PrefBlog

Price & Value! They’re not always the same thing – which is wonderful for those of us who achieve outperformance by exploiting the difference – but sometimes they get so far out of whack that real pain is experienced. We’re going to be hearing a lot about the two over the next few years, as the regulators wrestle with what they can do to avoid future procyclical margin calls on banks.

AIG, for instance, took an $11.1-billion hit in its fourth quarter, compared to its internal “worst case” stress test of $0.9-billion because its CDS positions (short) were marked-to-disfunctional-market. Bear Stearns investors are looking at book value $84, accepted bid $2. And, of course, it has become fashionable to make fun of mark to make believe accounting, enjoyment being inversely proportional to understanding.

Brace yourselves! There’s going to be a lot of discussion over the next year! Nouriel Roubini claims that the Bear Stearns price is, in and of itself, clear proof of insolvency:

As JPMorgan paid only about $200 million for Bear Stearns – and only after the Fed promised a $30 billlion loan – this was a clear case where this non bank financial institution was insolvent.

I think Prof. Roubini goes too far in his statements:

The Fed has no idea of which other primary dealers may be insolvent as it does not supervise and regulate those primary dealers that are not banks. But it is treating this crisis – the most severe financial crisis in the US since the Great Depression – as if it was purely a liquidity crisis.

While it is indeed true that the Fed does not regulate the brokers, the SEC does, and had examiners on the scene at Bear as the crisis evolved:

Cox said on March 11 the SEC was monitoring firms’ capital levels on a “constant” basis and sometimes daily in response to the subprime-loan meltdown that triggered the crisis.

Now, I will agree that it is better, in general, for the Lender of Last Resort to also wear the Regulators’ hat … this has been discussed before on PrefBlog, but now I find that the damn “search” function isn’t working and I can’t find it … but if the functions are separate (as they are in Canada and the UK, to name but two) it’s not the end of the world. Any bureaucracy is much more dependent upon esteem, morale and independence from politicians than it is on formal structure. If Bernanke calls Cox and asks (in J. P. Morgan’s famous 1907 phrase) “Are they solvent?” I’m sure he gets the best answer available.

Back to Roubini:

Here you have highly leveraged non bank financial institutions that made reckless investments and lending, had extremely poor risk management and altogether disregarded liquidity risks; some may be insolvent but now the Fed is providing them with a blank check for unlimited amounts.

All I can say is … it’s easy to second-guess. BSC management has come a cropper and it’s easy to say ‘I told you so’ … especially when, as in Prof. Roubini’s case, he DID say ‘I told you so’! And share-holders are looking at a wipe-out scenario as a result. The Fed moves involve a risk of moral hazard, but somehow I feel a little doubtful that BSC executives are currently exchanging high-fives at being bailed out so generously; if moral hazard exists in this matter, it is with respect to the bond-holders who, it would seem, have a good expectation of seeing their credit quality improve with a takeover.

The most familiar example of moral hazard is in banking; I have previously discussed the state of deposit insurance in Europe … it’s really lousy because they are absolutely terrified of moral hazard. It may be necessary to regulate brokerages more strictly and come up with some refinement of the rules to ensure that liquidity is always abounding … but I’m not sure if, ultimately, such an effort will be worth-while. How often does a market turn from go-go-go! to zero inside of six months, as has happened with sub-prime? How often does an eighty-five year old securities firm with $11-billion book value and profitable operations find itself with dusty telephones?

I’ll listen to suggestions, but I suggest that this is probably one to be permanently filed in the “Why Regulators Need Discretion” category. A much greater source of moral hazard is deliberate moral hazard, as is now being encouraged by Congress:

At the beginning of this decade, derivative risk management geeks, interest rate swaps traders and central bank econometricians filled up entire server farms with what-ifs on the balance-sheet hedging activities of the GSEs. The essential problem was that the GSEs were balancing ever-larger portfolios of fixed-rate mortgages on tiny equity bases. Fortunately, as we all knew, the credit risks of those portfolios were limited because homeowners rarely default on their mortgages. But that still left very large interest rate risks.

The core problem for the housing GSEs is, and has been, the prepayment option embedded in US fixed-rate mortgages. That has meant that the term of the GSE assets extends or contracts depending on whether homeowners can refinance at an advantageous rate. However, most of the long-term debt on the liability side of the GSE balance sheets has a fixed term. So the GSEs must more or less continually offset this imbalance between the average maturity of their assets and liabilities through the derivatives market, specifically the interest rate swap market. Otherwise the mark-to-market losses would overwhelm their small equity bases.

I have said before: the terms on a perfectly normal, standard US mortgage are ridiculous:

Americans should also be taking a hard look at the ultimate consumer friendliness of their financial expectations. They take as a matter of course mortgages that are:

• 30 years in term
• refinancable at little or no charge (usually; this may apply only to GSE mortgages; I don’t know all the rules)
• non-recourse to borrower (there may be exceptions in some states)
• guaranteed by institutions that simply could not operate as a private enterprise without considerably more financing
• Added 2008-3-8: How could I forget? Tax Deductible 

First, the GSEs need to be regulated as the banks they are; second, implementation of this discipline must be allowed to make the terms of US mortgages less procyclical. 

Back to Bear Stearns for a moment, with a hat-tip to Financial Webring Forum. There are some very interesting theories regarding why BSC stock is going up:

what could account for the rise in shares? One of the most intriguing theories, as expressed by observers like ThePanelist.com’s David Neubert, Portfolio’s Felix Salmon and Fortune’s Roddy Boyd, is that bondholders are buying up Bear Stearns shares. Bankruptcy would almost surely have been Bear Stearns’ fate if it had not secured an 11th-hour deal, which would have defenestrated shareholders and thrust bondholders into a potentially bruising battle with other, more senior creditors.

But the JPMorgan deal offers bondholders a potential payout: Upon completion, Bear Stearns bonds currently trading at steep discounts would be made whole by the banking giant. Buying shares in Bear Stearns would help ensure that the deal goes through, and so it’s possible that bondholders are buying up the still-cheap shares in hopes of guiding the JPMorgan takeover to completion.

Buying shares in Bear Stearns could also be a hedge, Mr. Neubert and Mr. Salmon add. If the deal falls through, the bonds will fall in value, but the stock could rise.

Mr. Roddy also points out that hedge funds who sell credit default swaps, financial instruments that protect buyers against the default of a given company, have an incentive to see the deal go through as well. As Bear Stearns’ financial health improves by forging closer ties to the bigger, steadier JPMorgan, the cost of insuring the company through these swaps goes down.

I’ve mentioned the decoupling of de facto & de jure economic interest before, in the context of Credit Default Swaps. Now maybe the swaps boys are at it again! Fascinating. Incidentally, another story making the rounds is that JPM wanted to bid more, but the Fed insisted that management not only be wiped out, but publicly humiliated to boot. Makes sense, but I will not venture an opinion on its accuracy!

Update:In the absence of an endgame, it makes more sense for the bond shorts (that is, those who have bought CDS Protection) to buy shares, since there’s a bigger payoff if they get their way, forcing bankruptcy and then forcing a fire-sale. There is the danger, however, that the company would walk into bankruptcy court with a ready-made plan signed by the Fed giving full recovery to bondholders. The game-players would then lose on both sides of their hedge. Those long bonds have the Promised Land at their feet as soon as the merger succeeds.

Econbrowser‘s James Hamilton approves of the Fed action:

Bear is not going to be last, but it is the model I think for what we’d want to see– owners of the companies absorb as much of the loss as possible, while the Fed does its best to minimize collateral damage.

And I’d say he’s right.

A good strong day in the preferred market, with volume picking up substantially.

There were thirty-one other index-included $25-pv-equivalent issues trading over 10,000 shares today.

This entry was posted on Tuesday, March 18th, 2008 at 9:40 pm and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.