Two good pieces yesterday on the Bear bailout hearings last week, one by John Hussman (hat tip reader Stephen), the other by Institutional Risk Analytics (hat tip reader bill). The posts focus on very different aspects of the Bear failure and bailout, so they make for good companion pieces.
One bit Hussman argues, and I am not sure I agree with it, is that Bear’s customers were never at risk of losing their cash or securities. While that may be narrowly correct, my understanding is that if the firm went bankrupt, customers would not have ready access to their accounts (they’d have to petition the bankruptcy judge, a time consuming process, or wait for the wheels of the court to grind). If you are a high velocity trader, which many of Bear’s customers were, the last thing you want to happen is to be unable to buy and sell your positions (even for a retail customer, that would be a considerable loss of freedom). And if you were using margin, my understanding is the process is more cumbersome, which I assume means more time consuming (knowledgeable readers invited to speak up). Even though Hussman argues that changes made to the bankruptcy laws in 2005 allow for expedited netting of derivatives such as credit default swaps, to my knowledge, this provision has never been road tested in a real court with a real bankruptcy judge and a large book of complex exposures. What works on paper may not work so well in practice.
The troubling aspect of the Fed’s action was not that it lent to a non-bank entity…. The problem is that it made its “loans” as “non-recourse” funding – meaning that it would not stand to be repaid if the collateral itself was to fail, even if Bear Stearns and J.P. Morgan survived. This feature converted the “loans” by the Fed into unauthorized “put options,” benefiting private entities at potential public expense. This is a terrible precedent, and it deserves far more scrutiny and reluctance before we accept that this was the only available option.
Another troubling aspect was that shortly after making an initial non-recourse loan to Bear Stearns, and indicating the funds would be available for “as much as 28 days,” the Fed pulled the funding over the weekend. By doing so, the Fed itself forced the de facto collapse of Bear Stearns…
What’s in that $30 billion “portfolio”?
The odd secrecy and vague description of the portfolio of assets held by the Fed is, let’s say, curious. On what might be called the “bright side,” evidently, a good portion of the collateral taken by the Fed in the Bear Stearns deal represents government mortgage obligations, including those of Fannie Mae and Freddie Mac. The portfolio also includes non-agency securities rated BBB- or higher among its “cash assets.” The characterization of these as “investment grade” is not reassuring, given that many such structured mortgage securities maintain such ratings only because of bond insurance from companies that are themselves increasingly in question.
More troublesome is the part of the portfolio described as “related hedges.” The question here is that the net value of a so-called “portfolio” might be $30 billion, but the gross or “notional” value of the portfolio can conceivably be a substantial multiple of that. If you own $100 billion in assets, but have $70 billion in offsetting liabilities against that, then sure, you’ve got a portfolio “worth” $30 billion, but as Long-Term Capital Management discovered, you could end up losing a whole lot more than $30 billion, depending on how well those assets and “hedges” offset. The description is just unclear – I would be a lot more comfortable about this if we were assured that the total notional value of the portfolio held by the Fed does not exceed $30 billion. We should also know what portion of that $30 billion represents strictly government agency obligations. That would clarify how large the maximum potential loss might be on this portfolio of “cash assets and related hedges.”
If the collateral was just a plain vanilla portfolio of securities, literally the only reason for the Fed to do the “non-recourse” loan would be to protect Bear Stearns’ bondholders from losses, since J.P. Morgan was willing to assume all customer accounts and counterparty liabilities of Bear Stearns, plus over $75 billion in debt obligations to Bear Stearns bondholders, yet needed only $30 billion of Federal assurances to do it.
Think of Bear Stearns’ assets as being divided into two boxes. One box holds $45 billion worth of valuable customer relationships (the actual customer securities are segregated and are not at risk even if the company fails) and a “book” of investment positions and transactions, including claims and obligations to counterparties. In the other box is either $30 billion in mortgage-backed securities, or a pile of packing peanuts. The only thing not in one of those two boxes is a $75 billion liability to Bear Stearns own bondholders (we’ll assume that shareholder equity has already been wiped out). How much would an acquirer pay? Well, if you were J.P. Morgan, you would say: I’ll take the $45 billion worth of known, valuable stuff, and the Fed can have the mystery box in return for $30 billion. That gives me $75 billion in assets. I’ll also take on the $75 billion in Bear Stearns debt. And of course, since the assets I’m getting are worth the same as the liabilities, I’m going to pay essentially nothing for the deal. If you were Ben Bernanke, you would say, “I can’t lose! I love packing peanuts!” This is the deal that was actually struck.
But why didn’t J.P. Morgan say: I’ll take the $45 billion of valuable stuff, and the mystery box. In that case, even if J.P. Morgan thought the box contained packing peanuts, it would still have been willing to pay a minimum of $45 billion for those boxes, provided it did not take on any of the debt to Bear Stearns bondholders. Customers and counterparties would have been protected, and despite “technical” default for Bear Stearns’ bonds, there would have been enough to pay at least 60%, and possibly 100% of bondholder claims, without the need for public funds. In this case, if you were Ben Bernanke, you could have said, fine, we’ll stand behind that deal and provide a loan of $30 billion, or even $45 billion in medium-term liquidity to facilitate that outcome. But you, J.P. Morgan, the bank, will have to put up Treasury and government agency collateral, and assume all risk of the deal. The Fed’s only risk, in that case, would have been the risk that J.P. Morgan itself would default. Instead, Bernanke’s actual response was apparently “Nope! I want a shot at those packing peanuts! And we ought to be using public funds to bail out Bear Stearns’ bondholders!” So that’s what they did…..
As for actions that might have prevented Bear’s sudden collapse, Timothy Geithner, the president of the Federal Reserve Bank of New York, indicated that the Fed had not made funds available to Bear earlier in the week, saying “I would not have been comfortable lending to Bear at that time. We only lend to sound institutions. Lending freely to Bear would not have been a prudent act.” Evidently it was prudent to commit $30 billion in public funds without the assurance of being made whole…..
As I said a couple of weeks ago, if we keep on believing that the default of Bear Stearns bonds (“bankruptcy”) would have caused a global financial crash, then I expect that we are in for a global financial crash anyway. Not because there is any true risk to customers and counterparties, but because investors are misinformed about how the financial markets work, and they will panic as foreclosures and writedowns inevitably soar in the months ahead. A financial panic is fully avoidable if Wall Street and the media stop propagating the utterly false belief that a Bear Stearns bankruptcy would have led to a “chain reaction” of financial losses. While we might very well see some over-leveraged firms go bankrupt, with substantial losses to their own stockholders and bondholders, the customers and counterparties are generally not at risk if there is enough stockholders equity and bondholder capital to eat through without leaving the remaining book value negative. Bankruptcy or no bankruptcy, the underlying book of assets and liabilities can be transferred quickly. The only question is how much the bondholders come away with. That “chain reaction” theory is just utterly irresponsible fearmongering.
Institutional Risk Analytics sees Bear’s collapse as a direct result of Greenspan’s failure to regulate:
In particular, in the two decades of Greenspan’s tenure, the Fed’s Washington staff, other regulators and the Congress allowed and enabled Wall Street to migrate more and more of the investment world off exchange and into the opaque world of over-the-counter derivative instruments and structured assets. This change is described by people like Greenspan and Treasury Secretary Hank Paulson as “innovation,” but our old friend Martin Mayer rightly calls it “retrograde.”
In a market comprised primarily of exchange traded instruments, there is little or no counterparty risk. OTC trades which reference exchange traded benchmarks are likewise far more stable. By replacing exchange traded securities with ersatz OTC instruments, Greenspan and the quant economists who dominate the Fed’s Washington staff have created vast systemic risk that need not exist at all and that now threatens our entire financial system.
BSC failed not because it had too little capital or too little liquidity, but because the thousands upon thousands of OTC trades which flow through the firm’s books are bilateral rather than exchange traded. It was the understandable fear of counterparty risk, not a lack of capital or liquidity, which killed BSC. The irony is that the “financial innovation” of OTC derivatives and structured assets takes us backward in time to the chaotic situation that existed in the US prior to the crash of 1929.
Would that the Congress and the Fed had the courage to confront Paulson and the other banksters who have turned America’s financial markets into an increasingly unstable, derivative house of cards. If all federally insured commercial banks, mutual and pension funds were required by law to invest only in SEC registered, exchange-traded instruments, the threat of further systemic risk could be eliminated tomorrow. What a shame that neither Chairman Bernanke nor FRBNY President Timothy Geithner said that last week when they appeared before the Senate Banking Committee.