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.
John Quiggin 
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”
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.
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
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.
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
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.
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.
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.
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.
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
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?
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.
Joseph Clark, you are assuming that one has money with which to effect said trades.
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.
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.
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.
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.
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.
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.”
Good one, Ikonoclast.
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.
“
I deleted this comment. I’d prefer we didn’t import blog feuds from elsewhere – JQ.
Ghandi
With advice like that Joseph is exactly the sort of guy you should not be listening to in market conditions such as these.
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.
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. 🙂
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.”
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?
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.
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.
Socrates, did you mean Jensen and Meckling? (with Murphy being a Freudian slip?
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
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
Swio,
The volatility smile has ABSOLUTELY NOTHING to do with traders believing EMH or otherwise. I really can’t emphasise that enough.
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.
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!
Interesting perspective, MH.
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.
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.
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
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.
“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.
Hasn’t the fed assumed most of the liabilities?
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.
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.
Will, yes but what proportion of those assets are CDOs or of equally questionable value?
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.
Ian,
Your second paragraph at comment #43 would seem to contradict John Quiggins first paragraph in the opening article.
Cheers Terje, thanks for clearing that up!
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.
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.