Tuesday, May 27, 2008

Bailouts, Wall Street, and the Bad Motivator

Bailout. To any believer in real honest-to-goodness capitalism, bailouts are an anathema. The way our system of economics is supposed to work, those that take risks and are successful are supposed to be rewarded, and those that fail are supposed to suffer the consequences. The system only works if there is both that upside and downside.

But in recent months, we've seen Bear Stearns bailed out. We've seen a "Hope for Homeowners Act" proposed in congress which will bailout certain borrowers. We've seen the Fed accept all sorts of collateral for loans. And if it comes to it, we will see the government bail out the GSEs as well.

So what happened to capitalism? Why couldn't we have just let Bear Stearns die? Or at least force them to seek a private transaction with no backing from the Fed?

The answer is that our financial system has become too intertwined. It has become too reliant on the continued solvency of all its players. Had Bear Stearns been allowed to fail, banks world wide would have lost their counter-party on various derivative transactions. A bank that assumed it had hedged some of its credit risk on a particular borrower would suddenly have all that credit risk back in its lap. I don't need to paint the picture as to the level of contagion that would ensue. I'm not even talking about fear here, merely that many financial institutions were relying on hedges in so many ways, that to suddenly lose a counter-party would be disastrous.

Let's say you allow Bear Stearns to fail and that caused XYZ bank to fail. Is that capitalism? Forcing XYZ to suffer for the sins of Bear Stearns? I posit that the ideal of pure capitalism becomes functionally impossible once financial institutions start relying on each other for survival. Capitalism is supposed to reward those that take good risks and punish those who take bad risks. What do we call it when our system might reward good risks, assuming all your counter-parties also take prudent risks?

Maybe capitalism is a religion where we've all fallen from the true faith. Maybe the Fed will always have to be there as a lender of last resort. But maybe we could make that last resort a little less common.

The first step is obvious. Credit-default swaps need to be exchanged-traded. Perhaps there needs to be some significant modifications to how CDS are structured in order to make this work. Fine. But given the myriad of derivatives and futures contracts that currently trade on exchanges, I can see no reason why the same cannot be done for CDS.

I imagine a system where the 20 or so largest banks and brokerages contribute cash to create the exchange. Or there could be seats on the exchange which were auctioned off. The exchange would then stand in the middle of all CDS contracts. Thus the failure of any one player in the CDS market wouldn't threaten the whole system.

Of course, if there is a single exchange there is also a single counter-party. But I argue this still is a reduction of risk to the system. Look, right now, the number of true market makers in CDS are very limited, probably around 10 or so. That means that for every CDS contract, there is a very limited number of firms standing on the other side. So as things stand, 1/10 of the $50 trillion CDS market could disappear if one of the current market makers goes down. Doesn't seem too wise does it? If you think about it that way, under the current system, tax payers are somewhat exposed to the demise of any of 10 different financial institutions. Would it really be so hard to capitalize an exchange such that it could withstand the failure of a small number of its members? And wouldn't the somewhat joint-and-several nature of an exchange improve confidence? Was anyone worried about the CBOE going under when BSC was in trouble?

There would be some relatively simple ways to bring such a thing about. What if banks were required to recognize the credit risk of their counter-parties directly? I.e., the capital needed to execute a private derivatives contract would be prohibitively large. I think back to banks needing to reserve for losses dealt to them by XLCA/FGIC/Ambac/MBIA's potential failure to perform on CDS contracts. Why not just make them reserve a larger amount for this possibility up front? Efforts to start an exchange would begin the next day.

I'd like to live in a world where Bear Stearns could have failed without it impacting better-managed institutions. Unfortunately I don't live in this world right now. But that shouldn't stop us from trying to move in that direction.

44 comments:

James I. Hymas said...

Had Bear Stearns been allowed to fail, banks world wide would have lost their counter-party on various derivative transactions.

I don't believe that this is correct. See my post Leverage, Bear Stearns & Econbrowser

urbandigs said...

Great read. Counterparty risk is exactly why BSC was not allowed to fail. After all, imagine how many billions JPM would have lost being an issuer of BSC cds. We know Buffet's feelings about CDS, especially seeing the rise in notional value in past 3-4 years. Its crazy.

I wrote about the BSC on urbandigs after I read this piece and discussed with a few friends I know who trade CDS at their hedge funds:

http://www.contraryinvestor.com/2008archives/moapril08.htm
http://www.urbandigs.com/2008/04/derivatives_tail_wagging_the_f.html

A great read, plus the permalink on UD. Im not savvy enough about CDS to comment about your suggestion, but clearly, something needs to be done.

PS: Im hearing things about LEH past week or so. Could we have our next BSC?

Accrued Interest said...

James: I read your piece at the time. My reaction is that we don't really know what would have happened if BSC actually declared bankruptcy.

Urban: On Lehman, I sure as hell hope not. The stock is up strong today, and last I saw the CDS was unch. It was +50 first thing this morning.

Personally, I think the Fed has made it very very very hard for a big broker to go under. There is just so much collateral that can be pledged, and given how lightly the TSLF has been utilized, we know that there is capacity for a Lehman to tap that.

I was trying to personally go long a LEH call this morning but fumbled it and never got the trade off. Just thought it was way over sold. Oh well. Can't win 'em all.

Anonymous said...

Let me get this straight.

Bank ABC lends money to BSC. BSC fails.

Now you want to step in and prevent ABC from failing because they made stupid loans? Do I have that right?

L.O.L.

Accrued Interest said...

You have a deplorable misunderstanding of the post. Besides that, I hereby ban the use of "LOL"

David Merkel said...

AI -- I posted this at another blog. I've been a little skeptical that using exchanges for CDS will solve matters, because of the great variety of products outstanding -- which is one reason bonds don't typically trade over exchanges... anyway, here is what I wrote, I am interested in your opinion...

=-=-=-==-=-==--=-=-=-==-=-=-



CDS has margin issues, because of length of contract, and size of exposures. How much does the exchange require of the buyer of protection to put up to guarantee that he will make his continued obligation, that would have to be paid if the obligation does not default? Or do they require a lump sum?

How much does the exchange require of the protection seller? He would be receiving maybe $20 per $1000 of protection for a middling credit, but his potential obligation is $1000. What margin would the exchange require?

Consider relatively vanilla products like CDX indexes. How would the exchanges handle margin requirements there? How much does that change if they try to handle tranched CDX indexes?

I think that pretty rapidly, the exchange has to monitor the creditworthiness of their counterparties, much as an investment bank does. The exchange, which hopefully would be well-capitalized, would then be a special-purpose investment bank.

John D said...

I agree with your post. In the wake of JPM/BSC, why didn't the Fed come out with some statement about CDS systematic risk and a proposal -- any proposal -- on how to change the system? As best I can tell their response was more akin to see-no-evil, hear-no-evil w.r.t. to CDS, while offering up a sizeable portion of the Fed's balance sheet as one big safety net.

Accrued Interest said...

David: I read your piece at the time as well. The line in my post about "significant modifications" was a shout-out to you and Felix Salmon who both wrote about this topic recently.

Anyway, it would seem like we could overcome those problems. CDS may not look exactly like they look now, but that would be OK. Maybe only one tenor trades. Maybe we have contract rolls like in future trading. Whatever it is. These problems aren't insurmountable.

As to the margin requirement issue... James Hymas' piece has it right. The individual dealers have their own margin requirements, so there is precident for how this is done. Besides, it is really all that different than naked options on stocks?

Anonymous said...

"The answer is that our financial system has become too intertwined." - AI

Please...you can do better than that. THAT is NOT the answer. It is a side effect of the answer.

The answer is that we have been in a self reinforcing credit expansion for 20+ years. This credit expansion was aided by the flawed analytical framework that assumed we could mathematically model risk, in micro, and in macro.

But the supposedly smart quants were actually too dumb to realize that thier models were self invalidating. Statistically based risk modelling works so long as you are the only one doing it. The easiest way to understand this is to think about diversification. If the markets is dominated by major funds and institutional players, then everyone diversifying does not really result in any diversification. Everything is locked together.

Same with risk modeling. All the models show that risk A and risk B simply can not happen at the same time, because they never have before. So everyone takes on side of A, and the other side of B. For a while it works, but when they leverage the hell out of it....and it goes slightly against them due to noise...then the forced margin calls cause those risks to do the "impossible" and correlate.

The current sitation is a failure of intellectual rigor and character on the part of regulating agencies. They gave up on understanding financial sector 'innovations' and instead pronounced them beneficial.

And here we are....and still a long long ways from the end of all this.

Accrued Interest said...

Anon:

I appreciate your comment, but its off topic. I was talking about why BSC needed to be bailed out and what could be done to prevent the necessity of another bailout.

The failure of risk modeling may well be why BSC fell apart, but that's not the point here. Can we keep the comments to discussion of solving the contagion problem created by derivatives and not rehashing the whole credit crisis?

James I. Hymas said...

I confess that I don't understand all the hand-wringing about margin requirements for sellers of credit protection.

Go short exchange traded equities (or options thereof) and exposure is theoretically infinite - a somewhat larger number than whatever strictly defined notional amount is at stake for a CDS.

The objective is not to ensure that the exchange will remain solvent no matter what concatenation of unlikely events occurs. Such things are simply not possible in this world. The objective is to come up with a solution that is reasonably acceptable to the players.

Buy a corporate bond, you'll put up 10% margin. That sounds like a reasonable place to start discussions of CDS margin requirments.

David Merkel said...

Okay, thanks AI -- at least I know that I'm not missing anything now. I know about collateral requirements for OTC derivatives today. I have had to monitor those in the past. What this means is that the same type of collateral agreement common to ISDA would have to be applied the exchange. Typically those have varied by the credit rating of the counterparty, so maybe the exchange would have different collateral requirements for each party.

There is a trade-off here though. The OTC market will always be more flexible. I personally think that a derivatives exchange would put a significant dent in the OTC market for the most common credit derivatives, but won't become the majority of credit derivatives trading.

UrbanDigs said...

Al,

"cant win em all"

Very true! Would have been a good trade after seeing it today. Stock got hit hard over past week or so of trading.

LEH, MER & C are still way exposed to toxic holdings from what I am hearing, and will need multiple rounds of capital raising. Why do I get a feeling that creative accounting is hiding how sever the damage is? Geez, that never happened before.

I learned long ago that the way a stock trades means very little in the world of reality. Stocks are just too damn irrational.

Great comment thread by the way.

Thanks James, David, & Anon 3:24 for comments!

gramps said...

AI: My reaction is that we don't really know what would have happened if BSC actually declared bankruptcy.

This is a rather self serving answer.

Taxpayers have to bail out incompetent Wall Street types who are supposedly smarter than us because not doing so would expose the system to too much counter-party risk... and then you defend your comment by saying we really don't know what would have happened?

I don't buy the notion that BSC failing would bring down the whole system -- although it probably would have brought down a couple other houses (LEH, MER). Before all the dust is settled, I think these houses will fail anyway.

But if your argument boils down to the Fed bailing out BSC in order to save the system -- your argument still fails. Assuming that CDS counter-party risk really was the Fed's concern (and you may be right on that point) -- why the hell didnt the Fed immediately start clamping down on CDS trading?

The Fed cannot "restore" confidence in a system by implying that the system is too intertwined to survive.

For openers, why not require ALL banks to clear the enormous backlog of unsettled CDS trades? Part of the reason "no one knows what would have happened" is because no one knows what their true net exposure would be if all trades settled.

If the Fed is worried about "the system", how could they possibly allow such a situation to continue?


First, the Fed is completely negligent in allowing such an unstable system to develop in the first place. The Fed clearly had all the authority they needed to force money center banks to be responsible, and other players would have been forced to toe the line. All of Wall Street clears their trades through Bank of NY or JPM -- both regulated by the Fed.

And then, having recognized this counter-party problem, the Fed makes a bad situation worse by creating a massive moral hazzard issue and STILL fails to issue even a single directive to protect the system.

And not one CEO was disciplined by the Fed for allowing their bank to threaten the system. No risk department even got a nasty letter. Nothing.

If this is your idea of the future of Wall Street, we all need to find other careers.

I understand you are trying to be practical, discussing how things are and not how they "should be"... but when talking about a problem that allegedly is going to bring down the entire financial system, you have to think outside the box.

For the sake of our industry, we need to take leadership and demand that the Fed do a better job. Rather than accepting the incompetence of Wall Street management, we need to insist that they live up to the rigors of their jobs or GET OUT.

This isn't some idealistic dribble-- this is self preservation.

The government stepped in to "protect" Pan Am from bankruptcy-- supposedly the entire world would shut down if this massive carrier were to fold. Well, decades later, the poorly run Pan An is toast anyway, and the entire industry is a shambles.

When you try to excuse the status quo on Wall Street, you condemn our industry to the same fate.

Josh Kalish said...

AI, Good post.

I think the switch to being exchange traded would be a net positive for reducing counterparty risk but also a few other things:

1. I have heard from friends in fixed income / fixed income derivatives that they have trades that book wrong or not at all. This would help fix that.
2. Risk systems would work better once the products are more standardized and can be reconciled every day.
3. More people could participate in the market if it was easy to trade and book. At work we've considered using CDS's as a substitute / complement to equity puts, but we couldn't trade them quickly and then didn't stand a chance of booking them right.

proton said...

yes, it would be better for everyone involved to move CDS trading to an exchange.

The margin issue is solvable. Initial margin at outset of trade and variation margin reset daily should take care of the counterparty concerns.

Probably, we should have standardized contracts with fixed coupons.

Incidentally, there are already exchange traded CDS index contracts. Like the earlier future and option type CDS contracts, these have not become popular.

It would take legislation to force investment banks to move trading CDS to exchanges. As soon as exchange traded CDS become a little liquid, we will not look back.

Similar to options on stocks, only exotic contracts should then be handled in the OTC markets.

David Merkel said...

I think for the same reasons you don't see bonds trading on exchanges -- there are too many variations, you will not see the majority of CDS business move to exchanges. Margin issues matter as well. A junk reference entity or protection writer should face higher margin requirements than for their investment grade counterparts.

Now, interest-rate swaps are a natural for moving to an exchange -- very vanilla. Why not try swaps as a test case, then see if you can do swaptions and caps/floors. If you can't move those onto exchanges, I can't see why you could expect to move credit derivatives onto exchanges -- they are far more diverse.

Anonymous said...

There is an old saying, "Everyone wants to go to heaven, but nobody wants to die"

Everyone is a free-market libertarian until their ox is the one getting gored. Today, 79% of CNBC viewers ( a free market capitalist group I would assume ) responding to a informal survey want the government to do something about oil speculators; the other 21% are invested in oil.

Accrued Interest said...

I agree that it will take some regulatory move to bring about an exchange-traded CDS (or rates swaps) markets. I like the idea of making banks recognize more counter-party risk vs. their capital. That way if a bank really thought that a privately negotiated transaction was advantageous, fine. But make it so that such a transaction is not as capital friendly. In other words, make it a trade off.

Another point: traders will go where the liquidity is. I remember back in 1999-2000 iShares had launched a technology ETF, but volume on it was far lower than QQQ. Now the iShares product was clearly a better pure play tech bet vs. QQQ (which at the time Bed Bath and Beyond was one of the top holdings), but QQQ was more heavily traded, so it was more liquid. Liquidity beget volume beget more liquidity beget more volume. The same would happen with exchange-traded CDS. If you could get the liquidity ball rolling, it would feed on itself. We just need to figure out how to get that ball rolling.

Dave M. said...

ACA failed and it didn't cause any major dislocations. Counter-parties just bought replacement coverage somewhere else?

As for your exchange traded CDS, it sounds like a remake of your LoanCo idea last year.

Accrued Interest said...

I think some firms took losses on ACA, but they were so small. Refco also went under and left some people in the lerch.

And LoanCo was a great idea.

PNL4LYFE said...

@David: Interest rate swap futures already exist, although I believe they are much less liquid than the OTC market. I don't know much about them though.

I think the inherent problem with margin requirements on CDS is that the payoff is binary. While it may be rare for a contract to go from a reasonable credit spread to default overnight, BSC would have been a perfect example. The Friday before the bailout, CDS was traded in the 700-800 range. Depending on the strike of the contract, that's in the neighborhood of 80-90 cents on the dollar in bond equivalent terms. If they had filed instead of being bailed out, protection sellers could have lost 40 points overnight (assuming 40ish recovery). If the exchange required 40% margin to protect against this eventuality, no one would trade CDS. If they required 10-15% margin as many dealers do, what guarantees that the protection buyer will be made whole? It would require massive amounts of capital for the exchange to guarantee all its contracts since one large corporate default would undoubtedly be followed by others.

Anonymous said...
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Anonymous said...

This is a surreal blog post.

The first rule when you find yourself in a hole is: stop digging.

How can anyone argue the U.S. needs any more debt?

How can anyone argue the financial markets need to increase trading in a highly leveraged derivative whose underlying model is, lets be charitable here, a little suspect?

Dave M. said...

AI said ""And LoanCo was a great idea."

I didn't say it wasn't. IMO, it sure is a much better idea than a govt. bailout. BTW, I like this definition of the govt. designed HOPE acronym...Help Obligated People Evade..!

James I. Hymas said...

If they had filed instead of being bailed out, protection sellers could have lost 40 points overnight (assuming 40ish recovery). If the exchange required 40% margin to protect against this eventuality, no one would trade CDS.

A solution to this - as far as the exchange / clearinghouse (CL) is concerned - is for the CL to settle net with its members ... in other words, if Merrill's clients have 100 shorts & 100 longs, then the CL's exposure to Merrill is zero - no collateral required.

Ensuring that Merrill's shorts have the ability to pay of Merrill's longs is Merrill's problem entirely.

Sajal said...

I'm trying to reconcile the differences between the high yield spread being down:http://bespokeinvest.typepad.com/.shared/image.html?/photos/uncategorized/2008/05/27/high_yield_spreads_thru_0523.png

and CDS spread on LEH/MER shooting up last week:http://hussmanfunds.com/wmc/wmc080527a.jpg

Any opinions?

-Sajal

Accrued Interest said...

On the margin issue: Aren't naked options positions even more dangerous? In other words, I'm naked short a call on Monday and on Tuesday there is a merger announcement 40% above the previous close. Stuff like that is relatively common (compared with a sudden bankruptcy at least).

Now I'm asking because I honestly don't know. How do the options margin reqs work on the exchanges? Because I think that's the starting point for CDS margin.

Accrued Interest said...

Sajal: One is a HY index, the other are CDS of two specific brokerages. They aren't going to be perfectly correlated, especially considering how technical CDS trading is.

Josh Kalish said...

There's large gap risk with options overnight for sure and also options have tremendous pin risks on expiry with gamma going nearly infinite as you get to expiry. But the market participants know this and trade it...

Accrued Interest said...

Funny aside... I was in a strategy meeting today and somehow it came up that the CDS on the United States of America traded at 17bps at one point during the BSC mess. That exact number might be wrong, but it doesn't matter for this story.

Anyway, someone else says, "Who exactly is the counter-party on that trade?"

Chris said...

If, as you say, banks will need to be bailed out by the Fed from time to time, then we need to be perfectly clear about the economic system we have here. It's not a perfect capitalism, it a hybrid capitalist/socialist system, where the stock owners get profit and take some risk, but in times of extreme problem, the public (taxpayers) ultimately support the private banks. If that's the case then, the Fed should have a deal for the American people and instead of guarenteeing a loan, bought out Bear at firesale prices and gained the profit if it turned around and a couple years from now applied that profit to the national debt. If banks want to come crying to the govt for bailouts, they need to acknowledge who their daddy is, and give up some of that future profit. No reward no risk. If it's good enough for JP Morgan, it's good enugh for the American Taxpayer.

Accrued Interest said...

Chris: Great idea, but somehow I doubt that's how it'll go down.

James I. Hymas said...

Speaking more generally about the BSC affair, I detect a note of revisionism in this post - that is, the argument that BSC had to be kept solvent in order to prevent CDS market chaos and contagion.

That may well be part of the answer, but I think your original reaction in the post The Precipice was more to the point: I will say that I wouldn't be a buyer of protection against any of the big banks or brokerages here. The Fed just delivered a big middle finger to people who bet against Bear Stearns.

According to all the information available, at the time of the crisis, BSC was both (i) solvent and (ii) profitable.

It was also greatly overleveraged, of course; it should definitely have had to pay an elevated rate for its financing but the fact that it couldn't find financing at all was due simply to blind fear.

Stepping in to situations like that and backstopping confidence in the financial system as a whole is the Fed's raison d'etre - you don't need to look for more complicated rationales.

Meanwhile, the derisory price given to the shareholders will serve as an object lesson to an entire generation of Wall Street treasurers.

Chris - the deal with the banks throughout most of the world is that they get access to the discount in exchange for supervision and fairly strict regulation of their capital that has the intent of ensuring that even if they become illiquid, they do not (on the whole, as a group) become insolvent.

The credit crisis - and I think the critical element is not sub-prime, but the ability to short credit - has exposed weaknesses in the regulatory system, but no failures. Even UBS retained enough value that it could be recapitalized on the open market.

American - and all other - taxpayers already have a great deal: a mechanism whereby the desire of borrowers to finance long can be matched with the desire of lenders to lend short, via the banks. To allow the Fed - or any other central bank - to operate as a vulture fund carries extreme risks ... what happens if the Fed bails out its buddies at too high a price? To extend the Fed's mandate in such a manner introduces unnecessary complications to their already compex triple mandate.

Benefits to taxpayers? Start with 30-year mortgages that are funded by bond funds and 5-year deposits. The liquidity gap is enormous and would not exist if it were not for the ability of banks "to come crying to the govt for bailouts"

James I. Hymas said...

To amplify my point about blind fear and confidence, I will suggest that at the time there was strong possibility of "indirect contagion", if I can call it that.

If Bear Stearns had succumbed to the blind fear on the Street at the time, the next logical target would have been Lehman. Then ...

The first domino is the easiest one to stop.

Anonymous said...

James Hymas: According to all the information available, at the time of the crisis, BSC was both (i) solvent and (ii) profitable.

Thank you for your opinion, however the people with access to Bear's books thought and said differently.

Bear management went to the Fed and said they would need to file bankruptcy. Bear management had access to their books; while you didn't and still don't.

The Fed elected to bail Bear out-- again, the Fed had access to the books. No point in bailing out something that is solvent.

JPM... Jamie Dimon had a gun to his head (held by the Fed) to buy Bear. Even with that, he refused unless the Fed agreed to take $30 billion in cr@p. Jamie Dimon had access to Bear's books, you didn't and still don't.

Bear shareholders agreed to be bought out at $10 per share -- well below what Bear was trading at the Friday before bankruptcty. Interestingly, Bear senior management sold out their positions BEFORE the final meeting. Here are guys with the most access to the most information, far more than any market player or some guy writing in from Canada, and they chose to sell out.

According to official SEC filings and audited shareholder reports, Bear lost more money in the last few months of operations than they supposedly "earned" in the previous 8 years. If that is your definition of profitable, I would hate to think what you call a loss.

Please check your facts before you comment here.

James I. Hymas said...

Anonymous 3:53:

You may wish to read Cox's testimony to the Senate Committee on Banking:What happened to Bear Stearns during the week of March 10th was likewise unprecedented. For the first time, a major investment bank that was well-capitalized and apparently fully liquid experienced a crisis of confidence that denied it not only unsecured financing, but short-term secured financing, even when the collateral consisted of agency securities with a market value in excess of the funds to be borrowed. ... At all times during the week of March 10 — 17, up to and including the time of its agreement to be acquired by JPMorgan Chase, Bear Stearns had a capital cushion well above what is required to meet the Basel standards. Specifically, even at the time of its sale, Bear Stearns's consolidated capital, and its broker-dealers' net capital, exceeded relevant supervisory standards.

This analysis was accepted in the Bank of England Stability Report - their "Chart 11" is a sight to behold.

I have not seen any credible contradiction of the SEC's statement; perhaps you can provide a reference?

There is a very big difference between insolvency and illiquidity.

According to the BSC 1Q08 10K, BSC profit in the three months to Feb 29, 2008, was $110-million.

I also not from the proxy statement (page 76) that the pro-forma goodwill to be assumed by JPM was negative $8,366-million; but "JPMorgan Chase currently estimates the range of adjustments not reflected in the purchase price allocation presented above to be approximately $3 billion to $5 billion after-tax"

It is my understanding that this has increased somewhat since then; but it should be remembered that terminating 6,400 (?) employees does not come cheap.

Finally, I note that JPM expects its earnings to increase by about $1-billion p.a. upon full integration.

That's what I'm looking at. If you could provide links to what you're looking at, this would be greatly appreciated.

Accrued Interest said...

James: I think the domino effect explains why the Fed created the TSLF and TAF. Not why they felt compelled to bail out BSC counter-parties.

As to whether they were profitable, I think the answer was yes. As to whether they were liquid in the literal sense of the term, the answer is no. I mean, its impossible to say they were liquid when they were about to go BK. The real question is whether they would have been able to remain liquid had the TAF been up and running back in January. Or for that matter, had they raised $1bb in equity capital to improve their balance sheet. In otherwords, to what degree was it pure fear that drove them under?

James I. Hymas said...

Well, we'll have to wait until Bernanke's memoirs are published to get more information on the rationale behind the deal. But I suggest that if BSC had filed Chapter 11 on March 17 at 9:00am, the run on Lehman would have started on March 17 at 9:01am.

Profitable? It seems we agree. Illiquid? Of course. Insolvent? I think we're agreed ... but you're being a little coy!

The parallels to other banking panics are eerie - or they would be eerie if any banking panic was significantly different from any other. Consider Moore & Schley, 1907: Oliver Payne was a major stockholder in Tennessee Coal and Iron Company. During the 1907 panic, several banks were shaken and Moore & Schley, a speculative brokerage house was $25 million in debt. This was Payne's major stockbroker. Moore & Schley had used a gigantic majority stake in Tennessee Iron and Coal as collateral against loans. It looked as if the brokerage would have to place the bloc of stock on the market, which would have collapsed the market and ruined Moore & Schley, severely damaging Payne's finances. At Payne's either acquiescence or urging, J Pierpont Morgan hatched a scheme that would save Moore & Schley by eliminating its need to sell the Tennessee stock on the market; instead it would be sold to United States Steel. Meanwhile other trusts partners were expected to prop up the other weak banks. The scheme succeeded with a wink and a nod from the US President, and Payne's fortune remained intact, or else increased!

More links regarding the Tennessee Iron & Coal affair (which became a political football) on my blog.

Accrued Interest said...

James:

I agree that the run would have begun with Lehman had the Fed done nothing. So maybe I should say that I think Reason #1 was counterparty risk. Reason #2 was to avoid a run on someone else. But had #2 really been #1, the Fed might have pushed a different plan.

I also think its possible that we needed someone to fail to prove the Fed's resolve.

Anonymous said...

James Hymas:

Read my lips. I did not have sex with my intern. I am going to clean up Wall Street.

For God's sake, stop parroting political spin.

Yes, I am sure SEC Chairman Cox is toeing the party line. So what. See how many other lying politicians you can make links to.

If Cox had the first clue what was happening, then where was he as all these problems were developing? You are actually going to sit there at tell us that a man who didn't see the problem coming is now assuring us that the problem isn't so bad?

In the immortal words of Watergate's Deepthroat: Follow the Money.

All the senior managers of Bear said the firm was bankrupt. They all opted to sell their shares to JPM at the revised price of $10 -- which doesn't make any sense if they thought the firm was worth north of $30 that it was trading at before the bailout. They are voting with their wallets, which carries a lot more weight with intelligent people than political spin.

Jamie Dimon wouldn't touch Bear, even with the Fed pressuring him to do so, unless the Fed carved out the garbage.

Now that the cancerous assets are removed, and about half the staff unemployed, its not a surprise that the remaining pieces will add to JPM's earnings. It would be far more surprising if they didnt. Dimon cherry picked the good parts of Bear, and left all the problems with the Fed and/or creditors.


AI has worked pretty hard to make this blog successful. If its just going to turn into a Yahoo board where everyone mindlessly parrots the party line, all his work is wasted.

James Hymas said...

Anonymous -

If you have any evidence to support your assertions - let's see it!

But as far as unsupported tirades are concerned, I'd say you've made quota.

Accrued Interest said...

OK every one needs to simmer down or I'll send you to your corners.

Anon: The evidence is strong that Bear was looking at a profit in 1Q. The WSJ reported so last week. The story said that Schwartz was hoping that by reporting a profit it would calm the rumors.

That seems pretty reasonable evidence to me.

dmg555 said...

I find it interesting the both ICE and the CME group have purchased companies that specifically deal with deriviative products. ICE purchased Creditex and CME purchased Credit Market Analysis. I would expect the Fed to push for more CDS business to be exchange traded.