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.

The big news today is the JPMorgan takeover of Bear Stearns, which has been the subject of so much commentary I’ll keep mine to a minimum. The interesting part is that the Fed is taking a first-loss position on the mortgage paper:

The steps were announced at the same time the Fed agreed to lend $30 billion to J.P. Morgan Chase & Co. to complete its acquisition of Bear Stearns & Co. The loans will be secured solely by difficult-to-value assets inherited from Bear Stearns. If the assets decline in value, the Fed — and thus, the U.S. taxpayer — will bear the cost.

The fact that this financing is non-recourse to JPM is confirmed by their investor presentation:

Special Fed lending facility in place; non-recourse facility to manage up to $30B +/- of illiquid assets, largely mortgage-related

The investor presentation is also remarkable for the coy nature of its disclosure of deal terms:

No material adverse change clause. JPM has customary protections

Huh? That’s it? One possibility that the deal is a stalking horse: JPM is backstopping an auction with a reserve price of $2 per share. In exchange, they’re getting a nice break fee and BSC is getting a “go shop” clause. But … Assiduous Readers who have heeded my advice that the first thing to examine in any commentary is what isn’t being said will note that no probability is assigned to this possibility!

The non-recourse provision is extraordinary and reinforces the arguments of the TSLF’s nay-sayers – such as interfluidity:

If you think, as I do, that the Fed would not force repayment as long as doing so would create hardship for important borrowers, then perhaps these “term loans” are best viewed not as debt, but as very cheap preferred equity.
…
The Federal Reserve is injecting equity into failing banks while calling it debt. Citibank is paying 11% to Abu Dhabi for ADIA’s small preferred equity stake, while the US Fed gets under 3% now for the “collateralized 28-day loans” it makes to Citi. Pace Accrued Interest (whom I much admire), I still think this all amounts to a gigantic bail-out. And that it is a brilliantly bad idea from which financial capitalism may have a hard time recovering. Like a well-meaning surgeon slicing up arteries to salvage the appendix, the Federal Reserve is only trying to help.

In an admirable discussion of the further implications of the TSLF, Econbrowser‘s James Hamilton pointed out:

One measure economists sometimes use for the liquidity of an asset is the bid-ask spread. By that definition, one might be justified in referring to the present problems as a problem of liquidity– the gap between the price at which owners would like to sell these assets and the price that counterparties are willing to pay is so big that the assets don’t move. That illiquidity itself has proven to be a paralyzing force on the financial system. By creating a value for these assets– the ability to pledge them as collateral for purposes of temporarily acquiring good funds– the Fed is creating a market where none existed, thereby tackling the problem of liquidity head on.

OK, but if we agree to use that framework to describe the current difficulties as a liquidity (as opposed to a solvency) problem, which is closer to the “true” valuation, the bid or the ask price?
…
Even in the worst possible outcome, the ultimate increase in outstanding Treasury debt would be substantially less than $400 billion, because the collateral is far from worthless. And I would trust the Fed to be taking a smaller risk on behalf of the Treasury than I would expect to be associated, for example, with congressionally mandated expansion of FHA insurance, or the unclear implicit Treasury liability that results from increasing the assets and guarantees from Fannie or Freddie. Nevertheless, the doubters seem to me to be correct that the risks currently being absorbed by the Federal Reserve are substantially greater than zero.

You don’t get something for nothing.

Accrued Interest provides an entertaining analysis of the knock-on effects of the BSC/JPM deal:

Nothing, nothing, would surprise me today. Down 500? Up 200? Who knows? What we have is a tug of war. Traders betting on things getting worse. The Fed and Treasury are trying to draw a line in the sand, telling the market they won’t let either banks nor primary dealers fail as long as they still have decent assets to pledge as collateral.
…
I will say that I wouldn’t be a buyer of protection against any of the big banks or brokerages here. The Fed just delivered a big middle finger to people who bet against Bear Stearns. If you want to bet against brokerages, the stock is a much smarter bet. The Fed doesn’t give a fuck if a stock falls 50%. They have basically unlimited power to prevent a bankruptcy.
…
The problems brokerages are facing today have nothing to do with the normal financial ratio-type analysis that the ratings agencies do. In fact, for a guy like me who likes to pour over financial statements when making an investment decision, analyzing credits now is next to impossible.
…
Lehman and Goldman’s earnings reports tomorrow are probably the most important earnings reports for the broad economy of my career.

Naked Capitalism points out that we are currently engaged in a monstrous game of prisoner’s dilemma:

[Eugene Linden observes] The problem facing the credit markets right now is yet another iteration of the “prisoner’s dilemma” from game theory, at least in the sense that participants know that if everybody takes the stance of “every man for himself” the markets will crater, but they also know that if they rush for the exits there’s a chance that they will get out the door relatively unscathed. Studies of the problem suggest that 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.
…
[Naked Capitalism reader Lune argues] We’ve already seen the law of unintended consequences so far:

1) Congress raises conforming limits on Fannie/Freddie to help unfreeze the mortgage market. Result: agency spreads skyrocket, bringing down Bear and a host of hedge funds. Mortgage markets still remain frozen.

2) Fed opens TSLF to unfreeze mortgage market. Result: Carlyle goes bankrupt as people rapidly arbitrage the difference between holding MBS in firms that can and can’t access the new credit facility. Mortgage markets remain frozen.

Now we have 3) Fed opens TSLF to broker-dealers.
…
[Also “Lune”] I’m wondering: if the demise of Carlyle and BSC was hastened because they were firms that couldn’t access Fed money and thus were foreclosed by firms that could, what will happen Monday? I’m thinking hedge funds, unable to access the Fed directly, will be eaten alive by the IBs.

Meanwhile, in a Financial Times piece dissed by Naked Capitalism as self-serving, Greenspan has pointed out the vulnerabilities of quantitative models:

The most credible explanation of why risk management based on state-of-the-art statistical models can perform so poorly is that the underlying data used to estimate a model’s structure are drawn generally from both periods of euphoria and periods of fear, that is, from regimes with importantly different dynamics.

The contraction phase of credit and business cycles, driven by fear, have historically been far shorter and far more abrupt than the expansion phase, which is driven by a slow but cumulative build-up of euphoria. Over the past half-century, the American economy was in contraction only one-seventh of the time. But it is the onset of that one-seventh for which risk management must be most prepared. Negative correlations among asset classes, so evident during an expansion, can collapse as all asset prices fall together, undermining the strategy of improving risk/reward trade-offs through diversification.

If we could adequately model each phase of the cycle separately and divine the signals that tell us when the shift in regimes is about to occur, risk management systems would be improved significantly. One difficult problem is that much of the dubious financial-market behaviour that chronically emerges during the expansion phase is the result not of ignorance of badly underpriced risk, but of the concern that unless firms participate in a current euphoria, they will irretrievably lose market share.

Paradigm-shift is indeed a problem in quantitative modeling – such models, including all the ones I’ve ever worked on, tend to perform poorly during trend changes, and not at their best when a definite trend exists. All you can do is manage diversification – ‘I can compare equities, and I can compare bonds, but I can’t compare bonds to equities’.

The key phrase in these remarks is: If we could … divine the signals that tell us when the shift in regimes is about to occur, risk management systems would be improved significantly. Can’t be done! The world is chaotic and every bad result has its own unique set of circumstances. So diversify! I am in complete agreement with Mr. Greenspan’s conclusion:

In the current crisis, as in past crises, we can learn much, and policy in the future will be informed by these lessons. But we cannot hope to anticipate the specifics of future crises with any degree of confidence. Thus it is important, indeed crucial, that any reforms in, and adjustments to, the structure of markets and regulation not inhibit our most reliable and effective safeguards against cumulative economic failure: market flexibility and open competition.

A horrible, horrible day for the preferred share market, particularly the PerpetualDiscounts, on light volume. The guy who sold a whack of RY.PR.F at 20.45 last week is starting to look a lot smarter!

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

Bear Stearns! Bear Stearns! Bear Stearns!

What can I say? Their options are limited:

• Find a parter – e.g., sell out to JPMorgan at a price of about maybe $27 – this is about $60 less than book.
• Hold a fire sale of assets. Then watch the business die.
• Go broke.

Whatever they choose, common shareholders are dead. The only question is whether the franchise will survive. I suspect that it will … there’s a gun to the directors’ heads, because trying to tough it out will just destroy their business before the month is out. There’s a lot of franchise value in Bear Stearns … so they have to go cap in hand to every major investment bank in the world, and desperately hope that at least two of them show an interest. As clearing bank, JPMorgan is most familiar with the assets – if they want it.

Another day of light action in the preferred market, with PerpetualDiscounts down again. CIBC was busy!

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