Friday, March 14, 2008

Bear Stearns Bankruptcy?

Bear Stearns announced today that it would receive temporary (28 days) secured financing on an as needed basis for JP Morgan Chase and (indirectly) from the Federal Reserve.

The plan was announced as a response to a major liquidity crisis that has been ongoing since two hedge funds imploded in August. Bear remarked that

Bear Stearns has been the subject of a multitude of market rumors regarding our liquidity. We have tried to confront and dispel these rumors and parse fact from fiction. Nevertheless, amidst this market chatter, our liquidity position in the last 24 hours had significantly deteriorated.

Furthermore, they announced that they are in talks with JPM regarding "permanent financing or other alternatives."

This unusual financing structure will see that:

Through its Discount Window, the Fed will provide non-recourse, back-to-back financing to JPMorgan Chase

Read both statements here.

This essentially turns JP Morgan into conduit. The collateral for the loans will come from Bear Stearns. Should Bear default and the collateral fail to satisfy the outstanding loan to JP Morgan the Fed will take the loss. The loan is "non-recourse" which means that the Fed cannot pursue assets of JP Morgan to satisfy the debt.

This unusual step has been taken because, as an investment bank Bear Stearns is not eligible to borrow from the Fed, whereas JP Morgan, a commercial bank, is a member of the Federal Reserve System and does have that right.

The problem is transforming from one of liquidity to one of solvency. Investment banks tend to have extremely high leverage, much higher than that of commercial banks, because I-Banks rarely hold investment assets for long periods. They underwrite and need keep assets on the books only until they have sold them to clients or other syndicate members. Commercial and retail banks, by comparison, tend to hold loan portfolios as investments and so use more "modest" 9:1 leverage (I-Banks are often 25:1).

Obviously, with such high leverage rates even small declines in asset prices can wipe out equity on thinly capitalized balance sheets. Merging Bear out of existence would reduce the leverage of the portfolio, by combining it with the much healthier balance sheet of JPM.

Temporary revolving credit such as the Fed is extending can solve liquidity problems, but it cannot solve a solvency crisis. Nor can it resolve the bigger problem for stand alone I-Banks that they need to be able to sell their paper to someone, at a premium, not simply trade it for cash.


  1. Is non-recourse a special case? If JPM needed the money for its own purposes (not as a conduit), would it still be non-recourse?

    If this is a special case for an i-bank, how different is non-recourse at the i-bank scale from no-doc at the homebuyer scale?

    (I'm not in finance, so this is genuine inquiry, not rhetorical.)

  2. Great question, anonymous.

    Most loans are "recourse" loans. That is, the lender has "recourse" to pursue assets of the borrower in the event of default.

    A non-recourse loan, as you already realize is one that is largely unsecured. Now, in this case, the Fed gets collateral (assets of Bear Stearns), but, if Bear defaults and the collateral is insufficient to meet the obligation, the Fed cannot pursue ADDITIONAL assets to satisfy the debt.

    This is not normal. In most cases, the Fed loans money under repurchase agreements. These are essentially collateralized loans because the borrowing bank hands bonds to the Fed and receives Fed Funds (cash) to use in further lending, but the do so under the agreement to repurchase. Normally the collateral is extremely secure, so it's not a big deal.

    The reason this is a non-recourse loans is because the loans is being taken by JPM on behalf of Bear. Thus, if Bear defaulted, JPM would be responsible to repay the Fed. JPM, naturally, does not want to be on the hook for a loan that Bear may not be able to pay, so this is protection for JPM. As JPM notes in its statement, it see no risk to equity holders as it has no obligation to repay in the event of default.

    This is a very unusual move - it's a 1930s-era power of the Fed. It hasn't been used since then, either.v