring under control these lavish compensation schemes on Wall St. which are enriching the employees at the expense of the shareholders. No more “inmates running the asylum”.

You are dead right. The investment banks should not be allowed to be publicly traded. That is the only long-term solution.

Private ownership is the only way to control the “heads I win, tails you lose” conduct and to allow for owners to see what is really on the balance sheet without compromising the firm’s competitive position.

“Heads I win, tails you lose” is what drove the Wall St. firms to expand leverage dramatically. It also drove them to move into increasingly illiquid trading assets.

Notice that precisely the same thing happened with the hedge funds. It is that combination of leverage, illiquid assets and lack of transparency that will prove to be lethal for a wide swath of hedge funds and investment banks. It is the perfect recipe for a systemic bank run.

RE: Your let’s nationalize them “Norwegian Style” post.

Great post! The key question is who is going to man the nationalized operations? For sure, It won’t happen in this inept administration!