Conversation from 10 years
ago: relating to John Meriwether of Long Term
Capital Management (LTCM) calling his friend at
Bear Stearns: Bear Stearns -
How much are you down by,
John? John -
Half. Bear Stearns - You are
finished. John - But I have
billions in cash, more fund raising to come, etc.
Bear Stearns
- John, when you are down by
half, people figure you can go all the way. You
are finished.
My article published on
Friday (see Forget Spitzer, fire
Bernanke, Asia
Times Online, March 15, 2008) touched upon the
unconventional rescue of a large securities firm
by the Fed last Monday when it announced a new
refinancing tool to help Wall Street. It appears
that the firm in question was Bear Stearns, an
ironic throwback to the advice given to LTCM that
I quoted above.
Over the weekend, JPMorgan
Chase agreed to buy Bear Stearns
for US$2
per share, a fraction of the $30 or so that the
company closed at on Friday, itself about 50% down
for the day. The infamous rule of "down by half,
finished" appears to have struck none other than
the very firm that used it to measure its risk
outstanding with other funds. Full credit for what
happened over the weekend though must go to what
the Fed did on Friday.
On Friday, the Fed
announced a more direct rescue of Bear Stearns, by
providing back-to-back financing through JPMorgan
wherein the latter would hand over all eligible
securities held by Bear Stearns to the Fed, and
would pass along all Fed credit to the investment
bank. Essentially, JPMorgan had the role of a
middleman with the ultimate risk being held by the
Fed as all financing to Bear Stearns was "without
recourse" - a legal term that essentially means,
once you make a loan against something, you are
pretty much on your own, pal.
Glass
Steagall Following from the near
collapse of the US financial system in the earlier
part of the 20th century, authorities moved to
separate normal banking activities from those of
investment banks. The separation has become
increasingly blurred in recent times, but in
effect while the Fed is responsible for commercial
banks, it does not have a direct role in the
financing and operations of the investment banks.
Each of the regional Fed banks (for example the
Federal Reserve of New York, or NY Fed as its more
commonly known) has responsibility for all
commercial banks registered in New York, and so
on. Thus, if any of these banks had a problem such
as bank run, the NY Fed would step in to help that
institution.
Bear Stearns, being an
investment bank, did not have direct access to the
Fed "window", leaving it at a competitive
disadvantage to commercial banks such as
Citigroup, JPMorgan and Bank of America when it
came to the process of accessing liquidity.
Therefore, on Monday as a first step the Fed made
a concession to the very kind of collateral that
investment banks were holding in large volumes,
such as residential mortgage backed securities
(RMBS). This kind of collateral is not a big
problem for commercial banks to hold - indeed it
can be argued that making mortgages to individuals
is their main business - therefore there isn’t
much of an issue keeping these securities on their
books funded by cheap deposits left by
increasingly scared individuals across the US.
Investment banks on the other hand saw
their cost of funding more than triple since last
year and more importantly, found that many tools
for refinancing were completely shut. The process
of selling mortgage-backed securities had already
ground to a complete halt, even as defaults were
rising on the underlying home loans - essentially
a dual hit for the investment banks.
As I
wrote in the above article, there was clearly a
break in the system wherein many of these
commercial banks refused to accept securities as
collateral from investment banks even if the
onward refinancing with the Fed was made
available. This is potentially due to two
concerns: 1. Firstly, some commercial banks would
have exceeded their specific credit limits to
various investment banks having provided them with
ever increasing lines of credit against
difficult-to-value collateral over the past 12
months. 2. Secondly, while these securities could
be refinanced with the Fed, they were all "with
recourse", ie if there was a problem with the
quality of collateral for example through a
ratings downgrade, the Fed could demand its money
back from the commercial bank while the latter
could possibly not hope to make a successful claim
against a failing investment bank.
Matters
seemed to have proceeded far faster than even I
had expected since Wednesday last week when I
wrote the above article. In effect, one or more
commercial banks had refused to lend to the likes
of Bear Stearns under "any circumstances", and
even refused to accept a modicum of risk that
exists in all market transactions such as buying
and selling foreign exchange, settling interest
rate contracts and credit derivative contracts.
Thus, on Friday, the Fed was forced to act
directly to help Bear Stearns by providing it with
unprecedented access to liquidity. The initial
reaction to the announcement was a sharp jump in
the share price of Bear Stearns in pre-market
trading.
However, even equity investors
are not that stupid these days. While they still
can be accused of living in aerial castles with
respect to the rest of the stock market, at least
their view of the risks of holding stock in
securities firms has matured over the past few
months.
Last year at one point, Bear
Stearns’ stock was trading close to $180. At the
beginning of last week, it was trading around $60,
falling from $80 at the beginning of March. On
Friday, after first rising a few dollars, around
10% in pre-market, the stock opened more than 10%
lower and continued to fall.
Even the most
gullible equity investor could no longer be fooled
about the turn of events. Bear Stearns needed a
rescue because it was going bust, and that was all
there was to the positive spin on the story from
the NY Fed, and all discussions from the company
about its real book value were hollow.
Financial institutions survive purely on
the confidence of investors, who after all trust
them to hold significantly more assets than their
capital bases would allow. A typical investment
bank with a market value of $10 billion would
typically have assets of over $200 billion, to
give you an idea of the kind of leverage we are
talking about here. I would hate to analyze the
figures of Bear Stearns on these counts because
many of those assets were impaired, and partially
that was already reflected in the reduced stock
capitalization.
Going
forward Much like a financial game of
whack-the-mole, the rescue of Bear Stearns puts in
question the next potential victim. As I noted in
the Friday article, other investment banks may be
better off for the immediate future, but all have
similar existential crises in front. Why should
any investor trust them to manage assets far in
excess of their capital bases?
Their
financial results for the first quarter ended
February, due over the course of this week, will
inevitably raise issues of potential downside and
worst-case scenarios. No bank prepares for all its
depositors to turn up on the same day to demand
their money back, and neither does any investment
bank.
A few weeks back, I wrote Mr Paulson, Tear Down This Wall
(Street) (Asia
Times Online, February 16, 2008) purely because of
a deeply held personal belief that a major
investment bank would go bust in 2008. I certainly
did not know that it would be Bear Stearns nor
that it would happen by the first quarter itself.
In any event, the reason for that article was to
implore US authorities not to expand the circle of
trouble by bailing out investment banks because
that would only make problems worse for the entire
global financial system.
It appears that
US financial authorities have been overly
influenced by their European counterparts and have
chosen to effectively nationalize troubled
companies. That process did not work in Japan
where banks remain moribund more than a decade
after these efforts began in earnest, nor in
countries like France where banks seem to lurch
from one crisis to the next. Thankfully, market
circuit-breakers in the US still work wherein the
firms being asked to buy troubled investment banks
are exerting their own pressure on price - as
JPMorgan showed by offering a price of $2 per
share rather than the $30 closing price (or even
the $20 that the weekend press indicated).
All commercial banks accepting to purchase
investment banks would put their own existence in
jeopardy, not the least because of the sheer size
of these companies as well as their complexity.
Accounting standards and regulations are vastly
different between these companies due to many
decades of Glass Steagall.
The acquisition
of Bear by JPMorgan means that investors cannot
trust the reported book value of US financial
firms anymore. If they cannot trust investment
banks, can the trust of commercial banks be really
all that higher? The discount to book value should
tell the Fed and all other central banks an
important truth namely that the bailers themselves
may need to be bailed out in time.
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