Monday, March 17, 2008

Why the Fed had to intervene to prop-up Bear Sterns

I wrote the article below yesterday afternoon and then decided to leave it for awhile so I could edit it. I didn't get a chance to get back online yesterday, and after waking up this morning discovered that the Fed had taken further action and that JPM had agreed to purchase BSC for $2 per share.

I have decided to post the unedited article - you will see that it takes something of a detour in paragraph 3, discussing derivates and counterparty risk - the driving force behind the Fed's unusual action to keep Bear afloat until it could be sold.


Quick quiz – what is the biggest risk that an insured takes after purchasing insurance? Answer - That the insurer won’t be able to meet the obligation in the event of a major loss. When the insured is himself an insurer of other risks the potential for reverberations to lead to systematic failure are too large to ignore. The Fed saw the need to prevent the fifth largest investment bank from failing specifically because it saw that the failure of Bear would lead to a collapse of the structured finance market, a catastrophe that had to be averted at all costs. One can argue that the Fed managed to get a pretty good deal.

Bear Stearns had to be prevented from failure because it served as both a source of liquidity and lending to several dozen large hedge funds (in the form of a prime broker) and also found itself as the counterparty of several transactions (many with the same hedge funds). Had it gone under, its hedge funds would have found it difficult to process transactions and also to obtain adequate financing. Furthermore, many hedge fund positions – though winners – would have been effective losers, since the insurer (the counterparty) couldn’t actually make good on the contract. If this were to happen, these hedge funds, who are themselves counterparties to thousands of transactions would themselves no longer be viable counterparties and the contract failures would resound throughout the system, potentially rendering the entire structured finance/derivative markets inoperative.

To understand things a bit more clearly, let’s first review the primary uses for derivatives. Over the next days and weeks we will likely hear several pundits cry, either shrilly or smugly, that rampant speculation is the cause of the problem. Perhaps. Derivates, however, are at least as often used for hedging as for speculation. Derivates, such as forwards, futures, and swaps allow one party to “lock in” a price or an interest rate which allows them to focus on their business and not currency markets. Options, though more often discussed, function quite differently from most other derivatives. Exporters regularly use currency forwards to ensure that their transfer prices remain stable (avoiding the problems with either prices or margins jerking up and down in response to currency fluctuations). Farmers and ranchers use futures to ensure that at least some of their crops or herds will be sold at a price known in advance, protecting them from the influence of weather. In any of these cases it is possible that one would have made more money with an un-hedged position. (E.g. the farmer who agrees to sell soybeans at $3.00 a bushel may find that when he actually comes to deliver that the market would have paid $4. But he accepts this because it ensures that he doesn’t find himself trying to sell for $2, which might lead to bankruptcy).

In principle, the counterparty to the transaction is usually also be seeking to hedge. A meat producer or Ag firm also locks in a price and can therefore contract with its suppliers and be certain of a profit. In actual fact, however, the counterparty may simply be trying to make money as an insurer – either by exploiting price differentials in the market (hoping that the prices really is $4 and that they can purchase at $3 and sell for a profit) or by generating sufficient premium income from writing the contract to cover a small loss.

Generally these products work well. In fact, it can be argued that they reduce risk, since they provide for price negotiation over a long period. (Contrast that to the daily fluctuations possible in these markets – small increases or reductions of supply or demand can cause dramatic price changes – Marc Rich can tell you all about how to do it).

The problem is, derivatives often lead to small losses or small gains, punctuated by rare, but often extraordinary, gains or losses. Such risks are indeed popular with hedge funds and traders, since they can usually exploit small price “errors” and make stable and reliable profits. The problem is when things break down. Naturally, when one side experiences an extraordinary gain (which might be offsetting a large currency loss for instance), the counterparty is experiencing the large loss. If he hasn’t ensured adequate liquidity to write that check, he can often find himself illiquid, or even insolvent.

Regardless of the technical correctness of the models used by the “insuring” party, it is easy to see that many people who had purchased insurance might find themselves uninsured after all. This would lead to yet more chaos and likely more insurance failures (or more extraordinary events) putting yet more strain on the system and moving from the financial sector to the real economy as the breakdown began to affect the movement of commodities and other products.

Against such a dire outcome, the Federal Reserve has essentially left itself open to taking a small loss on Bear’s collateral. In return, it is able to charge JP Morgan the discount rate for the cash. Seems like a good deal –IF and it is a capital IF – this holds the line.

I am less certain that it will. There are many other companies who have been engaging in the same practices and the markets are likely to remain stressed. We have no idea what price BSC will actually fetch when the negotiations for sale are completed. The stock closed around $30, but if the company is in this bad shape it is unlikely that it will go for this price in a distressed sale. Given the poor management (decisions like trying to bail out its own funds stripping equity from the balance sheet) and high leverage there may be few tangible assets at all. Intangible assets may also have little value. The name Bear Stearns will be erased as it is now tainted. And who can say how long the bankers will be allowed to stay? Customer lists are worth something. In any event I suspect that we will hear something quite soon.

There will likely be more hedge fund failures and possibly another investment bank will find itself overextended. It is more likely to be one of the exclusive I-Banks (like Lehman Brothers) and not a money center bank, but Citi is having its problems, so who knows?

One thing is for certain, claims by those like Larry Kudlow that this credit crisis is near over are simply untrue.

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