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.
Reading the doc on the NY FED website, I would suggest:
1) the portfolio includes such classic BSC structures as inverse floaters,CMO residuals and perhaps even IOettes. All these will have FNM/FRE MBS as underlying assets and will be ‘current’ with regard to interest and principal. However, securities that pay zero principal and don’t pay (nor accrue) any interest for the next ten years are usually current.
2)The ‘related hedges’ most likely include swaps based on the Constant Maturity Mortage Index, total return swaps and short put and call options on various MBS. The basis risk is probably extraordinary and most likely have already blown up. Further widenening of MBS/Tsy spds would could substantially increase the losses. JPM couldn’t get hedge accounting treatment on these ‘related hedges’ and the subsequent MTM losses would be material. Hence they go to the taxpayer.
3) Tranlsating the phrase ‘the assets were not indivdiually selected by JPM’ from NEWSPEAK to ENGLISH simply means that JPM filtered on a spreadsheet to find the ‘assets’ that showed either the lowest MTM, the largest MTM loss exposure to falling rates, or assets whose hedge MTMs have also declined. These assets were collectivey dumped to the taxpayer.
4) Translating the FED statement that disclosing the contents of a $30 billion portfolio somehow constitutes a ‘danger to markets’ from NEWSPEAK to ENGLISH: “the risk to the taxpayer far exceeds $30 billion and constitutes a danger to our current jobs and to future job prospects with Goldman, Lehman, or even one with a second tier hedge fund”
Note, Cox didn’t say Bear’s counterparties were protected; Cox just said that Bear’s customers were protected. This is the third week in a row that Hussman has persisted in claiming that Bear Stearn’s counterparties are protected. If Bear went bankrupt, and a counterparty to a financial transaction was in the money (e.g., the counterparty bought credit protection from Bear with respect to subprime mortgages, and the credit risk increased, so the value of the counterparties’ contractual rights had appreciated prior to Bear filing bankruptcy), then the counterparty’s claim would be translated into an unsecured claim for damages against Bear subject to losing money in bankruptcy, like any other unsecured creditor. Here is a link to an article in Derivatives Week by the law firm Patterson Belknap explaining the rules: http://www.pbwt.com/files/Publication/3ad02c75-b637-42a8-85e5-05ef6b0dcb7d/Presentation/PublicationAttachment/638eb373-0dfd-4b5b-83e0-0b32fcc4b9cc/DW_03_21_2005_PBWT.pdf
An example of this is the bankruptcy of Mirant, which had a book of energy trades. The debtor wanted to preserve the business, and the court gave counterparties a priority for claims under trades for market movements that occured ***AFTER*** Mirant filed bankruptcy, but not market movements that occurred ***BEFORE*** Mirant filed bankruptcy. Here is a link to commentary from the law firm Strook regarding the Mirant case. http://www.stroock.com/SiteFiles/Pub437.pdf
If you want to read the actual law, look at 11 usc sections 502(a), 502(g)(2), and 562; these provisions give a Bear counterparty an unsecured, nonpriority claim for amounts due under existing trades with Bear at the time Bear filed bankruptcy. Also, look 11 usc 752 or 766, these provisions give a “customer” a priority claim for assets held by Bear in the person’s brokerage account. There is not a similar provision giving a priority to counterparties to Bear’s existing trades at the time it files bankruptcy.
PS – This is not legal advice; seek your own advisor. People like Bob Rodriguez at FPA Funds and Andy Weiss at Weiss Asset Management get advice from lawyers so they don’t make foolish mistakes like Hussman’s regarding counterparties’ rights in bankruptcy.
I was a Refco customer (for futures trading) a few years ago when they went through bankruptcy and then came out again. I never lost access to my account. I never came near a margin call during that period, though, and I don’t know what would have happened if I had.
Could you please explain a little more clearly what the implications of this: “the court gave counterparties a priority for claims under trades for market movements that occured ***AFTER*** Mirant filed bankruptcy, but not market movements that occurred ***BEFORE*** Mirant filed bankruptcy.” are.
The implications of a Bear counterparty getting a nonpriority claim for pre-bankruptcy appreciation of the counterparty’s rights are like this.
Suppose a fund bought credit protection from Bear by entering into credit default swaps (CDSs), referencing the ABX. Suppose by Day X, suppose the ABX falls a lot and the fund could sell its positions against Bear for $1000k, and suppose on Day X Bear files bankruptcy. The fund would have unsecured nonpriority claims for $1000k, subject to taking a haircut like all the other unsecured creditors. So for example, if Bear’s unsecured bondholders get paid 10% of par in bankruptcy, the fund would also get paid 10%, and only get $100k on its claim of $1000k.
Now, suppose after filing bankruptcy, Bear wants to keep its trading business running, Bear could request that the bankruptcy court give priority unsecured creditor rights to counterparties trades Bear enters after it filed bankruptcy, and also for counterparties on trades with Bear outstanding at the time Bear filed bankruptcy. Suppose after Bear files bankruptcy, the ABX index falls a bit more, and the fund’s swap rights appreciate another $50k. The fund would have a priority claim for this $50k of appreciation, and so would get paid before Bear’s general unsecured creditors on the $50k.
PS – This is not legal advice. Seek your own advisor. It is very foolish not to do so.
Thank you, that’s clear now. One more question. If the Mirant precedent is followed, what happens to counterparties who owed Bear money. Is it possible that their debt would be fixed at the bankruptcy date value too? Or does the whole concept of hedging potentially get thrown out of kilter once a major counterparty goes bankrupt?
(Btw, conservatively invested in old-fashioned products and not in need of legal advice.)
Re: 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.
I like the way in which WaMu is allowing a non-bank to loan it $8 billion, but then that private entity is not regulated, and all the while, the insolvency issues are swept away while the illusion of an FDIC guarantee is projected into this smoke and mirrors congame, where now you see reality and now you don’t and — meanwhile, according to Hussman, counterparties are protected….yah, right!
I’m a bit slow, but after rereading your description I actually think I understand how Mirant makes sense. It was precisely to deal with the possibility of hedging being thrown out of kilter that claims before bankruptcy are unsecured, but claims for everybody including existing counterparties who already have an unsecured claim have priority after bankruptcy.
Assuming the Mirant precedent holds and a bankruptcy on Wall Street is in the offing, the legal situation seems to create very strong incentives to take down a big counterparty or two, before the reference entities in the CDS go bust.
What a mess!
You missed the critical point. The counterparties in trades with Bear at the time Bear files bankruptcy DO NOT get a priority based on pre-bankruptcy market movements, only POST-bankruptcy market movements. Thus, if the counterparty’s side of the trade is in-the-money at the time Bear files bankruptcy, it is as if the trade is reset into an at-the-money trade, and as compensation, the counterparty gets an unsecured, nonpriority claim for the amount of the appreciation that occurred before Bear’s bankruptcy filing, and the counterparty can take just as much of a haircut as a general unsecured creditor on that claim. Now afterward, if the trade appreciates in value, the counterparty gets a priority claim for that, but that is totally separate.
Read my example above in my posting at 2:25pm.
PS – this is not legal advice.
I may not have stated it clearly at 3:55, but I do now understand that all derivatives are effectively reset to be at the money at the date of bankruptcy and after this date the “reset” derivatives all have priority claims over other creditors.
While the decision in Mirant may have made sense for the specific case at the time, it clearly results in a huge increase in systemic risk. Derivatives holders can now game bankruptcy to try to make sure that as much as possible of the future value of their derivatives is accrued after a bankruptcy event rather than before.
Financial weapons of mass destruction, indeed.