While there have been dark mutterings about how Bear shareholders were cheated in the sale of the firm to JP Morgan, I don’t have much sympathy for that view. Plenty of businesses fail every day; equity investors usually lose their entire stake and employees are fired. While it is sad on a human level to see people take such a reversal, it happens all the time in Darwinist America. The only difference between Bear’s share owners and those of most other companies facing liquidation is that in going though the five stages of grief over their loss, they took the bargaining phase literally.
What does have me agitated (and this blogger prefers to stay detached) is the Fed’s $29 billion subsidy to JP Morgan’s purchase of Bear and the utter lack of candor and accountability about it. Paulson came up with an excuse to run away to China to avoid testifying at the Congressional hearings on the Bear bailout this week (perhaps, having been a staffer to John Erlichman, he is acutely aware of the danger of committing perjury before Congress). In the end, Paulson’s absence probably made no difference, because the key actors executed a brilliant strategem, the Rashomon defense.
As in Kurosowa’s masterwork, certain basic elements are not in dispute: in the movie, a rape; in the financial world, a rape an unprecedented commitment on the Fed’s part that appears to be well beyond its authority. (While the Fed can lend against all sorts of collateral in exigent and unusual circumstances, I have been advised those loans are for a maximum of 28 days. It might have been possible to arrange overlapping loans that would have achieved the same end, but the Fed couldn’t be bothered to observe the niceties.)
In both performances, the witnesses tell stories that simply cannot be reconciled. The SEC insists Bear had sufficient capital. Bear CEO Schwartz maintains there was no action he could have taken to save the firm. Bernanke and Geithner claimed that the deal was necessary to preserve the financial system because Bear was going to have to file for bankruptcy (they indicated the big worry was the credit default swaps). Dimon said his firm is sound and the fact that he did the deal means he thought it was good for shareholders.
So we have at least three possible scenarios, with no way to sort them out:
1. Bear really was solvent but did not manage the crisis or its cash levels defensively enough
2. Bear was worth either not much or nothing dead, but JPM used the panic and the possibility of a Lehman-on-the-ropes further ratchet down to extract big concessions from the Fed. Put more simply, JPM played what were real risks to the max and exploited the Fed and Treasury’s desperation to get a deal done
3. There was a black hole in Bear’s balance sheet (I mean this in sense of either serious negative equity in liquidation or an information void). The possibility of losses to JPM was real (although Dimon still could have overplayed it)
What makes me even more keen for disclosure is that the de facto subsidies to JPM were even greater than previously disclosed. From “Fed Loosens Capital Rules for JPM.” in Alea (boldface his):
Up to $220 billion of Bear Stearns assets can be excluded from J.P.Morgan’s risk-weighted assets.
Up to $400 billion of Bear Stearns assets can be excluded from the denominator of the tier 1 leverage capital ratio.JPMC also has requested that the Board provide JPMC with relief from the Board’s risk-based and leverage capital guidelines for bank holding companies.
Specifically, JPMC has requested that the Board permit JPMC, for a period of 18 months, to exclude from its total risk-weighted assets (the denominator ofthe risk based capital ratios) any risk-weighted assets associated with the assets and other exposures of Bear Stearns, for purposes of applying the risk-based capital guidelines to the bank holding company. In addition, JPMC has asked the Board to permit JPMC, for a period of 18 months, to exclude from the denominator of its tier 1 leverage capital ratio any balance-sheet assets of Bear Stearns acquired by JPMC, for purposes of applying the leverage capital guidelines to the bank holding company.
The Board has authority to provide exemptions from its risk-based and leverage capital guidelines for bank holding companies.
JPMC has agreed to several conditions that would limit the scope ofthe relief request.
First, JPMC proposes to exclude from its risk-weighted assets, for purposes of applying the Board’s risk-based capital guidelines for bank holding companies, the risk-weighted assets of Bear Steams existing on the date of acquisition of Bear Stearns by JPMC, up to a total amount not to exceed $220 billion.
Second, JPMC proposes to exclude from the denominator of its tier 1 leverage capital ratio, for purposes of applying the Board’s tier 1 leverage capital guidelines for bank holding companies, the assets of Bear Stearns existing on the date of acquisition of Bear Stearns by JPMC, up to an amount not to exceed $400 billion.
These regulatory capital exemptions would assist JPMC in acquiring and stabilizing Bear Stearns and would facilitate the orderly integration of Bear Stearns with and into JPMC. The Board notes that (i) JPMC would be well capitalized upon consummation of the acquisition of Bear Stearns, even without the regulatory capital relief provided by the exemptions; and (ii) JPMC has committed to remain well capitalized during the term of the exemptions, even without the regulatory capital relief provided by the exemptions.
Note that the existence of this huge and ugly-looking concession says that someone thought there was risk here, but it still doesn’t indicate conclusively how much of this was needed to overcome JPM’s hesitation versus a sign of the depth of the Fed/Treasury’s panic.
Or did JPM need regulatory relief irrespective of the Bear transaction, and the deal provided a much-needed fig leaf? According to Institutional Risk Analytics:
To understand the grim outlook for JPM, start the analysis with derivatives. Because of its huge market share in all manner of OTC derivatives, JPM represents a “super sample” of overall OTC market risk. In terms of total size vs the bank’s balance sheet, JPM’s derivatives book is more than 7 standard deviations above the large bank peer group.
Because of this huge OTC derivatives book, the $1.6 trillion asset bank can tolerate just a 15bp realized loss across its aggregate derivatives position before losing the equivalent of its regulatory Risk Based Capital (RBC). And much like the GSEs, JPM’s positions are too big to hedge – despite what Mr. Dimon may say to the contrary about laying off his bank’s risk. And note that we have not even mentioned subprime assets yet.
Look at the balance sheet of JPM’s three main subsidiary banks and the mounting stress from loans losses is apparent. At the end of 2007, JPM aggregated 97bp of gross loan charge offs, 1.25 SDs above peer, and produced a Loss Given Default of 85%, likewise well above peer. The Exposure at Default calculated by the IRA Bank Monitor using data from the FDIC was 202%, more than 2 SDs above peer.
At the end of 2007, JPM’s Tier One Risk Based Capital held by its subsidiary banks was just $88.1 billion, a tiny foundation for the bank’s vast trading operations. The Economic Capital (“EC”) simulation in The IRA Bank Monitor generates an EC benchmark of $422 billion for JPM or a ratio of EC to Tier One RBC of 4.79:1, suggesting that JPM needs almost five times current capital levels to fully support its economic risks (boldface ours).
If that isn’t ugly enough, consider another element: while none of the principals was likely to have admitted it out loud, they may have recognized privately that the inmates are running the asylum at all of the major trading operations on Wall Street. No one in authority, including the firms’ own management, knows the score. As Michael Lewis noted last week in Bloomberg:
There is, of course, a reason that the market doesn’t understand Wall Street firms: The people who run Wall Street firms, and who convey news of their inner workings to the outside world, don’t understand them either…
Late last November, in a superb account of the demise of Citigroup CEO Charles Prince, Carol Loomis of Fortune magazine revealed that Prince resigned after he was informed of the consequences of liquidity puts…Liquidity puts were about to make Citigroup the new owner of $25 billion of crappy mortgage securities at par, cost Prince his job, and put the company into the hands of Robert Rubin….
Rubin said he had never heard of liquidity puts.
To both their investors and their bosses, Wall Street firms have become shockingly opaque. But the problem isn’t new. It dates back at least to the early 1980s when one firm, Salomon Brothers, suddenly began to make more money than all the other firms combined. (Go look at the numbers: They’re incredible.)
The profits came from financial innovation — mainly in mortgage securities and interest-rate arbitrage. But its CEO, John Gutfreund, had only a vague idea what the bright young things dreaming up clever new securities were doing. Some of it was very smart, some of it was not so smart, but all of it was beyond his capacity to understand.
Ever since then, when extremely smart people have found extremely complicated ways to make huge sums of money, the typical Wall Street boss has seldom bothered to fully understand the matter, to challenge and question and argue.
This isn’t because Wall Street CEOs are lazy, or stupid. It’s because they are trapped. The Wall Street CEO can’t interfere with the new new thing on Wall Street because the new new thing is the profit center, and the people who create it are mobile.
Anything he does to slow them down increases the risk that his most lucrative employees will quit and join another big firm, or start their own hedge fund. He isn’t a boss in the conventional sense. He’s a hostage of his cleverest employees.
At this point you have to at least wonder if Wall Street firms should be public companies. Their complexity renders them inherently opaque. Investors are right now waking up to this fact: They will demand to be paid for opacity, and also for volatility.
The firms have been revealed to be so treacherous in bad times that the only way they survive as public companies is to make outrageously huge sums in good times. That is, as public companies, to be economically viable they are likely to be socially problematic.
If they aren’t about to go under, they are making so much money that everyone else hates them
.
Back to the premise. The witnesses in the Congressional hearings no doubt chose not to attempt to reconcile their organization’s version of events with other accounts, cleverly leaving the panel and the wider world the impossible task of trying to come up with a consistent, coherent picture.
But per Lewis, the main actors may also unwittingly be victims of their own incomplete understanding. While they may all be trying to script Rashomon, the real story may be the blind men and the elephant, each only able to discern a piece and unable to grasp the whole.
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All this BS has taught me one thing and that is that: There are no rules in finance. No trends, no charts, no fundamentals, no theories. Only insider trading and crony capitalism. Being an engineer used to advancing by ability and dedication, I do not understand all this financial slime. How can anyone in finance sleep at night? Buyer beware!
I’m glad you’re posting on this Yves, that the accounts of the Bear-JPM-Fed spiral don’t track. I’d thought about discussing this but simply didn’t have time to backtrack through three weeks of fragmentary news reports and blog posts to get the actual statements over time. For myself, I still cannot even put together a coherent timeline for 13-14 Mar; that is what worries me about this.
At the time, the word IIRC was that JPM called the Fed on Friday, 14 May with concerns on BSC. In ‘testimony’ to the Senate, we now _appear_ to hear that BSC called the Fed on Thursday, saying “We’re going to file unless . . .” Again, we seem to hear that BSC thought they got 28 days on a pass through via JPM (Thursday presumably?), but then somebody (who, I ask?) called on Friday to say ‘Time’s up.’ Now, one shouldn’t assume that that sheaf of statements is necessarily factual, in whole or in part, but if one puts them together it sounds like JPM called the Fed _on Friday_ to the effect that, “If you’re going to give Bear money for nothing, by the way we’re broke too: whatcha gonna do about it?”
It’s a basic of historical study that one simply starts trying to substantiate factual statements or actions, and then compares them for a ‘reason- and source-weighted’ assessment—except I still can’t even try this because the statements won’t square. I just keep coming away with the impression that JPM comes out of this like total bandits _unless_ they are in fact in as bad shape as BSC or worse.
Adding your last remark, that JPM gets to waive capital requirements _for 18 mo_ (or until castles in Spain trade near to par again) while keeping all real assets in BSC’s portfolio . . . either the public has gotten terribly screwed on this, JPM (and Lehmans and most of the rest) are lying through their teeth on their status, or both.
This all looks like the Fed In Oz, “Pay no attention to that pile of zombies behind the curtain, I am the Great and Fungible Fozz the Inscrutible!!!” Seriously, I can see why the Fed and the Treasury may feel a need to keep this under wraps but I just don’t see that deceit is an effective long-term strategy. BTW kudos on the Kubler-Ross analogy; that crossed my mind also but you’re the one who put it into pixels.
I have a dream, a vision a hope that we will all soon use legislation and hearings like that farce yesterday, as time-based events which will be used as mechanisms for hedged bets; e.g, I would have bet that Paulson would have lied his ass off at the hearing — then someone would have been a counterparty and thus taken the opposite side of that exchange traded bet. The counterparty would have obviously made a killing off of stooges like me, by knowing in advance that Paulson was going to be a no show. All I could have done, was to say, Damn, he was even on the agenda and invited, so, who would have guessed that one? The really good news is however, if you have bad bets like that and are friends with the casino managers, you can take unlimited chances and sometimes not even have to pay the bet off — let the good times roll, just as in Pottersville!
Be that as it may have been, I’m a little unsure as to ways to bet on the general aspect of congressional integrity (as applied to real outcomes) e.g, like someone doing something or saying something definitive or logical; connecting to some action or event. Nonetheless, congress would be a great place to bet, beause all you would do is bet along with SIFMA and other lobby groups like NAR and viola, your a winner on every hand at every table; how can that be bad for anyone?
To wit, a hearing like we saw with Dodd (as head puppet) however, has no real conclusion, no story, because it expands without reason and gets back to my favorite topic of entropy, i.e, the infinite expansion of chaos…. but, how can one bet on that, when you have no outcome to probability, i.e, no red or black, but just a whirling dervish, doing a dance(see link)? I’m not in sync with how that dance goes, but maybe you can time it and then bet on duration or spins. In the case of Dodd and these puppets, how could you bet on an outcome, unless there was a SIFMA script that could somehow dictate the final outcome of the hearing. Maybe some weird thing like a cough at an auction could be a trigger for some secret side bet that triggers a chain reaction of cascading events like a Deus_ex_machina??
http://www.youtube.com/watch?v=GJIofU-0jC0
Hence, the theoretical importance of that hearing should have given a type of positive nudge we could have bet on, and thus we could take sides against which way our financial system will tilt, i.e, will it be on the verge of systemic imbalance, warped and wobbling out of its normal orbit — or, will these ultra smart lawyers that know financial engineering so well restore some balance into being, back into the system they collapsed (like a black hole)? Or, will there be other side bets that nothing will get done at all by these crooks which all share turns spinning and twisting illusions intended to hide the genesis of their corruption and the web of collusion which they network within?
Also see Bonus material:
Utopia, Limited
http://en.wikipedia.org/wiki/Utopia_Limited
Utopia Limited, or The Flowers of Progress, is a Savoy Opera, with music by Arthur Sullivan and libretto by W. S. Gilbert. It was the second-to-last of Gilbert and Sullivan’s fourteen collaborations, premiering on October 7, 1893 for a run of 245 performances.
Gilbert’s libretto satirizes limited liability companies, and particularly the idea that a bankrupt company could leave creditors unpaid without any liability on the part of its owners. It also lampoons the “Stock Company Act” by imagining the absurd convergence of natural persons and legal entities. In addition, it mocks the conceits of the late 19th-century British empire and several of the nation’s beloved institutions. In mocking the adoption of the cultural values of a more “advanced” nation, it takes a tilt at the cultural aspects of imperialism. The libretto has been criticized as too long and rambling, and several subplots are never resolved, due to Sullivan refusing to set some scenes.
Haven’t watched Rashomon in ages but have seen enough translations of it to remember the original; actually, the “rape” itself was disputed, at least one version /viewpoint sees it as a willing participant affair. Could this be the case for bear stearns, after all, they made the call to the fed and treasury; surely, they only did that if they couldn’t try a better option.
Of course, if they only made things clearer with a concise, coherent tale, but hey, credibility is hardly the attribute of people blinded by the shine of greed.And they wonder why people are sceptical of all those claims that ML, Lehman etc don’t need more capital
“At this point you have to at least wonder if Wall Street firms should be public companies”
Nationalism them, all of them, minimize profits only to cover expenses these clowns have done enough damage, time to end this once and for all.
I believe you were questioning the continued use of RAROC and VAR sometime back. Also from Alea:
VaR and the Super Senior ABS CDOs
Interesting times
The loss, the first ever quarterly trading loss for the banking industry, follows weak trading results in the third quarter, and reflects unprecedented turmoil in capital markets, particularly for credit trading.
The poor performance of credit trading in the fourth quarter resulted from challenging market conditions across a range of credit trading markets, but most particularly from concentrated exposure to securities backed by subprime mortgages. Large write-downs on these collateralized debt obligations of asset-backed securities (ABS CDOs) reflect rising defaults on subprime mortgages. The losses on these securities, which initially had very strong credit ratings, also reflect extremely illiquid market conditions. Banks incurred an $11.8 billion loss from credit trading in the fourth quarter, compared to a loss of $2.7 billion in the third quarter.
Concentrations in highly rated but illiquid ABS CDOs, as well as non-normal market conditions, caused several large dealer institutions (both bank and non-bank) to incur very significant trading losses in the fourth quarter.
Historically, these [super senior] ABS CDOs had not exhibited significant price variability given their “super senior” position in the capital structure, so measured risk in VaR models was very low. However, rapidly increasing default and loss estimates for subprime mortgages have caused an abrupt and significant reassessment of potential losses in these super senior ABS CDOs. Because VaR models rely on historical price movements and assume normal market conditions, this particular risk measurement tool may not fully capture the effect of severe market dislocations.
Posted by jck at 4:41 pm EST on April 2nd, 2008 |
Mr. Bernancke stated that without Fed action system risk was very possible. Yet, in response to Senator Shelby, Mr. Dimon stated that JPMorgan’s exposure to BSC was so minimal that it faced no risk should BSC go bankrupt.
It cannot be both. Either there was system risk should BSC go bankrupt, effecting JPMorgan as well as others, or there was not.
This contradiction as revealed in the Senate hearings begs resolution, which itself requires full public exposure. The Senate committee should demand no less. It didn’t, and isn’t likely to in the future.
At this stage of this game, all we can do as citizens is to watch ratings and polls to see if the people in Dodd’s home state are still asleep at the wheel and as corrupt as Dodd, i.e, will they allow this charade and farce to continue, or will they voters stand up to corruption and dishonesty?
The conclusion is already at hand, as all one has to do is look at public opionion in regard to these congressional crooks and see the proof that this congress has the lowest ratings in American history. Thus, public opinion and polls do not translate into action or change and this business of mafia collusion by these paid for shills will just continue until Rome is burning!
Thank you Dodd for being a pig!
They’re all crooks. Birds of a feather. No honor among thieves. If we ever get them to trial, I’ll build the gibbets at cost. F that: I’ll build them for free.
Some devil’s advocate points:
Whatever the reality of Bear’s capital position, the alternative to the deal was bankruptcy, and this was due to liquidity risk directly, not its capital position. The capital assessment was involved only indirectly and to the degree that the perception (and not necessarily the reality) of Bear’s capital was a contributing factor to its real liquidity risk.
In considering the deal and its structure, there were two main forks in the road that might have still have led to Bear’s bankruptcy. The first was that the alternative to a deal per se was bankruptcy due to liquidity failure. The second was that even in the case of an announced deal, a failure to contain liquidity risk in the wake of the announcement might also have led to liquidity failure and bankruptcy. Therefore, the deal had to be structured to minimize liquidity risk.
It was on the basis of considering the first case above that the Geithner suggested he would have been reluctant to extend the JPM conduit loan to Bear from Monday forward, had a deal not been in place on Monday morning.
Presumably this means that not only did JPM need the Fed to structure an actual deal, but the Fed needed JPM to avoid its own excessive exposure to Bear even via the conduit. A deal was required to protect the Fed’s exposure, given its overarching objective of relieving systemic risk.
It was on the basis of considering the second case that JPM required substantial liquidity backstopping from the Fed, with the obvious contingent credit risk that such implies.
None of this relates directly to the actual capital position of Bear. It relates directly to liquidity risk, bankruptcy risk, and the risk of distressed pricing of and sales of assets in the bankruptcy process. As far as the suspension of capital requirements for Bear assets is concerned, one should consider that it is a suspension rather than elimination. The real alternative of bankruptcy effectively includes an elimination of capital requirements. Suspension amounts to an expected funding of at least some of additional capital requirements over time via earnings, rather than a new external equity issue.
So I’m not sure the various statements on Bear’s actual capital adequacy can’t be somewhat squared in the context of liquidity risk being the overriding consideration. There is a difference between liquidity and capital.
I’ve been reading about this quite a bit and as an engineer and an outsider much of it has been hard to grasp. But it’s becoming clearer. And every bit of clarity I get is devastating.
This is one of the worst reports I’ve read. Yves, you do a real public service.
I just don’t see how we are going to get out of this one without a crushing wave of … what?
Part of the problem is that crony capitialism and stupidity don’t just rule on Wall Street, but in Washington.
Last week the Senate allocated 3 billion for strapped homeowners and 25 billion for homebuilders. ‘Nuff said.
Yves,
Awesome post; thanks a lot for it.
I have a couple of comments,
The “de facto subsidies to JPM were even greater than previously disclosed.
Up to $220 billion of Bear Stearns assets can be excluded from J.P.Morgan’s risk-weighted assets.
Up to $400 billion of Bear Stearns assets can be excluded from the denominator of the tier 1 leverage capital ratio.
JPMC also has requested that the Board provide JPMC with relief from the Board’s risk-based and leverage capital guidelines for bank holding companies.
First, JPMC proposes to exclude from its risk-weighted assets, for purposes of applying the Board’s risk-based capital guidelines for bank holding companies, the risk-weighted assets of Bear Steams existing on the date of acquisition of Bear Stearns by JPMC, up to a total amount not to exceed $220 billion.
Second, JPMC proposes to exclude from the denominator of its tier 1 leverage capital ratio, for purposes of applying the Board’s tier 1 leverage capital guidelines for bank holding companies, the assets of Bear Stearns existing on the date of acquisition of Bear Stearns by JPMC, up to an amount not to exceed $400 billion.”
OOOOOOK!
If I read this correctly, the bottom line is:
1) This whole mess has allowed JPM balance sheet to become MORE opaque than before, and SHALL STAY OPAQUE for at least 18 other months onward. “Specifically, JPMC has requested that the Board permit JPMC, for a period of 18 months, to exclude from its total risk-weighted assets (the denominator ofthe risk based capital ratios) any risk-weighted assets associated with the assets and other exposures of Bear Stearns…” Oh well! Somehow, I should feel reassured by that?
2) The Fed and JPM “decided” that the best way to reduce further systemic risk was to occult said risk to allow JPM to shore up their capital base.
“At the end of 2007, JPM’s Tier One Risk Based Capital held by its subsidiary banks was just $88.1 billion, a tiny foundation for the bank’s vast trading operations. The Economic Capital (“EC”) simulation in The IRA Bank Monitor generates an EC benchmark of $422 billion for JPM or a ratio of EC to Tier One RBC of 4.79:1, suggesting that JPM needs almost five times current capital levels to fully support its economic risks (boldface ours).”
If this is not proof positive that the regulators were not completely asleep at the switch, then I’m the direct descendant of the actual Pope.
About these inmates running the asylum:
“This isn’t because Wall Street CEOs are lazy, or stupid. It’s because they are trapped. The Wall Street CEO can’t interfere with the new new thing on Wall Street because the new new thing is the profit center, and the people who create it are mobile.”
This argument fails to capture another very important element of the puzzle, ie. the boss(es) knows darn well that his (their) personal risk is very limited. Compensation in the corner’s office is now all upside with no downside. If the whole thing implodes, he/she walks away with a severance package that could rival the GDP of Micronesia or the Fiji’s Islands. Sure, they may wonder with some degree of anxiety if this whole thing isn’t too risky, but why worry when the penalties to oneself are so limited? If they knew they could be given the boot with NOTHING, (or worse) I’ll bet you my net worth that they’d take a much less sanguine view about the whole matter.
Should the IBs become all private? Pray tell, would that have changed one iota the actual situation? Would the systemic risk entailed by a private BSC be less? I do not know, someone with more expertise…please, pretty please answer that question for the mere mortals among us.
Isn’t it about time that we start discussing and preparing for the Norwegian solution, letting the mega-banks take the full brunt of their losses and run out of their capital, then recapitalizing them through nationalization at the full expense of their shareholders? Merging impaired banks into still solvent ones has the twin demerits that it further increases concentration and the too-big-to-fail syndrome, and that there simply are not any really “good” banks out there for bad banks to be merged with. And perhaps there is no other solution to the problem of level 3 “assets” than to run them off, analogously to the policies of a BK insurance firm, and then make sure that they never come back again. After nationalization of most, if not all, of the core banking system, it could be redesigned and reregulated to reduce concentration and render it actually functional for the financial intermediation for the real productive economy, rather than the latter being disintermediated in favor of a sheerly virtual financial economy, before being sold back into private capital markets. And the legal and fiscal framework for such a prospect of nationalization must be set up before catastrophe strikes, to force private banks to shape up and fess up on their own, if they want to avoid such a fate, rather than allowing them to hold the entire economy hostage. Yes, I know that such a course is regarded as politically/ideologically impossible in the U.S., but it may be the only really functional solution. (SWFs would be the alternative source of recapitalization, but, other worries aside, I doubt that they would be willing to take a second bite at the poisoned apple). Then we need to move on to addressing the overall problem of regulatory capture in the U.S. political system.
“Up to $220 billion of Bear Stearns assets can be excluded from J.P.Morgan’s risk-weighted assets.
Up to $400 billion of Bear Stearns assets can be excluded from the denominator of the tier 1 leverage capital ratio.”
? Risk weighted assets are the denominator for the tier 1 capital ratio.
Investment banks should not be public companies and anyone who buys shares in same is making a big mistake. Since the primary driver of profits at these companies is proprietary trading, quite often investment bank traders will be on the opposite side of trades from their shareholders, unknowingly or otherwise. Thus you have a conflict of interest.
Also since revealing proprietary trading strategies in regulatory filings would be suicidal, shareholders in a public investment bank are never going to have a true idea of what management is doing with their investment.
The old model of investment banking where the bank was owned by a group of partners whose own capital was at risk makes sense because the partners’ incentives are aligned with their traders. And partners can be informed about proprietary trading strategies without tipping the company’s hand in the markets.
Of course, if they only made things clearer with a concise, coherent tale, but hey, credibility is hardly the attribute of people blinded by the shine of greed.And they wonder why people are sceptical of all those claims that ML, Lehman etc don’t need more capital
All the big banks, PDs are broke. Too much leverage, too many WMDs. at 25:1 leverage (GS the lowest is 26) a 4% decline in the value of your assets wipes you out. i.e., 100% loss.
john c. halasz said…
RE: Your let’s nationalize them “Norwegian Style” post.
Great post! The key question is who is going to man the nationalized operations? For sure, It won’t happen in this inept administration!
Scott,
You are dead right. The investment banks should not be allowed to be publicly traded. That is the only long-term solution.
Private ownership is the only way to control the “heads I win, tails you lose” conduct and to allow for owners to see what is really on the balance sheet without compromising the firm’s competitive position.
“Heads I win, tails you lose” is what drove the Wall St. firms to expand leverage dramatically. It also drove them to move into increasingly illiquid trading assets.
Notice that precisely the same thing happened with the hedge funds. It is that combination of leverage, illiquid assets and lack of transparency that will prove to be lethal for a wide swath of hedge funds and investment banks. It is the perfect recipe for a systemic bank run.
Scott,
Private ownership should also bring under control these lavish compensation schemes on Wall St. which are enriching the employees at the expense of the shareholders. No more “inmates running the asylum”.
Anon 6:02
Average assets are the denom for the Tier 1 Capital Ratio (not risk weighted assets)
funny the spectrum of opinions: from nationalize to completely privatize (no public shareholding). Banking is a strange beast.
The Bear Stearns people, Alan Schwartz and his folks, could never testify or give credible testimony because they are/were too close to the problem. The problem is that every investment bank was making a hay day living on financially engineered ABS, CDO’s and other heavily leveraged and tranched products. Unwinding, and weighting their market value with diligent risk weighted equivalency was given up a long time ago, as the “problem” kept escalating and vast amounts of money kept getting made every day.
Bear Stearns got caught up in a few dynamics of the market for sure, but that was not the core of the problem. Their inability to police themselves and manage “fairly” their responsibility to stockholders, employees, counterparties and the public, became increasingly out of reach as their “lifestyle” and business model kept pulling them in other directions, out of moral scope.
Take a look at the upcoming meeting next week of ISDA in Vienna – the International Swaps Dealers Asssociation. Take a look at the Board Members and the Vision charter. Ask yourself exactly what these guys and this organization were doing for the past 15-20 years. Giving themselves awards and having lavish parties and golf outings at taxpayer expense. Watching the problem escalate for years with no corrective influence or industry value. These guys should be brought before a “Financial Crimes” judicial panel and sentenced harshly.
Bear Stearns simply followed the rules in place at that time. One unit came in every morning, and sought to “fund” the firm by repoing out securities. They identified sources of funding who wanted certain types of collateral, and they phoned JPMorgan Chase and “borrowed that collateral”, putting up either cash at 102% or other securities collateral at 105% or more. They did this with other Custodian Lenders like State Street Bank, and Northern Trust, and others until they “locked in” a rate that was their basis point profit every hour until conditions in the market changed that model. Someone called the securities back, the interest rate changed, the securities became premium, or other factors. JPMorgan Chase was very prominent in the Bear Stearns resolution, since a failure of Bear Stearns would have devasting effect on JPMorgan Chase, and resolving Bear Stearns solvency was a prime driver for JPMC.
Another unit of Bear Stearns came in every day and needed to borrow securities to covering trading shorts by counterparties, and they needed money or securities to back their collateral requirements.
Another unit came in every morning for years and made a fat living and wined and dined their way into individual personal breakthroughs in earnings and income through their packaging of securitized ABS, CDOs, and CMOs, while using these “financially engineered and complex intruments as their “collateral” in the market. When that collateral started to become too expensive to insure, the counterparty began demanding different collateral or proposing to return it to Bear Stearns for their cash. In order to come up with the cash to make the first guy happy, BSC had to “liquidate” its holdings of some of these derivative securities at less than the current “fictitious” market value or mark, or in situations where lack of liquidity pushed the price downward. This set off a chain reaction of activity that worked at unwinding Bear Stearns faster than there was adequate liquidity in the market to get their cash at a reasonable price.
Certain counterparties began refusing to take Bear’s collateral, or wanted their good collateral back and wanted to give Bear back its cash at a reduced Mark. In other words, the market started to gang up on Bear, not as a “gang”, but as individual counterparties protecting their vested interests. Schwartz didn’t discuss the “development” of the problem, just the ramifications.
Bear Stearns pioneered the start of Prime Brokerage services, and was one of the leading firms in the industry along with Citicorp Services (The old Salomon, Smith Barney unit), Morgan Stanley, Lehman Brothers, and others like UBS, Credit Suisse. As Hedge Funds proliferated, Prime Brokerage services were in a windfall situation. As more and more Asset Managers sought to realize Hedge Fund profit models, they formed new Hedge Funds, giving rise to more need for Prime Brokerage services,more trading and more borrowing and lending activity.
Bear Stearns was at the lead of this Prime Brokerage services sector, and kept financially engineering its product portfolio to support demand for collateral to borrow money to fund its Hedge Fund clients, and its own operation.
Knowing that it was creating more and more risk and fragility in its highly leverage instruments and securitized packages and trenches used for funding collateral, Bear continued to swim in shark infested waters. Leveraging the business further everyday on a distant gap mismatch that could never catch up with itself. Alan Schwartz never spoke about the “digging of the hole” and what he and his management team were doing to surveil and police this exposure and contingency risk.
Schwartz called it a “run on the bank”, but failed to rspond to why this run on the bank occurred. He advanced the notion that it was “a few firms” taking short positions in Bear and this gave rise to “rumor”. But he failed to dig in and accept responsibility for the cause of the problem – unbridled greed, and willingness to ransom the firm for market share in Prime Brokerage and to continue to sponsor and encourage banks to let Bear Stearns “package up their mortgages”, giving rise to the banks looking for more sources of raw material- the Mortgage Brokers, and the ugly food chain that started with Bear being the principal market maker.
Schwartz stated that a “few Hedge Funds” went short on Bear stock, giving rise to uncertainty and rumor. But those Hedge Funds’ Prime Brokers all receive reports of trades done away from the main Prime Broker so Bear would have had to become aware of this growing basis of problem, even if it was substantial enough to challenge Bear’s credibility and ability to remain out of default.
The real problem, not the Schwartz “blame it on them” thesis, is the market activity and behavior that caused the problem. More investigation needs to be initiated in to Securities Lending, Repo, Prime Brokerage, Gap Duration Mismatching, leverage in OTC markets, and risk-weighted equivalency of a portfolio. When was the last time that anyone saw a price ticker on a Securities Loan? When did you last see any trading ticker of securities loans and borrows volumes? The push to collateralize with non-cash to keep items off the balance sheet, and therefore reduce capital adequacy and also to allow trading desks to be unrestricted in bringing in new volumes of business that don’t need to be on the balance sheet. Investigation into the work and “non-work” of ISDA would be a good peripheral examination, and taking a look at the complicity of these board members in their firms’ failure to manage “leverage” more judiciously and safely for the benefit of their employees and stockholders.
Tom Ricciardi
Bangkok, Thailand
Maybe this is more JPM’s death warrant more than a big break? A bank can’t trade without others having confidence in it. It’s now public knowledge that JPM is undercapitalized, really although not its official numbers.
To anon devil’s advocate:
I’m inclined to agree with your point that BSC faced a _liquidity_ crisis, not quite yet a capital solvency crisis on 13-14 Mar; thanks for making that point of important distinction explicit. If true, this would explain why Bear didn’t draw down its big credit lines in Japan, even after purportedly losing $10B on Thursday, 13 Mar; they were still solvent as of that day. Thus, one might assume that Schwartz of Bear called Geithner of NYFed on Thursday, 13 Mar not because he was ‘bankrupt’ or about to be as stated for public consumption, but because he was in a severe squeeze, and begging for 28-day liquidity to get his mismatches realigned.
Why then was Bear in a squeeze on Thursday? One assumes broadly with Tom Riccardi posting above that a bunch o’ folks called back their collateral all at once, and at bad marks which tore great chunks of capital from Bear’s hide. But effectively, Bear was done in when the other ibanks slammed down their interbank lending windows on Thursday as rumored (though this is only _rumored_; not reported, and certainly not announced by anyone under oath). At that point BSC was effectively out of business whether or not they were technically solvent since if the ibanks won’t counterparty, either from prudence or for less charitable reasons, a bank-broker is soooo gone. From that perspective, BSC was attacked by a horde of flesh-eating zombies and then had the portcullis banged down in its greedhead face: cut out, cut up, cut off . . . cut dead. That might also, spinning inferences, explain why Bear’s management ‘had no other options’ per Schwartz’s testimony and the failure of management to kick at JPM’s terms on Monday, 17 Mar; as a stand-alone business, the industry had declared them dead.
On another point, though, the MAIN point, the contention that the Fed ‘had to’ work via JPM ‘to protect itself from liquidity exposure’ from BSC makes no sense whatsoever, to me. The Fed is vastly larger than JPM, has far fewer constraints on how it acts, and despite all the repos it has out is vastly more liquid. If said ‘liquidity risk’ from Bear was so great that the Fed ‘needed protection’ that would seem to put JPM at risk in the deal—Morgan agreed to guarantee the exact same positions even in just keeping BSC alive before acquiring them—thus jeopardizing this much larger *cough* white knight [sic]. Yes, the ibanks may feel more comfortable with Morgan’s capital than with Bear’s, thus easing the liquidity squeeze which Bear could not accomplish if they themselves got public liquidity guarantees. —And then the Fed turns around and (again rumored) says it will lend ‘whatever it takes’ to Lehman’s to halt a similar run? Nah, I don’t buy that the Fed cut in Morgan to limit _it’s own_ liquidity exposure.
Furthermore, after getting a measly $30B in backstop liquidity against said ‘uncertain’ liquidity exposure incoming with BSC, Dimon at JPM announces that he sees _NO EXPOSURE_ to Morgan in the deal; he could be wrong, but that’s what he said. Further yet, Dimon went through a great deal of personal embarassment and trouble from Monday, 17 Mar over the following week to get Bear’s shareholders to take the hemlock, even re-negotiating the highly unorthodox, not to say extra-legal, financial terms with the Fed to do so while accepting $1B of further expense to Morgan. Yes, Dimon got in the battered junker once called Bear Stearns and drove it home gladly to his garage, as if that dead weight in the boot was a footlocker of ingots rather than a dogpile of radioactive alien corpses. (Quick: what’s the film reference? —That’s right.) Not the act of a man taking on a liquidity risk _too great for the Fed_, say what you will.
One could postulate many reasons why the Fed refused to either provide, or having provided refused to honor, a liquidity guarantee to BSC while most swiftly doing the same to JPM—who promptly acquired the exact same liquidity risks in guaranteeing BSC’s trades. I’m not a fan of conspiracy theories, at all; it’s just that this whole thing reeks. (Don’t bother dialing Rent-A-Rumor, I’ll lend you one: Paulson nixed Thursday’s liquidity promise to Bear and said “Kill ’em” on Friday. He’s supposed to have personally insisted on a negligible price for BSC’s equity, and is the guy who didn’t show for the hearings. “Who wasn’t there?” as they said in a different movie about, as in this instance, gangsters opening fire in public spaces.) The real problem to me in all this is that we still don’t know why the Fed decided to kill Bear and save or backstop the others. Just forcing a bad actor ouf of the game? That’s certainly the end result, yes. Simple ineptitude?? Don’t let’s, as Yves says, rule out _that_ potentiality. Genius, nefarious or otherwise, is in the tail end of the distribution, while incompetence bulges the middle out; ergo . . . .
‘Twas an ill-death, done badly. I don’t cry for Bear’s stakeholders, they got more than they deserve. But we all remain exposed to whatever reasons and agendas went down with this deal—and that’s what put’s a frission in my brisket on this pigsticking.
Richard Kline:
Thanks for your response re my ‘devil’s advocate’ comments. Re the Fed’s ‘exposure’ and your related comments, I was referring more to the Fed’s credit exposure as a function of Bear’s liquidity exposure, not the Fed’s own liquidity exposure. Without a weekend deal, the Fed would have faced a decision on Monday on whether or not to continue or even expand the size of the JPM conduit loan to Bear. The decision would have been a choice between bankruptcy for Bear, or extending the JPM conduit facility while Bear was still on its own and while JPM was still prepared to act as a conduit. In extending it, the Fed would have been exposed to continuing liquidity pressures on Bear, and therefore having to increase the size of the conduit facility in order to sustain Bear even temporarily. In other words, without a deal, the Fed would have been exposed to Bear’s liquidity risk in the sense of an increased JPM conduit requirement.
This would have exposed the Fed’s own balance sheet to credit risk via the increased size of the collateral it might have taken on. The primary concern for the Fed was not its own liquidity risk (as you point out), but its own credit risk as a function of Bear’s liquidity risk in the absence of a deal. It was very interesting also that Geithner responded to one question about all this by saying that if a deal had not been structured over the weekend, and assuming that the Fed had still announced a newly expanded discount window facility on Monday, he would have been very reluctant to allow Bear to use the discount window directly on Monday, due to its liquidity problems, and the fact that the Fed still has the last call on whether to allow an institution “in trouble” to use the discount window. This is because, given Bear’s liquidity problems, its use of the discount window directly (just as its use of the JPM conduit) would have created an open-ended credit risk exposure for the Fed. The discount window, while providing last resort funding for situations that have some prospect of containment, is not intended to be the final funding source for financial institutions that have absolutely no hope of survival due to a complete collapse in confidence. That’s when other measures must be taken, as they were here. (I didn’t follow Dimon’s comment closely regarding JPM’s lack of risk due to the Bear deal, but I think it was ill advised.)
Face it citizens! As long as the family trusts of the Rothchilds, Rockefellers, Morgans, Warburgs and a few others own our currency along with numerous corporations both foreign and domestic (some of which they also own) NOTHING will ever change. The Rockefellers and the Morgans created the FEDERAL RESERVE in 1913 and they have owned it since and they answer to no one! To them MONEY IS DEBT AND DEBT IS MONEY! When you talk about these billions in bailouts all it is is counterfeit! It is worthless paper! As long as the world is in debt to them they rule the world and it’s finances!
Wolfman