Bear Conspiracy Theories and Carry Trade Unwind

A reader sent me the link to this week’s Institutional Risk Analystics, and I am posting despite the fact that at points it undermines its own credibility.

Most of the article, “Novated Bears & the Education of Ben Bernanke,” is a combination of trader gossip about the fall of Bear Stearns, some of it quite informative, such as Goldman CFO David Viniar maintaining “we have 100 percent confidence in Lehman Brothers,” when the firm was refusing to trade with Lehman and take clients out of Lehman exposures.

But the piece takes some interesting tidbits and goes overboard, muttering darkly that the government allowed Bear to fail and not Lehman and Goldman.

Simple explanations are usually best. Bear hit the wall first, therefore it went under. The government made the mistake of announcing a new liquidity facility for primary dealers a good, what, ten days or two weeks before the facility was effective. The Fed’s announcement made it sound as if the delay in implementation was due to the need to work out technical details. But Bear’s liquidity crisis hit before the lending program was in place. The Fed felt could not allow two sizeable dealers to fail (it may be hard to recall the panic of two weeks ago). As an aside, I’m not of the school that Bear should have been salvaged, but that’s a separate issue.

Moreover, Bear did not put up much of a fight. Alan Schwartz was reported to given a presentation on the firm’s liquidity that if anything heightened worries. And as we noted, Bear had substantial bank credit lines that it did not use. By contrast, Lehman has gone on the offensive (one investor called the conference call March 17 “Orwellian,” but hey, those techniques have proven effective).

What is most surprising is that the newsletter puts its most important bit of information at the very end, as almost an afterthought:

Many people inside and outside the Federal Reserve System don’t seem to appreciate that the US Treasury is dependent upon the primary dealers. Dealers like BSC, LEH and GS are the main outlet for funding all of the great ideas that emanate from Washington. We hear from several Fed insiders that Geithner, at least, understands this nuance, but it seems incredible to us that the Fed staff in Washington were not able to construct a rationale for invoking Section 13 (3) of the FRA [the “unusual and exigent circumstances” provisions] long before March 16.

“People were not novating with Bear and the CDS market was careening out of control, like a collapsing Ponzi scheme” the head of asset allocation at one of the largest corporate pension funds in the world tells The IRA. “The Fed finally stepped in very late to save the Treasury’s ability to issue debt, but this clumsy effort is not without cost. The credit standing of the United States has started to be perceived as being impaired because foreign investors think our government officials don’t know what the hell they are doing. Even though asset quality problems inside many European banks are far worse than in the US, for example, you don’t hear any noise coming from the EU.”

The pension mogul continues: “Now add to this perception problem the fact that Bernanke has pushed interest rates on US government debt down to Japanese levels. At Japanese levels, the yen-dollar carry trade unwinds and we are going to see a massive contraction of liquidity coming out of Japan. The yen crashes through 100 and is most likely going to 80 per dollar as liquidity is sucked back into that market like an imploding black hole. People are looking at the US for the deflationary problem. No, the deflationary problem is coming from the collapse of the carry trade and the liquidity created by the Bank of Japan.”

As the yen has rallied from below 120 to under 100, talk of the carry trade unwind has receded. It may well be that a fair number of foreign borrowers were able to make timely exits and reestablish positions at higher yen/dollar levels. But a fair bit of the pain and losses emanating from hedge fund land no doubt come from carry-trade-related losses.

Despite the negative that a higher yen has on Japanese exports, our contacts in Japan tell us that the officialdom regards the yen as still cheap and the dollar’s fall as the result of developments internal to the US. That means they will not be terribly inclined to intervene, at least for a while. Thus the yen going to 80 is far from implausible, and the consequences would be, to use a Japanese turn of phrase, severe.

Now to the gossipy parts of the newsletter:

First, we all of us need to understand that the bailout was not of BSC, but rather of Lehman Brothers (NYSE:LEH), Goldman Sachs (NYSE:GS), JPMorgan Chase (NYSE:JPM), and the rest of the primary dealer community. BSC was the sacrifice, the Easter Pascal lamb put to the knife while the Fed belatedly bailed out the rest of the Street.

The actions taken by the Federal Reserve Bank of New York during the week of March 10, culminating with the March 16 announcement of the acquisition of BSC by JPM and the creation of an emergency loan facility for broker dealers, was not to rescue BSC but instead everyone else on Wall Street, particularly LEH, GS and JPM. In the case of JPM, a BSC bankruptcy filing could have started a chain reaction in the credit default swaps (“CDS”) market that might have seriously damaged this huge derivatives dealer.

Some BSC partisans tell The IRA that the firm was the victim of a concerted “bear raid” by a number of hedge funds, which actively worked to undermine the BSC’s liquidity while shorting the firm’s stock and debt. Hedge funds reportedly were buying counterparty risk positions with BSC from other parties, and then demanding immediate payment or the return of collateral, deliberately accelerating the firm’s collapse. Note: It is illegal to take such actions against a commercial bank, but not against a broker dealer.

On Wednesday March 12, BSC CEO Alan Schwartz told investors that the firm remained liquid and solvent, but by the market close on the following day BSC’s fate was sealed by the hedge fund mafia, at least according to this version of events. Strange, is it not, that the managers of BCS’s mortgage and repo desks did not give Schwartz a friendly heads up on the Wednesday.

Other observers, however, tell The IRA a different story, whereby the dealer community, and not vicious hedge funds, actually caused BSC to fail by refusing to face the struggling bank in the interdealer market. As all manner of clients tried to trade out of or novate counterparty positions with BSC to other firms, dealers began to refuse to take further exposure with BSC.

By the close of business on Thursday, March 13, BSC effectively lost access to the repo and interdealer markets, the death knell for any investment bank. As one BSC official told The IRA on a not-for-attribution basis, had the Fed acted a week earlier, there would have been no liquidity crisis….

As BSC was being shut out of the interdealer market, LEH was also being shunned by other dealers and attacked by the hedge fund hordes in the same fashion as BSC. Several veteran traders in the CDS market say that LEH was essentially in danger of failing as well.

One hedge fund veteran, who was and is short LEH, complains to The IRA that LEH was essentially dead in the water on Monday, March 17, but the Fed intervened. When the markets opened after the Easter holiday, clients and other dealers were backing away from LEH and the shorts were swarming in for the kill, he claims….

Indeed, the only reason that LEH did not fail as well, claims this well-connected trader, was a conference call on that Monday with the top ten dealers organized by the Fed of New York. During that call, the Fed of New York reportedly told the other dealers that it would lend LEH “whatever is necessary” to keep that leading mortgage-backed security underwriter and CDS house afloat. That open-ended promise, not the Fed’s new lending facility, reportedly saved LEH from collapse – for now….

Chairman Dodd and his SBC colleagues should understand that the real beneficiaries of the “BSC Bailout” are neither that firm nor its shareholders, who have paid a very steep price for not being part of the “Too Big to Fail” club. Rather, in our view, it is GS, LEH, JPM who benefited indirectly from the Fed’s tardy largesse. When Chairman Dodd convenes his hearing, hopefully he will ask the witnesses from the Fed several key questions:

** What logic drove the Fed to pick LEH et al to survive and BSC to die? As and when any other of the major dealers become insolvent, will the Fed allow a market resolution? Is there an objective standard used by the Fed in picking winners and losers? If so, what is that standard?

** What role has Secretary Paulson played in the Fed’s bailout of LEH, GS and the other major dealers? Do Fed officials have any concerns about the existence of a real or apparent conflict of interest in having the former CEO of GS involved in these deliberations? Despite the fact that Paulson is in almost constant contact with Chairman Ben Bernanke, are we really expected to believe that the Fed went into that week unaware that the primary dealer community was about to collapse?

** Secretary Paulson has proposed giving the Fed additional oversight responsibility for dealers, funds and other non-bank institutions. In view of the Fed’s failure to anticipate this crisis and the fact that no other industrialized nation in the world gives its central bank primary responsibility for safety and soundness of financial institutions, why should Congress not instead strip the Fed of its regulatory role and limit its responsibility to monetary policy and providing market liquidity?