Sunday, March 16, 2008

Bear Death Watch: Update and Nightmare Scenarios

(Naked Capitalism) Given the weekend, there was not much in the way of news on the Bear Stearns front, save further clarification of how perilous its state is.

From CNBC:
Department heads at Bear Stearns met with officials at J.C. Flowers and JPMorgan Chase Saturday afternoon to give an overview of their business divisions, including headcount and profit and loss positions, CNBC has learned....

On Friday... S&P lowered its long-term counterparty credit rating on Bear to "BBB" from "A," and it placed long-and short term ratings on credit watch with negative implications.

Because of that S&P downgrade, bankers have now come to the conclusion that a deal must be done by Monday morning because no one on the street will trade or lend to Bear Stearns, which is rated a notch above junk bond levels. If the downgrade hadn't happened, Bear management would have had more time to work the Street for a deal, sources said.

CNBC failed to note that Moody's had cut Bear's long-term counterparty rating to Baa1 and Fitch to BBB.

The irony is rich. Moody's and S&P were arm-twisted into not lowering the ratings of the monolline insurers because it would Cause the End of the World of Finance as We Know It. But their diligent, speedy response on Bear might set off a nasty chain reaction.

The significance of the downgrade goes beyond taking the firm out and shooting it in the head (as if that isn't bad enough). Some readers did an astute job of addressing these issues, so I'll turn the mike over to them. From Steve on the immediate impact:
I doubt anyone wants to pick up Bear's level 3 book and pending lawsuits. As for piecing out prime brokerage and wealth management, the first question is how big a hole has been blown into them by the run, and whether there's a buyer who wants to `rebuild' those businesses for a price that management can stomach. Bear is dead in the water. They can't trade their positions and the client run isn't going to stop. If there isn't some (partial) resolution by Monday morning, I expect they'll be filing by Monday afternoon. The Fed's liquidity support means nothing if no one wants to do business with their brokers and desks.

Let's consider that unpleasant scenario by itself: Bear files for Chapter 11. This is not an area of expertise of mine, but I imagine anyone who didn't start the process of moving their accounts out would now find it difficult and protracted. And the last time you want to have access to your accounts restricted is when markets are haywire, which they certainly will be next week.

But worse, if you were trading on margin, your collateral will be seized and will become part of the bankruptcy. Eeek. If any sizable hedge funds get caught, God only knows how nasty the knock-on effects might be.

A further, and potentially disastrous development is that a Bear bankruptcy could trigger the unravelling of the credit default swaps market. Reader reality-based lawyer worked through the narrower issue of the impact of a downgrade big enough to trip collateral triggers:
Bear wrote credit-default swaps in large volume. All/most of the swaps probably require Bear to post collateral in the event it's downgraded below a specified level (a rating trigger), typically "A-." Do you know whether S&P's downgrade to "BBB" trips the rating trigger, or does it require two rating agencies, or is it set at "BBB"? If the last, the trigger wouldn't be pulled unless/until Bear is downgraded below "BBB-", at which point it very likely wouldn't be able to meet the resulting collateral posting requirements (depending on the market value of its net exposures) and would simply go directly to somewhere in the "C" or "D" range. If the first, meaning the trigger's already been pulled, the question is how S&P could give Bear a "BBB" rating - how much funding do they think the Fed will provide?

Bankruptcy would lead to ratings downgrades beyond BBB- and probably independently lead to the collateral trigger being tripped.

Now RBL assumes the Fed can step up to fill the gap. But can it? It has about $400 billion of firepower left under current balance sheet constraints (one reader argued that the Fed could expand its balance sheet much more; I'm not clear in practical terms how that could happen and other analysts have taken the opposite view). I suspect in dollar terms this is more than enough, but I wonder whether the Fed/JPM tag team will be able to deploy it successfully, given the constraints of operating in bankruptcy.

Let's look at this unenlightening-by-design chart (click to enlarge) and related disclosure from Bear's November 2007 10-K (hat tip Prudent Bear via Michael Shedlock):
As of November 30, 2007 and 2006, the Company had notional/contract amounts of approximately $13.40 trillion and $8.74 trillion, respectively, of derivative financial instruments, of which $1.85 trillion and $1.25 trillion, respectively, were listed futures and option contracts.

The aggregate notional/contract value of derivative contracts is a reflection of the level of activity and does not represent the amounts that are recorded in the Consolidated Statements of Financial Condition. The Company's derivative financial instruments outstanding, which either are used to offset trading positions, modify the interest rate characteristics of its long- and short-term debt, or are part of its derivative dealer activities, are marked to fair value.

The Company's derivatives had a notional weighted average maturity of approximately 4.2 years at November 30, 2007 and 4.1 years at November 30, 2006. The maturities of notional/contract amounts outstanding for derivative financial instruments as of November 30, 2007 were as follows:


Now it isn't evident that the rather scary looking $10 trillion line (yes, that's $10 trillion, but remember that is notional amount; the economic exposure is a teeny fraction of that) is credit default swaps. Given the "swaptions, caps, collars, floors" this looks to be in large measure interest rate swaps.

However, the interest rate swaps market is the bread and butter of short-and-intermediate term interest rate management. Disruption in that market would be nasty. It would almost certainly have a serious, adverse impact on interbank funding rates, and they were looking rocky before the events of last week. Similarly, one of the trades that brought LTCM down was being on the wrong side of rising swaps spreads. Anyone (and it really could be anyone, hedge fund, securities firm, bank) who had similarly placed the wrong bet could be badly impaired.

Now that is pretty bad, but if reality-based lawyer is right and Bear wrote a lot of credit default swaps, the downside is probably even worse. Remember, the protection writer is the one who has to pay up if there is a credit event. So if they get downgraded or go bankrupt, suddenly that guarantee looks pretty unreliable.

Further, many users and writers of CDS hedge their exposures with other CDS. So if one piece looks like it might fail, that hedged position suddenly looks unhedged. This would cause a scramble for more protection writing when hardly anyone is writing protection and spreads are already at extremely elevated levels.

To reiterate: the issue is probably not the magnitude of the Fed commitment, but operational difficulties due to bankruptcy rules that impede the Fed in delivering on its backup.

So that means it is imperative that someone buy Bear by Monday (perhaps this can miraculously be strung out another day, but I defer to the experts). I'm not clear if mechanically that can happen. Even getting to a letter of intent by Monday would be heroic (and for sports fans, letters of intent unless someone screws up have language that makes them not legally binding and subject to due diligence). And Bear is a regulated entity, which means additional hocus-pocus has to happen before a deal is done.

So we appear to have two outcomes: that somehow the clever folks at Lazard get something signed that looks enough like a deal (even though it can't possibly be a deal) that between it and the Fed bailout Bear does not have to file for bankruptcy. Or it files.

Now let's go one step further. Unless someone leaks a very very positive update to the Financial Times (best because it closes its online edition much earlier than the Wall Street Journal), anyone who has an operating brain cell and can trade in Tokyo time is going to be unwinding carry trades as fast as possible. No one who is reliant on yen funding wants to be exposed to what might happen if Bear goes BK. And a sharp move in the yen will feed on itself. You could see the yen move to 98 or 97 if the recognition that Bear could go bankrupt fast and what that might mean takes hold.

And all bets are off if we see further unwinding of the carry trade. The markets are already panicked, rumors will swirl as to who is at risk, and per Bear, those rumors of trouble can become self-fulfilling. And that could redound to the stressed credit default swaps market.

We had this typically cheery view from Nouriel Roubini:
And Bear is only the first broker dealer to go belly up. Rumors had been circulating in the market for days that the exposure of Lehman to toxic ABS/MBS securities is as bad as that of Bear: according to Fitch at the beginning of the turmoil Bear Stearns had the highest toxic waste ("residual balance") exposure as percent of adjusted equity on balance sheet; the exposure of Bear was 54.5% while that of Lehman was only marginally smaller at 53.3%; that of Goldman Sachs was only 21%. And guess what? Today Lehman received a $2 billion unsecured credit line from 40 lenders. Here is another massively leveraged broker dealer that mismanaged its liquidity risk, had massive amount of toxic waste on its books and is now in trouble. Again here we have not only a situation of illiquidity but serious credit problems and losses given the reckless exposure of this second broker dealer to toxic investments.

His gleeful tone that his prediction that "one or two systemically important broker-dealers will go belly up" has come to pass is troubling, I don't particularly enjoy seeing the financial equivalent of broken bodies.

I'm in no position to comment on Lehman. On the one hand, the Wall Street Journal went to some length to indicate that Lehman had much better liquidity buffers than Bear had, and perhaps more important, the advisors to hedge funds who told them to pull back from Bear are not worried about Lehman. On the other hand, that $2 billion in new facilities doesn't buy much. Recall that Bears' $17 billion cash and equivalents hoard went poof in a mere three days.

But consider what other lessons have been learned in this saga;

Investment banks can go under with remarkable speed. The last time we had an investment bank failure was Drexel Burnham Lambert, but everyone on the Street hated Drexel, it was in a niche business that its competitors coveted, so everyone stood aside and the firm was gone in no time flat (I dimly recall that crisis to failure was maybe three business days). But here, even with the Fed and another major bank putting their muscle behind a rescue operation, the outcome will probably be much the same. That isn't just sobering, it's a reality that many haven't witnessed. It will elevate the prevailing level of nervousness.

Efforts to reduce risk can have the opposite effect. This was a point made in Richard Bookstaber's A Demon of Our Own Design, that in what he called tightly coupled systems, insurance measures can make things worse (witness: everyone running to buy credit default swaps to contain their risks is making prices skyrocket, which is increasing prices considerably for anyone who want to finance, which hurts the real economy, which increases fundamental risk). And that specifically means that the Fed's moves may well backfire. As we noted yesterday (this obsrevation came from a reader):
The TSLF probably had the perverse effect of killing Carlyle Capital, the exact opposite of what was intended (Robert Peston @ BBC, via Alea). The TSLF gave creditors every incentive to seize Carlyle Capital's collateral in order to present it at the Fed window in exchange for "lovely liquid Treasuries", something which Carlyle Capital itself couldn't do. Bear, on the other hand, is allowed to use the TSLF... but the TSLF doesn't go live until March 27.

Specifically, if the yen rallies to 98 or higher on Monday and Tuesday trading in Tokyo, a 100 or even 75 basis point cut by the Fed Tuesday could be disastrous.

The Fed is badly out of its depth. Not that this is a surprise, since its actions have looked desperate for a while (was it Barry Ritholtz who said "75 is the new 25"?). This confirmation comes from a hedgie reader:
A last note on the Fed. A friend who’s got very good contacts told me today that they’re completely at sea here, not understanding what’s going on, flying by the seat of their pants, and making policy completely on an ad hoc basis. Not precisely what one would hope for in this situation.

Let's all hope next week is not as exciting as I fear it could be.

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