Home > Economics - General > White knights

White knights

March 17th, 2008

It’s just been announced that JP Morgan will buy Bear Stearns for $2 a share, implying a value of about $250 million. Given that the company headquarters is said to be worth about $1.2 billion, that gives the BS banking business a value of negative $1 billion. And that’s only after the Fed agreed to take on $30 billion worth of toxic waste from the BS portfolio, politely described as “less-liquid assets.â€?

Clearly, under any normal circumstances, a company like this would have been left to go bankrupt. The problem is that this would jam up the entire credit market because BS is a counterparty in a vast range of transactions with other banks. (We debated this issue a month ago here and at CT with a number of commentators arguing that the problem of counterparty risk was not such a big deal).

Some light relief is provided by the announcement by Standard & Poors, the day before Bear imploded, that the worst was over. This will go down with Irving Fisher’s comment in late 1929, that the stock market had reached “what looks like a permanently high plateau”. But at least Fisher wasn’t being paid to judge the stock market. Surely it’s now time to kill off the quasi-official role of the ratings agencies, as Justin Fox has just argued in Time

Looking ahead, the limits of the white knight strategy employed in this case must be approaching. JPM will take a while digesting this mess, and Bank of America has already done its bit when it agreed to rescue Countrywide. The other big banks have their own problems. Any future maidens in distress will have to look directly to Uncle Sam for a rescue.

Update Readers used to the natural order of things might be concerned by the implication that with such a giveaway price, the top brass at BS might be forced to bear the financial consequences of events that were obviously beyond their control. Never fear. According to this Reuters report in the Guardian, while most employees up to junior executive levels will lose both their jobs and the shares they were encouraged to buy, with no “golden parachutes”:

JPMorgan Chief Financial Officer Mike Cavanagh late Sunday said taking over Bear would generate about $6 billion in merger-related costs.
JPMorgan has not broken down those figures, but much of that will be earmarked for severance pay and potential exit packages for top executives like Schwartz.
A person familiar with the transaction told Reuters that roughly $1 billion of those costs would be earmarked for severance and retention.

Categories: Economics - General Tags:
  1. smiths
    March 17th, 2008 at 10:35 | #1

    who loses most in a systemic banking crisis,
    and who wants to avoid them most?

    Governments might have to intervene with taxpayers’ money to shore up the financial system and prevent a “downward credit spiral� from taking hold, the International Monetary Fund said on Wednesday.

    John Lipsky, the IMF’s first deputy managing director, said: “We must keep all options on the table, including the potential use of public funds to safeguard the financial system.�

    He urged policymakers to “think the unthinkable� and prepare now for what they would do if the worst case scenarios materialised and “low probability but high impact events� threatened to jeopardise global financial stability.

    http://www.ft.com/cms/s/0/ee21ddbc-f08b-11dc-ba7c-0000779fd2ac.html?nclick_check=1

    the bank closest to the powerful in america, goldman sachs has managed beautifully so far,
    and so have characters like buffet who are screaming doom very loudly,
    the imf is sowing messages of collapse,
    so fear is the dominant sentiment,

    i dont care if i am described as a chicken little or a conspiracy monger,
    this is being managed and propelled, and the middle classes of the advanced economies stand to lose most,
    as a wit iread somewhere else remarked
    “gold is for optimists, i am diversifying into canned goods”

  2. gandhi
    March 17th, 2008 at 10:38 | #2

    Apparently the Chairman of Bear Stearns was playing cards in a bridge tournament last week while his company went down the tube. That’s pretty emblematic of this whole mess, to my mind: the rich will still walk away from the disaster with their family fortunes intact, while governments pour billions of (rapidly shrinking) taxpayer dollars into potentially useless rescue packages.

  3. smiths
    March 17th, 2008 at 10:47 | #3

    and also consider the white knights in light of the big news of last week,
    instead of giving you an eliot spitzer quote from then, heres one from early 2006,

    “Last year, New York Attorney General Eliot Spitzer tried to quiz major U.S. banks to see if their lending practices discriminated by race and argued the OCC does not do enough to protect consumers.

    The OCC and an association of banks sued to block Spitzer, accusing him of exceeding his state authority, and prevailed in federal court last October.”

    he was even described as their most powerful enemy by some,
    consider that as the private fed gives public money to those same big banks without powerful opposition

  4. swio
    March 17th, 2008 at 11:36 | #4

    You wouldn’t consider JP Morgan getting a loan from the Federal Reserve to buy Bear Stearns a bailout from Uncle Sam?

    “low probability but high impact events�

    Sounds like LTCM on steroids. If the models used to value derivatives and assess risk are like the ones that LTCM used then its almost certain that these trillions of dollars in contracts out there are based on risk models that just don’t take into account the kind of unusual events that are happening right now. If the fall of one bank could bring down the entire financial system then there must be systematic under valuing of the risk of a bank failure throughout the financial system. How on earth could thousands of bankers managing billions of dollars all got a risk like this wrong? That is blatant a demonstration that there is a fundamental failure in financial risk modelling.

    Benoit Mandlebrot of Chaos theory fame wrote a fascinating book about risk and financial markets called “The (Mis)behaviour of Markets” which made the argument that the financial risk models usually understate the risk of significant events because at their heart they depend on the Efficient Market Hypothesis. This causes them to believe adverse events are much rarer than they actually are. Hence we hear failed investors complaining about their bad luck in being wiped out a once in a century event, every couple of decades. Its a great book for anyone wondering why Wall St could get it so wrong.

  5. Oz
    March 17th, 2008 at 11:42 | #5

    The huge scale, complex entanglement and questionable (to say the least) lending practises of the financial institutions seem to be resting on increasingly fragile foundation.

    If government bailouts become the norm won’t banks be free to take on more and more risk, secure in the knowledge that we taxpayers will foot the bill should anything go wrong?

    - Oz

  6. gordon
    March 17th, 2008 at 12:09 | #6

    Brad Setser (a couple of times now) has recently touched on the idea of using dollar reserves held by non-US Govts. and sovereign wealth funds to buy presently unsaleable mortgage-backed securities. I fear we may hear more of this. It is, of course, a strategy of plunder.

  7. Fred Argy
    March 17th, 2008 at 12:23 | #7

    Does anyone know why our share market is behaving much more bearishly than Wall Street? Today is no exception. Why is the level of uncertainly and concern about the “unknown” in bank balance sheets so much greater here? And shouldn’t APRA and the RBA be making some reassuring noises?

    The wealth effect in Australia, especially when the super and investment funds start to release their quarterly reports, is going to be huge. Coupled with the high dollar, slowing exports and continued rises in borrowing costs, we may face a recession by early 2009. If the Rudd Government does some advance contingency planning, and throws out is fiscal straightjacket, it might actually be able to implement many of its economic, social and environmental programs when the crunch comes. But will Rudd be prepared for a recession and will it be willing to run deficits for a time? Swan was quoted only a week ago as saying that we would not be greatly affected. This assumes commodity prices remain at current speculatively inflated levels and China does not falter. We can all dream.

  8. Spiros
    March 17th, 2008 at 12:50 | #8

    It’s not a bad outcome, for not only the shareholders cop it but so do the BS employees. According to the NYT:

    “On its Web site, Bear says that its employees own about one-third of the firm. That translates into about a $5.23 billion loss on paper for Bear’s employees over the last year, as the firm’s stock plunged 79.4 percent.

    Bear also states on its Web site that non-management directors are required to hold at least 500 shares of common stock or equivalents (which include vested options and restricted stock), while executive officers must own at least 5,000 shares.”

    All those bonuses, paid as now near-worthless shares! It’s a crying shame.

  9. gandhi
    March 17th, 2008 at 13:26 | #9

    Fred Argy,

    Does anyone know why our share market is behaving much more bearishly than Wall Street?

    The conventional wisdom is that international investors should put their money into “safe” economies like Australia, NZ and South Africa. How long that “wisdom” will remain in place is yet to be seen.

    It was, after all, the “conventional wisdom” which got us into this mess.

  10. smiths
    March 17th, 2008 at 13:38 | #10

    i think it only fair to point out as well,
    that this thread, makes the shelf life of this comment faily short,

    First, though, the company has to fail – and none of them have – which at the very least makes you wrong on that point, Ikonoclast.

    and on the “paper trillions�, Ikonoclast, i think you will shortly be proven right myself

  11. March 17th, 2008 at 14:07 | #11

    speaking on behalf of ‘maidens in distress’, if our rescue depends on the probity of the u. s. government, why is it buying up all these brothels?

  12. Joseph Clark
    March 17th, 2008 at 15:37 | #12

    Just a friendly reminder to all you market prophets: if you have any information about the future direction of markets you should trade on that information rather than sharing it with your fellow blog-readers.

  13. gandhi
    March 17th, 2008 at 15:43 | #13

    Joseph Clark, you are assuming that one has money with which to effect said trades.

  14. Joseph Clark
    March 17th, 2008 at 16:44 | #14

    ghandi,

    If you are sufficiently confident of your predictions you need very little money to enter into a trade. I’m happy to help out with structuring if you need a hand.

  15. MH
    March 17th, 2008 at 16:59 | #15

    Bear Stearns only obtained a 28 day funding facility via the US Feds, JP Morgan made them an offer they could not refuse. The markets are in irrational mode, with fear predominating denial a second running second. These ‘shadow banks’ are beset by a good old fashioned ‘run’ (redemptions)and are according to some are’insolvent’ not merely ‘ill-liquid’. Where it goes nobody knows. I am not sure bloggers are exempt from having a license to offer financial advice.

    If you are interested in watching the crash unfold then try:

    http://hf-implode.com/

    (Acknowledgment to N Roubini and Associates.

  16. Ernestine Gross
    March 17th, 2008 at 18:05 | #16

    The article by Justin Fox brings water to the mills of those who know about Grasham’s law – bad money drives out good money – and those who have queried the wisdom of aggregating information that is intrinsically disagregated and not directly observable (preferences, including risk preferences) and those who are sceptical about the idea that information can be ‘produced’ and ‘sold’ for profit like sousages, needles, or breadrolls. IMHO, a related ‘bad habit’ is the notion of ‘consensus views’. All these ‘bad habits’ fits managerialism but not markets.

    Imagine what would happen if this managerialism would become ‘the norm’ at universities – grade inflation to make money? IMHO, it would be worse because a ‘salvage operation’ would require much more than changing numbers and parameter values in a complex system which we call the banking and financial markets.

  17. Ikonoclast
    March 17th, 2008 at 19:39 | #17

    What were they doing calling a company “Bear” Stearns. Surely that was tempting the Market Fates. I reckon Standard and “Poors” will be next. The omens are not good.

    Interesting to consider, the billions which “disappeared” essentially did not exist anyway. ‘Twas all smoke and mirrors.

  18. SJ
    March 17th, 2008 at 19:50 | #18

    IMHO, a related ‘bad habit’ is the notion of ‘consensus views’. All these ‘bad habits’ fits managerialism but not markets.

    IMHO, OTOH, a related ‘bad habit’ is the use of fairly meaningless descriptors. All these ‘bad habits’ fit ravens but not writing desks, at least according to my own private definitions of these terms, which I refuse to discuss.

  19. Ikonoclast
    March 17th, 2008 at 20:13 | #19

    If I were of a pun-ishing turn of mind I would say;

    “The people are getting Moody at the performance of both Standard and Poor investments in the current Bear market with its Stern writedowns. The only place there is still a Bull is in the China shop though I would hate T’bet that even that cookie of fortune will retain its Olympian promise for long.”

  20. Ernestine Gross
    March 17th, 2008 at 20:50 | #20

    Good one, Ikonoclast.

  21. March 17th, 2008 at 21:16 | #21

    I’ll cross post my comment from the ALS blog given that it is Quiggin inspired anyway.

    http://alsblog.wordpress.com/2008/03/16/fed-bails-out-bear-stearns/#comments


    JPM don’t need the fed to cover for illiquid assets. It could value those assets at nil and bid accordingly. What it needs (or wants) the fed to assume is the Bear Stern liabilities. The fact that the fed gets some worthless assets along side the liabilities should hardly be news worthy. It is the act of assuming liabilities, not the act of assuming poor assets that the US taxpayer should be concerned about.

    If this was a company in any other industry the administors would go in, flog off the assets for the best price possible at market, tell the creditors to take a hair cut and leave the shareholders with nought. The fact that bankers, a profession which pays some extrodinarily genereous salaries and commissions, should be bailed out by the taxpayers is obscene. If the creditors can’t afford to take a hair cut they should dilute stock to pay their way out. If the government insists on bailing out such individuals it should insist on an equity stake (or at a minimum a very high rate of interest). Rewarding failure to manage risk, in an industry that is meant to specialise in risk, is unacceptable. These guys should feel the harsh pain of capitalism just like the average joe mechanic does when things go south. The world does not owe bankers a living. If they can’t do their jobs they should pack up and move on.

  22. SJ
    March 17th, 2008 at 21:27 | #22

    I deleted this comment. I’d prefer we didn’t import blog feuds from elsewhere – JQ.

  23. sdfc
    March 17th, 2008 at 21:59 | #23

    Ghandi

    With advice like that Joseph is exactly the sort of guy you should not be listening to in market conditions such as these.

  24. costa
    March 17th, 2008 at 23:48 | #24

    When all the fear and panic subsides it will show that both Bank of America and JP Morgan have bought two companies for a bargain.

  25. Steve Bloom
    March 18th, 2008 at 06:32 | #25

    swio wrote: “(T)he financial risk models usually understate the risk of significant events because at their heart they depend on the Efficient Market Hypothesis. This causes them to believe adverse events are much rarer than they actually are.”

    There’s a cause and effect issue here. IMHO the EMH is just the convenient means of the moment with which to understate things. Specific rationalizations aside, in a market with a major speculative component it’s not too likely that meaningful numbers of the high rollers will ever publically say something like, “Yeah, it looks like a crash in about six months, so everybody batten down the hatches.” Not going to happen.

    My conclusion from the very active promotion by the Bush regime several years ago of using Social Security funds to liquify the financial markets was that somebody (probably a lot of somebodies) could see the chickens on their way to roost.

    That in turn brings to mind the question of why serious jail time and forfeiture of assets isn’t being contemplated for those who indisputably knew there was a problem but continued to make it worse. Instead we see a whole lot of discussion about how the instruments were so compolex that nobody understood them. The general surreality of that assertion aside, at the least the people who assembled them did, and the fact that those names aren’t being named speaks volumes about the depth and breadth of the pervasive corruption.

    I’m barely old enough to recall the tail end (circa 1970) of the non-speculative stock market. From a sociological it’s quite interesting that the last of the people who experienced the 1929 crash had to retire before the speculative cycle could begin again.

    Finally, that all of this speculation has been tracked by the massive enrichment of the investor class and in particular executives is no coincidence at all.

    But of course I’m no economist. :)

  26. Hank Roberts
    March 18th, 2008 at 08:56 | #26

    from: http://www.fourmilab.ch/evilempire/

    “Impress your friends! Persuade the undecided! Meet new and interesting people! Get your car shot up by right-wing yahoos! Be smeared on the front page of The Wall Street Journal!

    “… The Prophetic (July 1990), The Authentic “Evil Empires: One down, one to go…â€? bumper sticker, anticipating the obsolescence of railroad era continental-scale empires in the information age.”

    ————————-
    from:
    http://www.nakedcapitalism.com/2008/03/how-prisoners-dilemma-and-unintended.html

    > the more anonymous the context, the more likely
    > that players will adopt “every man for himself,”
    > and, of course there’s nothing more anonymous
    > than markets. …

    “It is wonderfully perverse that vampire bats are more community-minded than Wall Street.”

  27. Socrates
    March 18th, 2008 at 09:09 | #27

    Regarding the update and the details of the buyout deal, don’t shareholders have to agree to it? It looks as though shareholders are getting next to nill (paid $230million or $2 per share compared to $170 per share over a year ago) while executives are getting billions in payouts. Why would shareholders agree to this?

  28. Joseph Clark
    March 18th, 2008 at 10:32 | #28

    Steve Bloom,

    I can help you. If your hypothesis is correct you can construct a trading strategy to bet against all us silly traders. Buy out of the money options. You should get started as soon as possible.

  29. Socrates
    March 18th, 2008 at 13:49 | #29

    Steve and Joseph

    As for executives behaviour over this, so much for Jensen and Murphy’s theories that bonuses would “align” executives’ interests to those of their company. What nonsense. All they do is encourage executives to falsify the reporting, or in this case even the corporate structures themselves, to still get the bonuses as the company sinks slowly in the west.

  30. Ernestine Gross
    March 18th, 2008 at 14:49 | #30

    Socrates, did you mean Jensen and Meckling? (with Murphy being a Freudian slip?

  31. swio
    March 18th, 2008 at 15:19 | #31

    Joseph Clark,

    That strategy won’t work. Since ’87 enough traders have stopped believing the EMH that today “out of the money” options price in a risk of significant market movements much bigger than the the EMH predicts.

    In other words, there are plenty of traders that agree with Steve. Check ou the implied volatility of out of the money options for proof.

    See the Volatility Smile for more.
    http://en.wikipedia.org/wiki/Volatility_smile

  32. smiths
    March 18th, 2008 at 15:21 | #32

    somebody could see the chickens on their way to roost

    for the possessor of money capital (the banks and financial houses): “the process of production appears merely as an unavoidable intermediate link, as a necessary evil for the sake of money-making.
    All nations with a capitalist mode of production are therefore seized periodically by a feverish attempt to make money without the intervention of the process of production.�

    There is no means of avoiding the final collapse of a boom brought about by credit expansion.
    The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

    for all the lovers of the mythical free market,
    some marx and mises

  33. Joseph Clark
    March 18th, 2008 at 15:57 | #33

    Swio,

    The volatility smile has ABSOLUTELY NOTHING to do with traders believing EMH or otherwise. I really can’t emphasise that enough.

  34. swio
    March 18th, 2008 at 17:08 | #34

    The efficient market hypothesis in its original form when Louis Bachelier proposed it said that moment to moment price movements are random in size and direction, follow a bell curve distribution and are indepedent of each other. That hypotheisis of a bell curve distribution is at the heart of the Black-Scholes formula for option pricing. The whole theory of options pricing based on Black-Scholes depends on that assumption being correct. The problem with this is that a bell curve predicts that extreme price movements are much rarer than they actually are. The Volatility Smile shows that in the real world options traders agree with this. They price options such that extreme price movements are more likely than Black-Scholes and truly random price movements predict. In other words that Bachelier’s version of the efficient market hypothesis (all price movements are random, and independent of each other) comes up with the wrong price for way out of the money options.

  35. MH
    March 18th, 2008 at 17:58 | #35

    Well as it is called a sub-prime crisis, I guess the sub-primees can take heart at the fact that the most exploited and abused base line working group in the US (The working poor) brought down the mighty US financial system. That’s what you call a revolution. The skapegoating and allegory employed by those really responsible via phrases such as;’sub-prime’ ‘SIV positive’ ‘illiquid’ etc., has been a fascinating re-run of loony neocon predjudice – in summary – the black man did it sir!

  36. Ernestine Gross
    March 18th, 2008 at 18:15 | #36

    Interesting perspective, MH.

  37. Joseph Clark
    March 18th, 2008 at 19:28 | #37

    swio,

    Thanks for the tutorial. If price moves are identically distributed then Black-Scholes prices will be correct as a consequence of the central limit theorem. If they are not identically distributed (for instance if the volatility of the innovations varies with time) the distribution will probably have fatter tails than a normal distribution. The existence of fat tails has nothing to do with EMH.

  38. SJ
    March 18th, 2008 at 20:05 | #38

    swio, I think all that Joseph Clark is trying to tell you is that there are other options pricing models that don’t rely on Black-Scholes. There won’t necessarily be a neat mathematical derivation of the price, but you can basically plug in any kind of distribution and the model will spit out a price.

    EMH has its own problems, and it’s best attacked independently of Black-Scholes.

  39. smiths
    March 18th, 2008 at 21:42 | #39

    you know what,
    you can debate all day about EMH and black-scholes pricing thingies, but that is not why this is unfolding like it is,

    its the ‘massive leverage’ stupid,

    carlyle capital went down with something like 32 to 1 ratio,

    its theft when it works, and wipeout when it doesnt

  40. SJ
    March 18th, 2008 at 21:49 | #40

    I’ve got no problem with that, smiths, and I suspect that swio doesn’t either. Joseph Clark is some kind of melt-down denialist.

  41. Ian Gould
    March 19th, 2008 at 00:22 | #41

    “i think it only fair to point out as well,
    that this thread, makes the shelf life of this comment faily short,

    First, though, the company has to fail – and none of them have – which at the very least makes you wrong on that point, Ikonoclast.” – Smiths

    Failure in this context refers to a bankrupcy. Bear Sterns didn’t fail, it was bought as a going concern even if it was a forced seller at a deeply depressed price.

    Had Bear Sterns been liquidated, it’s assets would have to be sold off (in what’s already a very nasty market) to pay its creditors immediately.

    As it is, JPM has assumed the Bear Sterns liabilities and will probably be able to expense them off over several years.

  42. March 19th, 2008 at 01:06 | #42

    As it is, JPM has assumed the Bear Sterns liabilities and will probably be able to expense them off over several years.

    Hasn’t the fed assumed most of the liabilities?

  43. Ian Gould
    March 19th, 2008 at 02:02 | #43

    No, the Fed has loaned funds to JPM secured against the Bear Sterns assets. The loans are non-recourse, meaning that if JPM can’t repay the loans, the Fed can sell the security but can’t pursue JPM for any shortfall.

    Some (probably a relatively small proportion) of the security are dodgy assets of little or no value, other assets may well turn out to have a final realisation value well above the current distressed market value.

  44. Will
    March 19th, 2008 at 02:03 | #44

    I suggest a little more caution in terminology. The liabilities of Bear Stears represent 90%+ of its balance sheet assets – it is a bank after all.

  45. Ian Gould
    March 19th, 2008 at 02:09 | #45

    Will, yes but what proportion of those assets are CDOs or of equally questionable value?

  46. March 19th, 2008 at 02:17 | #46

    Will,

    Liabilities are what they owe.
    Assets are what they are owed.

    For bank house morgages are assets, whilst the deposits from savers are liabilities.

  47. March 19th, 2008 at 02:17 | #47

    Ian,

    Your second paragraph at comment #43 would seem to contradict John Quiggins first paragraph in the opening article.

  48. Will
    March 19th, 2008 at 02:32 | #48

    Cheers Terje, thanks for clearing that up!

  49. Will
    March 19th, 2008 at 02:42 | #49

    Cheers Terje, thanks for that!

    My comment was in response to Ian’s comment about JPM expensing off Bear’s liabilities. To the extent that it assumes Bear’s liabilities then they have to be paid when due; no question of “expensing” them off, otherwise JPM would be in default.

    Now assets can be written off to bad debt expense, in which case capital (equity) is also written down to the same extent. This would already be captured in the $236mln valuation of Bear equity, that effectively represents the difference between the assets and liabilities of Bear that JPM has agreed to take on.

  50. Will
    March 19th, 2008 at 02:42 | #50

    Cheers Terje, thanks for that!

    My comment was in response to Ian’s comment about JPM expensing off Bear’s liabilities. To the extent that it assumes Bear’s liabilities then they have to be paid by JPM when due; no question of “expensing” them off, otherwise JPM would be in default.

    Now assets can be written off to bad debt expense, in which case capital (equity) is also written down to the same extent. This would already be captured in the $236mln valuation of Bear equity, that effectively represents the difference between the assets and liabilities of Bear that JPM has agreed to take on.

  51. March 19th, 2008 at 02:48 | #51

    Will – I suspect sarcasm. Yet your comment #44 was not at all cautious with terminology.

  52. Will
    March 19th, 2008 at 03:04 | #52

    Terje, it’s tough trying to have a normal conversation in bald text, with other posts intervening. No offense meant, but I couldn’t quite let your post go past without a very little dig back. Of course, things were not helped by my response posting itself three times while I was writing it!

  53. smiths
    March 19th, 2008 at 10:33 | #53

    its always semantics around here,

    Failure in this context refers to a bankrupcy. Bear Sterns didn’t fail, it was bought as a going concern even if it was a forced seller at a deeply depressed price.

    this is BS in its original meaning,

    everyone in the world knws bear stearns failed

    why is honesty so difficult with economics

  54. smiths
    March 19th, 2008 at 10:44 | #54

    more light relief

    July 12 2007: (Fortune Magazine)

    “This is far and away the strongest global economy I’ve seen in my business lifetime,” U.S. Treasury Secretary Hank Paulson declared on a recent visit to Fortune’s offices.

  55. smiths
    March 19th, 2008 at 11:01 | #55

    i obviously have too much time on my hands,
    anyway from the financial times

    martin wolf on the possible end of the hedge funds model:

    http://www.ft.com/cms/s/0/c8941ad4-f503-11dc-a21b-000077b07658.html

    Hardly a week goes by without the implosion of a hedge fund. Last week it was Carlyle Capital, with an astonishing $31 of debt for each dollar of equity. But we should not be surprised. These collapses are inherent in the hedge-fund model. It is even conceivable that this model will join securitised subprime mortgages on the scrap heap.

    and john kay on warren buffets success and the weakness of the efficient market hypothesis:

    http://www.ft.com/cms/s/0/899ed662-f502-11dc-a21b-000077b07658.html

    Mr Buffett’s success demonstrates the weakness of one economic
    theory, the efficient market hypothesis, and the strength of another – the central role that the pursuit and defence of economic rents plays in modern corporate life. Still, the first view remains much more popular among economists than the second. Mr Buffett became the first man in economic history to parlay an economic disputation into great personal wealth.

  56. Ernestine Gross
    March 19th, 2008 at 14:11 | #56

    smiths, thanks for your references. The Martin Wolf article contains nice examples of problems with performance schemes that are based on outcomes without asking why and how; ie the problem with KPIs.

    Just a small point regarding ‘economics’. The Efficient Market Hypothesis belongs to Applied Finance, specifically to the posivist version as represented by E. Fama. In the 1970s this school was very focal in distinguishing itself from Economics on the grounds of being more applied, more useful, etc.

  57. Ernestine Gross
    March 19th, 2008 at 14:12 | #57

    Please replace focal with vocal in the second last line. Sorry.

  58. Ian Gould
    March 19th, 2008 at 23:23 | #58

    “My comment was in response to Ian’s comment about JPM expensing off Bear’s liabilities. To the extent that it assumes Bear’s liabilities then they have to be paid when due; no question of “expensingâ€? them off, otherwise JPM would be in default.”

    By expensing them off, I mean JPM can repay them over an extended period along with the other regular expenses of the business rather than having to declare them in the net reporting period as extraordinary losses.

  59. Ian Gould
    March 19th, 2008 at 23:29 | #59

    Terje: Your second paragraph at comment #43 would seem to contradict John Quiggins first paragraph in the opening article.

    Yes it does. I think John is taking an overly pessimistic view of the situation. The Fed loaned JPM $30 billion secured against assets of Bear Sterns.

    I’ve yet to see a published analysis of exactly what those assets represent so I think it’s premature to assume they’re all worthless or, as John put it, “toxic sludge”.

    To be blunt too, I suspect that the Fed will be telling JPM that if they simply walk away from those loans, even if they are legally entitled to do so, the lending window will be sh*t in any future crisis.

    Some of the loans will probably be covered by the sale of the security, a chunk of any shortfall will probably be met (over a period of several years) by JPM, only the residual will be met by the Fed. The US Treasury is only likely to become involved if the Fed needs to borrow T-bills to finance the rescue.

  60. Ian Gould
    March 19th, 2008 at 23:31 | #60

    “this is BS in its original meaning,

    everyone in the world knws bear stearns failed

    why is honesty so difficult with economics”

    Because, economics like any academic discipline has its own special vocabulary and you can’t simply redefine terms or apply them in their nontechnical sense.

  61. Ian Gould
    March 19th, 2008 at 23:48 | #61

    Just to reinforce my point about the definition of failure: BCCI failed – thousands of depositors didn’t get a cent back. Enron failed – and defaulted on billions of dollars in contracts.

    So far not a single investor with Bear Sterns or a single party to a trade with Bear Sterns has lost a cent – and the JPM takeover is designed to ensure it stays that way.

  62. costa
    March 20th, 2008 at 02:38 | #62

    BS is not bankrupt!

    In fact it’s trading around 5-6 dollars. Sure there are pleny of sad/mad shareholders but once the dust settles JP Morgan will potentially be sitting on a pile of profit and one of the greatest trades in a long time.

    There’s even a good chance the equity holders might veto the takeover.

    Meanwhile investment banks can now tap the Fed for short term liquidity. This was not available to Bear last week but a great potential buffer to others should they need quick cash.

  63. March 20th, 2008 at 02:42 | #63

    I’m shocked that a SWF didn’t swoop in and offer $7/share or something similar. Maybe it was because of the immediacy and operational aspects of the deal?

    - Richard
    Hedge Fund Consultants Blog
    http://richard-wilson.blogspot.com

  64. Ernestine Gross
    March 20th, 2008 at 07:58 | #64

    Ian, It seems to me you are using accounting-law definitions to describe something which might not fit into the accounting-law framework (ie you interpret ‘failure’ to mean ‘bankruptcy’ and ‘investor’ to mean ‘depositor’). From my perspective, the Fed-JPM deal is a deal aimed at preventing a total financial system failure.

  65. SJ
    March 20th, 2008 at 18:18 | #65

    BS is not bankrupt!

    In fact it’s trading around 5-6 dollars. Sure there are pleny of sad/mad shareholders but once the dust settles JP Morgan will potentially be sitting on a pile of profit and one of the greatest trades in a long time.

    Barry Ritholtz has a better explanation:

    There is a simpler explanation, one that might surprise you: BOND HOLDERS are buying up Bears loose stock. As much as they can get.

    Why?

    THEY WANT TO MAKE SURE THE DEAL GETS DONE!

    Consider: there is ~$75 billion in outstanding bonds (see Bloomberg screen below), and another $75 billion in other miscellaneous paper. (UPDATE: The NYT pegs it at $300B). Prior to the BSC/JPM deal’s announcement, the BSC Bonds were trading for 80 cents on the dollar.

    Imagine your fund owned a one billion dollars worth of Bear bonds (mark to market = $800 million). Isn’t it worth buying 10 million shares or so at $3 – 4 or so dollars a share? You will get $2 per share in JPM stock, so buying it a few bucks over the takeover price isn’t all that risky. Remember, insiders own 30%, and Joe Lewis also owns about 10%.

    So as mad as the accumulation appears, its actually quite rational — IF YOU ARE A MAJOR BOND HOLDER, and are doing this to capture voting stock. (All the other idiots buying BSC are pretty much f**ked).

  66. Ian Gould
    March 20th, 2008 at 18:40 | #66

    Ernestine, I wasn’t the first person to use the term “failure” or “fail” – I think it was Rog or possibly Andrew Reynolds.

    It’s pretty clear what sense of the word the original post meant – and it’s equally clear that a forced takeover which protects the interests of both lenders and counterparties doesn’t meet that definition.

    For that matter, the JPM share price is looking pretty depressed currently. In a couple of years that $250 million in JPM stock could well turn out to be worth substantially more.

  67. SJ
    March 20th, 2008 at 19:09 | #67

    “…that $250 million in JPM stock…”

    BSC stock?

  68. Ian Gould
    March 21st, 2008 at 00:28 | #68

    SJ – no the $250 million (at current values) worth of JP Morgan shares that current Bear Sterns shareholders are being offered for their shares.

  69. SJ
    March 21st, 2008 at 00:31 | #69

    OK.

  70. March 25th, 2008 at 10:50 | #70

    Looks like it was not sweet enough – JPM have had to increase the price to $10 per share and assume more risk.
    http://news.bbc.co.uk/2/hi/business/7311179.stm

  71. jquiggin
    March 25th, 2008 at 16:39 | #71

    I imagine the extra risk will be passed on to the Fed, that is, the US general public.

  72. March 25th, 2008 at 17:56 | #72

    PrQ,
    JP will be in the first loss position for $1b on the $30b portfolio (the “toxic waste” as you put it), so if it starts going bad they will lose up to $1b on them.
    This, at least as I have read it, increases the risk above that in your original post starting this thread.

  73. jquiggin
    March 25th, 2008 at 19:46 | #73

    To restate the same points
    (i) JPM gets Bear, minus $30 billion of toxic waste (this term is from NY Times and WSJ, not original for me) for a share issue worth about $1 billion, another $1 billion in exposure and maybe $6 billion in restructuring cost
    (ii) The Fed gets the toxic waste, currently trading at huge discounts if it can be sold at all, at a price of 97c in the dollar (allowing for the 1/30th share borne by JPM
    (iii) Bear shareholders get $10 and bondholders get 100 cents in the dollar for securities that would respectively be worth zero, and much less than 100 per cent in a bankruptcy liquidation

    You can argue about whether (i) is a good deal or not. I don’t think there is any room for dispute about (ii) or (iii).

  74. March 25th, 2008 at 21:49 | #74

    To labour the point neither JPM, Bear Sterns nor either of their shareholders are the significant beneficiaries of this action. The real beneficiaries are those that leant funds to Bears Stern. And given that most of them were banks that should know about lending risk I think they should have got a hair cut instead of a handout.

  75. March 25th, 2008 at 21:59 | #75

    No – sorry, but you are wrong (in parts) on all three. The first loss position of JPM means that they are exposed not to a share of the loss, but the entire loss up to $1bn. Only after the losses exceed $1bn does their exposure cease. So, if the losses are $500m, JPM loses $500m and the Fed loses nothing. If the losses are $1.5bn, JPM loses $1bn and the Fed loses $500m. JPM have what is known in the business as the “equity” position in the instruments – the riskiest tranche. 97c in the dollar, with someone else taking the equity tranche may be a good deal – but it is difficult to know now. They could pay out 100c in the future. OTOH, they could be worth very little if the revenues from them are low. This covers (i) and (ii).
    You are also possibly wrong on (iii) – an orderly liquidation over several years may have realized much more than $10 for Bear’s shareholders – which would have meant that the bondholders would have got 100% – but neither of them would have got it now. The way the Fed has rammed this through, though, means we will probably never know if this was to be the case. If the US economy tanks it may turn out to be a shocker of a deal. If not, it may turn out to have been inspired. The share price of JPM shows what the market participant’s view is – to the extent that we accept that verdict.
    http://www.nyse.com/about/listed/lcddata.html?ticker=JPM

  76. SJ
    March 25th, 2008 at 22:01 | #76

    Terje Says: “And given that most of them were banks that should know about lending risk I think they should have got a hair cut instead of a handout.”

    This is a bit simplistic. The actions were intended to prevent a failure of the banking system. What you call a “hair cut” translates to “failure of the banking system”.

    There’s no guarantee that it’s all going to work out well anyway.

    Breaking news is that JP Morgan is next in line for collapse.

  77. rog
    March 25th, 2008 at 22:04 | #77

    JPM estimated that BS exposure to subprime mortgage at $2B so the Fed may only have $1B to lose.

    JPM analysis put BS value much higher than $2 (as evidenced by increased offer to $10), includes the $1.6B building, but it appears that political realities were paramount.

  78. March 25th, 2008 at 22:05 | #78

    SJ,
    Regulators are very fond of justifying anything by running around saying they have saved the financial system. What they are not good at is looking at whether they are the reason it is having problems int he first place.

  79. rog
    March 25th, 2008 at 22:12 | #79

    That analysis of JPM is sobering

  80. March 25th, 2008 at 22:12 | #80

    SJ – what specifically do mean when you say “failure of the banking system”?

  81. SJ
    March 25th, 2008 at 22:18 | #81

    OK, Andrew, I’ll bite. Why is the financial system having the problem in the first place?

    Terje: You know, abandoning the gold standard. That sort of thing. Ruination. Kinda, except not.

  82. rog
    March 25th, 2008 at 22:28 | #82

    Two essential elements to a JPM collapse, lowering of credit rating and increase in interest rates. JPM has $26T in derivatives, 85% of which are interest rate contracts . Either a credit rating or an interest rate move could see a major loss of revenue to JPM as clients seek more secure positions. For the time interest rates are on hold, will S&P also steady their hand?

  83. Will
    March 26th, 2008 at 06:01 | #83

    Its worth remembering one of the last times the world almost ended for US banks; the LDC (Lesser Developed Country) debt crisis starting in in 1982. I won’t give the history, just a very good link: http://www.fdic.gov/bank/historical/history/191_210.pdf

    Described then by the FDIC as the worst crisis since 1930, the major point is that all of the top 8 US banks then would have been all bankrupt on a mark-to-market basis. On average they had loan outstandings to LDC countries equal to 217% of their capital and reserves in 1982 when Mexico defaulted and started a massive chain of defaults amongst 40 LDC countries. There was plenty of warning up to 5 years before that LDC lending was out of control but the banks didn’t stop and the ratings agencies missed it entirely. To say it was the sub-prime crisis of its day is, to me, to overstate the sub-prime crisis.

    What is very important to note is the simple fact that a regulated bank having negative equity on a mark-to-market basis is absolutely no obstacle to it continuing to operate and fulfilling a role in the banking system. The US regulatory response to the LDC crisis was called, by the FDIC itself, “regulatory forebearance”. The US banks were simply given time to rebuild.

    And far from being unique it is the approach followed by regulators in almost every single major banking crisis. Consider the Japanese banking system in the 1990s. The Japanese banks together had, almost without question, net negative equity. Yet they are all still here today, and even profitable again.

    Someone even wrote a paper once about the concept of operating banks with negative equity and called them “zombie banks”. They are a feature of almost every financial crisis, and many non-crisis situations, and demonstrate again that regulated banks are very, very different animals from other firms.

    This current crisis, while it might look different, and everyone will say its different because of this and that, is really just another in a long chain of similar banking crises. You can perhaps understand why Its a great frustration to me that we don’t teach these as a core element of university finance (at least in Oz, which is my experience). Every time its like moral hazard has been discovered for the first time.

  84. TerjeP (say tay-a)
    March 26th, 2008 at 08:28 | #84

    SJ – unless you properly quantify “failure of the banking system” then how can we decide if saving all those stockholders profits using taxpayers money, or printed money, is tolerable or not? It seems to me that the defenders of action are fearful of some vague shadow called doom and despair. The problem with vague shadows is that we can use them to justify almost anything (such as aggresive invasion of foreign nations). Do you believe the fed saved us from total economic collapse merely because they say so?

  85. March 26th, 2008 at 09:14 | #85

    SJ,
    If you are interested, have a browse around ozrisk. Probably best to start here.

  86. March 26th, 2008 at 09:24 | #86

    Just found another – this just popped into my inbox.
    While I do not completely agree with it, the points it makes on regulators (and the analysis behind them) looks sound.

  87. Ian Gould
    March 26th, 2008 at 11:00 | #87

    Terje, here’s what happens when you get a systemic failure in the banking system:

    1. Runs on retail banks as peopel try to withdraw their savings.

    2. Banks calling in loans from viable businesses to try and shore up their balance sheets and meet short-term liquidity needs.

    3. An effective halt to new business lending.

    4. Massive increases in unemployment resulting from 2. and 3. leading to further consumer debt defaults which weaken banks further leading us back to 1.

    Read up on the 19th century and early 20th century “Panics” in the US.

    Or for that matter read up on Indonesia in the 1990s.

  88. March 26th, 2008 at 13:58 | #88

    Point 3 won’t cause unemployment. It will merely cause some operational difficulties.

    Point 1 won’t succeed if the banks don’t have the cash. My bank has a clause in it’s terms and conditions to cover temporary liquidity shortfalls. Which seems sensible. This seems like more of a political and PR problem than an enduring economic issue.

    I’ve read about panics from the past. Most seem to have been due to errant policy – not that we lack errant policy today. However who is to say this was such a beast?

  89. March 26th, 2008 at 13:58 | #89

    p.s. And the panics from the past did not cause the banking system to stop existing. They were temporary problems.

  90. SJ
    March 26th, 2008 at 16:38 | #90

    Andrew, the story at the first link (#85), says that the existence of an unregulated part of the market undermines the regulation of the regulated part, by creating incentives to try to weasel around the regulations.

    The second link (#86), explicitly states that the problem lies with “the politicians, the lawmakers, the law enforcers, the regulators, the policymakers and so on”, because they failed to regulate.

    If that was the point you were trying to make, then fine, I don’t disagree.

  91. SJ
    March 26th, 2008 at 16:52 | #91

    Terje, Ian has tried to describe how things work in the real world.

    “Operational difficulties” really do cause businesses to shut down, and cause unemployment. Your supplier suddenly wants cash before he’ll send you the next shipment, and you can’t get any cash from the bank. Bang, you’re out of business.

    BTW, the answer to this problem is not “gold standard”.

    There have been a lot of these “temporary problems” in the past, as Will says, and the idea is to avoid repeating them, not to try and reenact them.

  92. jquiggin
    March 26th, 2008 at 17:47 | #92

    #75 AR, I’m sorry if I was unclear, but I fully understand JPM’s position. I’m starting from the presumption that the loss will be much more than $1 billion, and therefore as I said the $1 billion in exposure to that loss is part of the price paid by JPM for BS. The losses after that, which will be large, are borne by the Fed, in return for the very small probability of a profit based on the minimal discount to face value negotiated as part of the deal.

    The rest of the analysis follows fairly straightforwardly. It seems surprising to me, at this late stage, that you are treating this purely as a problem of psychology, accepting the claims that the underlying assets are sound, or nearly so.

    It should be clear by now that not only subprime mortgages but lots of supposedly higher grade mortgages are going to default on a large scale, and that similarly bad debts are widespread throughout the financial system. Moreover the securitisation process has clearly increased the difficulty of resolving defaults, and reduced the amount that can be recovered.

    There are further problems associated with attempts to turn ultimately illiquid assets into liquid securities. The idea of an orderly liquidation over several years makes no real sense in this context.

  93. Will
    March 26th, 2008 at 19:44 | #93

    Ian

    Your reference (post 87) to Indonesia in the 1990s raises an important point. Banking crises reach the level of widespread bank failure really only when the state itself fails economically, as it did in Indonesia then and as it did in Argentina in the 2002. When the state remains economically able to backstop the system, then illiquid assets can be turned into liquid ones.

    To go back to my example of the LDC crisis, the banks’ LDC loans were turned into Brady bonds backed by the US government, creating liquidity so could be sold by the banks, allowing them to get some certainty about their balance sheet positions and start again.

    I’m not sure we’re there yet in the context of the US banking system; at the moment none of the regulated US banks has zero or negative equity. We’re still working through the market solutions for the problems in the brokerage houses (such as JPM buying Bear). But if the major regulated banks do get in capital trouble then I expect the ultimate solution will, again, be some kind of government wrap on their illiquid assets, a la Brady.

    In that case you would see an orderly liquidation of the illiquid over several years.

  94. Ian Gould
    March 26th, 2008 at 19:50 | #94

    Terje, no-one is suggesting the financial system will “stop existing”.

    What I am suggesting is that a systemic failure will throw millions of people out of work in the developed world; wreck businesses; gut the retirement savings of millions more people and cause vastly greater suffering in the developing world.

    If we can avoid that (and in this context “we” means the major financial institutions, the major developed economy governments and the multinational institutions like the World Bank and the IMF), we should.

    I’m sorry if the suggestion that public money is used as part of that offends your libertarian sentiments but the consequences – including to the public finances – of failing to act are worse.

    which do you prefer – spending say 1% of US GDP in total over the next couple of years to prevent a systemic failure or spending far more over the next decade in unemployment benefits and foregoing a massive amount of economic growth?

  95. Ian Gould
    March 26th, 2008 at 19:57 | #95

    John, I’m still unclear as to how you come to the conclusion that the losses on the BS assets will be significantly greater than $1 billion. I’m not going to nominate a value for the likely loss – I don’t think there’s sufficient data to draw a conclusion at this point.

    As I indicated earlier I also suspect that the Fed will do substantial arm-twisting to ensure that if losses do exceed $1 billion, JPM meets a major part of the excess.

    THe principal point of the non-recourse nature of the #30 billion in loans isn’t to give JPM an escape route – it’s to convince counter-parties and other banks that JPM isn’t going to go under.

  96. March 26th, 2008 at 23:49 | #96

    What I am suggesting is that a systemic failure will throw millions of people out of work in the developed world; wreck businesses; gut the retirement savings of millions more people and cause vastly greater suffering in the developing world.

    Millions losing their jobs across the entire developed world is merely statistical noise. Whether it has any net impact on unemployment is somewhat unprovable either way. Jobs come, jobs go.

    “Wrecking businesses” means allowing people to fail. Which is one of the key strenghts of capitalism. I’m not sure why bankers should be exempt.

    Gutting the retirement savings of millions means investors carrying the can on risks that they take. And yes putting your money in the bank is an investment.

    On the flip side bailouts perpetuate moral hazard and set us up for another go at “systemic failure” a few years from now.

    which do you prefer – spending say 1% of US GDP in total over the next couple of years to prevent a systemic failure or spending far more over the next decade in unemployment benefits and foregoing a massive amount of economic growth?

    Which do you prefer, spending less or spending more? Your question is a rhetorical setup.

  97. Ian Gould
    March 27th, 2008 at 00:38 | #97

    “Whether it has any net impact on unemployment is somewhat unprovable either way.”

    Go explain that to anyone who was living in Indonesia in 1998.

    Bur your attachment to your ideology is almost admirable in a perverse way. As Stalin said “a million deaths is only a statistic”.

  98. Marc
    May 30th, 2008 at 08:10 | #98

    The citizens of this country need to get their heads out of the sand and investigate all the iisues relating to politics and business. There is no reason to bail out BS. They have assets worth more than their exposure and were just in a liquidity crisis. Just like the other large banks, corporations and financial institutions, Bs had hundreds of billions in assets and should have been forced into bankruptcy to sale said assets. If the other financial institutions were so stupid and greedy to get involved in this crisis then they too should be forced to sale assets to pay for their greed and stupidity. Bank of America has over 1.5 Trillion in assets and they are not the largest bank or financial institution. These financial institution are owned by the elites who have a virulent appetite for greed and buying our poloticians to pass laws to help and protect this malvalent, if not criminal behavior. They are supposed to be leaders but have shirked this responsibilty and only care about how much money they make. Why should their destructive behavior be rewarded with bailouts and special laws and priviledges the rest of us do not receive? May they all rot in hell!

Comments are closed.