Did the Fed Prevent a Financial Chernobyl?

There are two useful but frustrating articles addressing different aspects of the extraordinary measures implemented by the Federal Reserve in the last ten days, in particular the bailout of Bear Stearns.

A New York Times article, “What Created This Monster,” is very much worth reading despite its shortcomings. It attempts to say how we got to where we are today, but lacking a clear problem definition (are the markets in trouble due to excessive leverage? Overly complex instruments? Lack of transparency? Poorly thought and inadequate regulations? Those negative real interest rates under Greenspan?) it comes off being unfocused. However, it interviews a lot of Big Names and have some fascinating moments. My fave is this one:

Two months before he resigned as chief executive of Citigroup last year amid nearly $20 billion in write-downs, Charles O. Prince III sat down in Washington with Representative Barney Frank, the chairman of the House Financial Services Committee. Among the topics they discussed were investment vehicles that allowed Citigroup and other banks to keep billions of dollars in potential liabilities off of their balance sheets — and away from the scrutiny of investors and analysts.

“Why aren’t they on your balance sheet?” asked Mr. Frank, Democrat of Massachusetts. The congressman recalled that Mr. Prince said doing so would have put Citigroup at a disadvantage with Wall Street investment banks that were more loosely regulated and were allowed to take far greater risks. (A spokeswoman for Mr. Prince confirmed the conversation.)

It was at that moment, Mr. Frank says, that he first realized just how much freedom Wall Street firms had, and how lightly regulated they were in comparison with commercial banks, which have to answer to an alphabet soup of government agencies like the Federal Reserve and the comptroller of the currency.

Eeek. Barney Frank is really smart and diligent as Congressmen go, and he didn’t know this? Ooh, we are in for a rough ride.

We also have a sleep deprived, immediately-post-Bear-deal statement from Jamie Dimon:

We have a terribly global world and, over all, financial regulation has not kept up with that,

But the story is also annoying on some levels. It mentions derivatives frequently, yet fails to define terns or explain which sorts are troubling and why. No one is worried about exchange traded equity and index options, for instance; it’s the OTC variety which is the focus of worry, particularly credit default swaps, which is arguably a big unregulated insurance market. There is also some good detail on how Greenspan discouraged the regulation of derivatives, and some long overdue reservations about innovation for innovation’s sake.

The other sighting of the evening is Ambrose Evans-Pritchard’s “Fed’s rescue halted a derivatives Chernobyl.” The piece is a little more breathless than I like, but argues that the reason that the Fed intervened with Bear was to prevent a crisis in the CDS market. Unlike the New York Times piece, the Evans-Pritchard has a few useful factoid that I have not seen elsewhere.

The flaws in both pieces ultimately are not those of the authors, but reflect the inherent difficulty in researching complex, largely or completely unregulated over the counter markets. Data is scarce, so a reporter is heavily dependent on triangulating among source.

And the scary bit is that the regulators are not much better able to get information than the press.

From the Telegraph:

We may never know for sure whether the Federal Reserve’s rescue of Bear Stearns averted a seizure of the $516 trillion derivatives system, the ultimate Chernobyl for global finance.

“If the Fed had not stepped in, we would have had pandemonium,” said James Melcher, president of the New York hedge fund Balestra Capital.

“There was the risk of a total meltdown at the beginning of last week. I don’t think most people have any idea how bad this chain could have been, and I am still not sure the Fed can maintain the solvency of the US banking system.”

All through early March the frontline players had watched in horror as Bear Stearns came under assault and then shrivelled into nothing as its $17bn reserve cushion vanished.

Melcher was already prepared – true to form for a man who made a fabulous return last year betting on the collapse of US mortgage securities. He is now turning his sights on Eastern Europe, the next shoe to drop.

“We’ve been worried for a long time there would be nobody to pay on the other side of our contracts, so we took profits early and got out of everything. The Greenspan policies that led to this have been the most irresponsible episode the world has ever seen,” he said.

Fed chairman Ben Bernanke has moved with breathtaking speed to contain the crisis. Last Sunday night, he resorted to the “nuclear option”, invoking a Depression-era clause – Article 13 (3) of the Federal Reserve Act – to be used in “unusual and exigent circumstances”.

The emergency vote by five governors allows the Fed to shoulder $30bn of direct credit risk from the Bear Stearns carcass. By taking this course, the Fed has crossed the Rubicon of central banking.

To understand why it has torn up the rule book, take a look at the latest Security and Exchange Commission filing by Bear Stearns. It contains a short table listing the broker’s holding of derivatives contracts as of November 30 2007.

Bear Stearns had total positions of $13.4 trillion. This is greater than the US national income, or equal to a quarter of world GDP – at least in “notional” terms. The contracts were described as “swaps”, “swaptions”, “caps”, “collars” and “floors”. This heady edifice of new-fangled instruments was built on an asset base of $80bn at best.

On the other side of these contracts are banks, brokers, and hedge funds, linked in destiny by a nexus of interlocking claims. This is counterparty spaghetti. To make matters worse, Lehman Brothers, UBS, and Citigroup were all wobbling on the back foot as the hurricane hit.

“Twenty years ago the Fed would have let Bear Stearns go bust,” said Willem Sels, a credit specialist at Dresdner Kleinwort. “Now it is too interlinked to fail.”

The International Swaps and Derivatives Association says the vast headline figures in the contracts are meaningless. Positions are off-setting. The actual risk is magnitudes lower.

The Bank for International Settlements uses a concept of “gross market value” to weight the real exposure. This is roughly 2 per cent of the notional level. For Bear Stearns this would be $270bn, or so.

“There is no real way to gauge the market risk,” said an official

“We don’t know how much is backed by collateral. We don’t know what would happen in a crisis, and if we don’t know, nobody does,” he said.

Under the rescue deal, JP Morgan Chase will take over Bear Stearns’ $13.4 trillion contracts – lock, stock, and barrel.

But JP Morgan is already up to its neck in this soup, with $77 trillion of contracts. It will now have $90 trillion on its books, a sixth of the global market.

Risk is being concentrated further. There are echoes of the old reinsurance chains at Lloyd’s, but on a vaster scale.

The most neuralgic niche is the $45 trillion market for credit default swaps (CDS). These CDS swaps are a way of betting on the credit quality of companies without having to buy the underlying bonds, which are less liquid. They have long been the bête noire of New York Fed chief Timothy Geithner, alarmed that 10 banks make up 89 per cent of the contracts.

“The same names show up in multiple types of positions. These create the potential for squeezes in cash markets, magnifying the risk of adverse dynamics,” he said.

“They could increase systemic risk, by amplifying rather than dampening the movement in asset prices,” he said.

This is what happened as the banking crisis gathered pace. The CDS spreads measuring default risk on Bear Stearns debt rocketed from 246 to 792 in a single day on March 13 amid – untrue – rumours that the broker was preparing to invoke bankruptcy protection.

Was it the spike in spreads that set off the panic run on Bear Stearns by New York insiders? Or are the CDS spreads merely serving as a barometer?

In the old days it was hard for speculators to take “short” bets on bonds. Credit derivatives open up a whole new game.

“It is now much easier to short credit, ” said James Batterman, a derivatives expert at Fitch Ratings in New York. “CDS swaps can be used for speculation, and that can cause skittish markets to overshoot,” he said.

For now the meltdown panic has subsided. Yet the hottest document flying around the City last week was a paper by Barclays Capital probing what might happen in a counterparty default.

It is not for bedtime reading. Direct losses from a CDS breakdown alone could be $80bn, but the potential risks are much greater.

In theory, the contracts are matching. One sides loses, the other gains, operating through a neutral counterparty (ie Bear Stearns). But if the system seizes up, the mechanism is not neutral at all. It becomes viciously one-sided.

“Upon the default of the counterparty, [traded] derivatives would be immediately repriced, with spreads widening dramatically,” said the Barclays report.

This is “gap risk”, the stuff of trading nightmares. Fortunes can vanish in a moment.

One side would suddenly be trapped with staggering losses on their books. Yet the winners would be unable to collect their prize from the insolvent bank in the middle. It would take years to unravel all the claims in court. By then the financial landscape would be a scene of carnage.

Warren Buffett famously described derivatives as “weapons of mass financial destruction”. The analogy is suspect, of course. Allied troops never found the alleged weapons in Iraq.

This time, Washington’s pre-emptive shock and awe may have been well-advised.

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  1. TallIndian

    I surprised share holders in other investment banks aren’t clamoring for adoption of such poison pills as sale of a compay for anything less that 15% of its previous close would require the immediate filing of bankruptcy and stop all payment to bond holders (unless approved by 2/3 of the share holders).

    These articles about derivatives exposures also fail to seperate interest rate derivatives from credit derivatives.

    The default risk on interest rate derivatives is a fraction of the notional value and can be easily handled by margining.

    Credit derivatives are an entirely different animal!

  2. Yves Smith


    Agreed re interest rate v. credit derivatives, and thanks for bringing that up. It was an oversight not to have mentioned it.

  3. Jojo

    John Mauldin and others have also piled on the bandwagon. It seems a lot of people are trying hard to justify that the FED did the right thing at the right time. Why?

    Maybe they don’t want the FED to be scared off next time around, so an attaboy is good insurance?

    Or maybe they really do believe that a calamity was about to happen and again, the FED rode to the rescue just in time.

    Me, I think the FED over-reacted and the Bear shareholders got screwed royally.

  4. TallIndian

    JoJo, your point is well taken.

    Not to turn this into a political forum and apoligize being so long winded, but to us old timers, the BSC taking brings back chilling memories of the federal seizure of Franklin Savings in 1990.

    The govt. declared that Franklin was undercapitalized, siezed all assets, reduced shareholder value to 0 and then sold (given away, perhaps would be more operative term) the assets to other institutions.

    Very similar to BSC, outside observers (and Franklin shareholders) questioned whether the company ws really undercapitalized and why assets were being sold at bargain prices. Indeed, for a bankrupt company, Franklin asset sales sure seemed to generate substantial cash.

    What the Bush I regime was a form of financial triage where healthy institutions were being liquidated and their assets distributed to weaker, albeit, more politically powerful instituitions. There was even courtroom testimony that Franklin was seized and sold to cover the government losses from the Silverado S&L (owned by Neil Bush and in the same regulatory district as Franklin).

    Bush II seems to have applied the same triage method here. BSC killed and its assets used to save other more favored financial institutions.

    Alas, the courts have ruled that government does have such power!

  5. Anonymous

    No the FED just put it off for now it’s still coming.

    John Mauldin works as a hedgeie adviser what do you expect him to say. He’s got a vested intrest in peddaling a bunch of crap.

  6. Mike


    I’m not quite sure what you mean about the difference between interest rate derivatives and credit derivatives. I’m a student so I’m not very familiar with this type of thing. Could you elaborate a little or point me in the right direction? Thank you.

  7. Yves Smith

    The “attaboy” aspect is actually quite important.

    I don’t pretend to know if we would have had a real train wreck if Bear had BK’d. It would have revealed how awful it is to have your accounts stuck in a BK’s firm. They might have been worried about a flight of retail as well as institutional customers from various brokers (I had a savvy guy asking me months ago about whether he should keep his accounts at Merrilll).

    And the CDS market is a disaster waiting to happen.

    But having said all that, the Fed lacked enough info to have an independent point of view. Everything Bear owned could have been just fine. But the Fed was reliant on what the big banks and brokers were telling them. And they were going to tell them that Bear was a risk because they couldn’t see inside the firm (and even if they had some G2, it would be snippets. The vast majority of gossip is desk-specific. Yes, I am setting aside possible nefarious motives. The mere straight-up-the-center case would lead them to argue for a Bear rescue operation).

    This all goes back to LTCM. The Fed considers that to have been a great success. Recently, poking around the Web for some specifics about it, I came across quite a few papers and articles shortly after that intervention arguing that this was a dangerous precedent, an altogether bad extension of the Fed’s mission, and LTCM should have been allowed to fail.

    The Fed is now run by the “too big to fail” syndrome. And had LTCM collapsed, it would have instilled a lot of caution into the Street. We probably would not be in as deep doodoo as we are now.

  8. Anonymous

    An important takeaway from the Times article is the notion that the Fed moved to block triggering the CDS in both the Countrywide and BSC instances.

    With the Federal Reserve acting as the guarantor of bonds, the CDS are worthless. The CDS purchasers (speculators) are big losers and the moral hazard metric has increased substantially.

    I am not saying it was the wrong thing to do. As far as I know, the Fed is doing yoeman’s work. But, somebody just lost a whole lot of money purchasing/speculating using flimsy credit protection. All the oustanding CDS on other potential dead men walking are probably worthless also. Hedge fund capital vaporized. Yeah ?

  9. TallIndian


    In an interest rate swap, the notional principal amount is typically not exchanged so there is no principal risk. On a $100MM five-year swap, if one side defaults, the risk to the other side might only be $5 million.

    Also, interest rate derivatives are typically ‘linear’ products — the price sensitivity moves smoothly from day to day. That is, if the market value is $1 million today, it will most likely be between $990,000 and $1,010,000 tomorrow. Daily margining to control risk is feasible.

    Credit derivatives are a completely different animal. The notional value is at risk in the event of a default. One side has to pay the recovery value in the event of exercise. On a $100MM credit default swap,that amount most likely will be as much $50 million and could be as high as the full $100MM.

    Also, credit default swaps behave more like equity options. If the value of your credit default swap is $1MM today, it can be $500K or $5MM tomorrow. Margining in this case becomes ineffectual (your counterparty could have gone bankrupt before you can issue the margin call).

    Hope this helps!

  10. lawrencejay@earthlink.net

    Your figure for derivative exposure at Bear Stears…$ 13.4 Trillion…should be $ 134 Trillion.

  11. Yves Smith


    This comes from Bear’s 10-K via Prudent Bear:

    As of November 30, 2007 and 2006, the Company had notional/contract amounts of approximately $13.40 trillion and $8.74 trillion, respectively, of derivative financial instruments, of which $1.85 trillion and $1.25 trillion, respectively, were listed futures and option contracts.

  12. lawrencejay@earthlink.net

    You are right…I was wrong…$13,396.7 Billion is in fact $13.4 Trillion.

    Sorry to have cycled you on this. Keep up the good work.

  13. Anonymous

    This fits perfect!

    Comptroller general vacancy intensifies Bush-Hill battle
    By Jordy Yager
    Posted: 03/13/08 07:01 PM [ET]
    U.S. Comptroller General David Walker’s early departure from the Government Accountability Office (GAO) Thursday places new pressure on Democrats to decide which president should choose his successor.

    Selecting a new comptroller is in itself a difficult political process. Ten of the highest-ranking congressional lawmakers from both parties draw up a list of candidates. The president then nominates one and sends the name to the Senate for confirmation.


    Screwed up America!

  14. Anonymous

    Also, interest rate derivatives are typically ‘linear’ products — the price sensitivity moves smoothly from day to day. That is, if the market value is $1 million today, it will most likely be between $990,000 and $1,010,000 tomorrow. Daily margining to control risk is feasible.


    Yes, but a change in interest rates affects ALL swap contracts in the system whereas a credit default swap is limited to a specific incident. Couldn’t a drastic interest rate hike cause systematic problems?

  15. TallIndian

    anon 2:09

    You are correct in that the risk is there. However, it is extremely remote.

    I have a five year swap on $100MM (I’m receiving fixed). If rates were to jump by 100 basis (extreme but not unheard of) I’d only lose $5MM

    If rates jump 300 basis points tonight (an event that probably has happened twice since 1973), I would lose about $14 million on my position.

    If rates were to jump 1000 basis points tonight (even CNBC would have to admit that such a move was not good for the stock market), I’d only be out $37 million.

    Rates would have to go up about 2000 bais points before the losses that I can see on a credit default swap show up on an interest rate book.

  16. Let It Sink

    I have been reading quite a bit about this for the last year, and I have made money by placing bets on increased turmoil in the financial markets. But I would like to know at a very basic level why any of this matters. All of the explanations seem somewhat self referential. The explanation of what would happen if Bear Sterns blew up usually consists of a list acronyms that would decrease in value. And then that is called bad because another financial firm would lose money. Why does this matter? These are new products whose only benefit seems to have been to create a series of bubbles that are now popping. So they seem to be somewhat like subatomic particles that appear out of the ether on borrowed energy, and then return to the ether to repay the debt. Why does the vanishing of a new financial product which created profits by borrowing them from the ether matter? Why does the vanishing of one or more banks, whose profits were illusions, matter? If Bear Sterns, Lehman Brothers, et al vanished on Monday, I tend to think it would not matter.

  17. eh

    All you really need to know is that debt growth has FAR outstripped income growth for a good while, with subprime being the coup de grace. There is just not enough genuine wealth creation and income to justify and to service all that debt.

  18. S

    Jamie Dimon comment is the most asture and goes back to the FT article some months back regarding the financial plumbing needing complete retrofitting. Subprime is but a lesion. The malignancy is the political economy architecture that has fosters the malinvestment and behaviors that are coming home to roost. What is downright scary is to listen to hedge counterparts talk in breezy tones about how this too shall pass – by summer. And then we are back off to the races. Whispering in tones that question the feasability of the current system is the real third rail. It is why Bush is constantly stumping of late for free trade and sighting useless statistics about income and productivity to justify a system which is simply not working for the majority of Americans. Maybe the greatest irony of all is reflecting on our calling card financial services comparitive advanatage? Kindof like the storng dollar policy.

  19. Anonymous

    I think we still have some toxic sludge in the reactor:

    “This popping of the bubble in real estate has been much more pronounced than anybody would have expected,” Gumbinger said. “If property prices are falling, think how property tax revenues have to fall. There is a troubling connection between the decline in one market, especially one as wide as real estate, and government’s ability to operate.”

    What the OFHEO did Wednesday was make a “significant portion” of those tied-up reserves available to Fannie and Freddie to do what they do for a living — which is to buy up loans that meet their criteria, either repackaging them into mortgage-backed bonds or putting them on their own shelf for a while.

    The multiplier effect involved works similarly to a bank receiving a large new deposit.

    The amount of lending that can be accomplished ends up being significantly greater than the deposit itself.

    In this case, OFHEO is freeing $200 billion on Fannie and Freddie’s books, and authorizing the two to push their own mortgage-investment holdings to as high as $2 trillion.

  20. TallIndian

    Let it Sink

    Assume that Bear Stearns was a health insurance company. It’s customers have paid premiums over the years and expect BSC to pay off on their claims. Many have had surgery. Some have had babies.

    Assume also that these customers have borrowed money (for cars, homes, etc) from JPM.

    If BSC doesn’t pay their health insurance claims, the customers will have to pay out of their own pockets. And they won’t have money to pay the interest and principal on their loans to JPM.

    If all these people stop making payments to JPM, JPM goes belly up.

    The govt really doesn’t care about BSC. They care a lot about JPM. Even the slightest threat to JPM is viewed with concern.

    Simple solution: the govt has JPM take over BSC. JPM pays off on the health insurance claims (or,at least, says it will). The customers now have the money to py the loans back to JPM.

  21. S

    One interesting tidbit that slid under the radar from the CIT call was when they were asked whether they had access to the window. They said no but they have been able to access the FHLB. Yet another consuit in this scheme to defraud. This was the early preferred method for Countrywide and its banker GS. I recall someone sayoing well if the market will keep buying the debt we will keep lending.

    JPM also went a long way to defuse the CDS misperceptions during its investor day. I belive Jamie Dimon was going to have his credit guys put out a white paper to explain how the NY Times article vastly misunderstood the true nature of the exposure. Be interesting to see if that report ever sees the light of day.

    As for Robert Rubin chiming in with a call to goivernment action, he should be in the cellblock for establishing the failed precedent that laid the foundation for where we are and then the willful neglect at Citi. I belive he was n Arb guy at GS

  22. Yves Smith


    The fact that Rubin was former co-president at Goldman and was on the board when Citi got up to its eyeballs in dubious paper is appalling. Most banks have a lot of lightweights (in terms of business/financial acumen) on their board (deans of colleges are one of my faves). Rubin should have been asking tough questions and evidently chose not to.

    Rubin was head of risk arb at Goldman, which meant he speculated on corporate takeovers. He dealt in the equity markets not the debt markets.

  23. Yves Smith

    Let it sink,

    The health insurance metaphor is quite clever, and may well have a lot to do with the Fed’s action, but there are also broader worries.

    Remember LTCM. The Fed got a bunch of institutions it for the most part did not regulate (it was mainly securities firms like Goldman, not banks like JPM or Citt that were exposed) ti rescue a hedge fund, which it in now way, shape, or form regulates. And that was back in 1998, when the financial system was less tightly coupled than now.

    Remember how in 2003 a small failure in the electrical grid near Cleveland took down much of the east coast? That it the Fed’s world view, that if someone not necessarily very large in the abstract, but sufficiently involved in the vulnerable parts of the system failed (and Bear was a big player in lending to hedge funds and credit default swaps, two worrisome areas), it could take big parts of the financial system down.

    Why should this matter? Since 1980, banks have lost market share in credit intermediation to investment banks. Only 15% of non-agricultural lending is via banks. If investment bank balance sheets are damaged, or securitization goes into hyberntation, as now, credit becomes scarce. Look at the stories about banks cutting unused credit card and home equity credit lines, Mortgages are hard to get even for good borrowers. Highly rated corporations are paying high costs on bond issues due to credit default swaps prices being high.

    If that sounds bad now, the Fed does not want to take the chance that it would become vastly worse if a Bear or bigger failed.

    I’m not saying I agree with the logic; I’m appalled that the Fed doesn’t have a better grasp of the downside. But that’s the scenario they are worried about.

  24. Francois

    “The International Swaps and Derivatives Association says the vast headline figures in the contracts are meaningless. Positions are off-setting. The actual risk is magnitudes lower.

    The Bank for International Settlements uses a concept of “gross market value” to weight the real exposure. This is roughly 2 per cent of the notional level. For Bear Stearns this would be $270bn, or so.

    “There is no real way to gauge the market risk,” said an official

    “We don’t know how much is backed by collateral. We don’t know what would happen in a crisis, and if we don’t know, nobody does,” he said.”

    WTF mate? They are telling us “actual risk is magnitudes lower” and 2 sentences down “”There is no real way to gauge the market risk,” said an official”

    Is it just me or is there an inherent contradiction here? If risk cannot be quantified, where does this 2% come from? Past experience? A “model” perhaps? Like Countrywide with RMBS which central assumption was that houses prices would not go down for more than 6 months in the next 50 years?(!) (Excuse me while I reach the airbag…)

  25. Yves Smith

    That little discussion of CDS was one of the reasons I chose to feature the article long form.

    I’ve long suspected that no one has the foggiest idea of what the economic exposures of CDS really are (oh yeah, they are hedged? How? Dynamically? Using correlation models based on a few years of data and also happen to be blowing up?).

    This market has never had a big shock. We are going to find out how well these hedges work in due course.

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