Summer Rerun: Bear/JP Morgan: The Rashomon Defense

This post first appeared on April 8, 2008

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.