PrefBlog

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.
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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?
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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.
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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.
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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.
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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.
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[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.
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[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.

There was a very gratifying article about the lopsided (disfunctional?) CDS Market today in the Financial Times reprinted by Naked Capitalism:

“The credit default swap market has become lopsided,” says Peter Fisher, co-head of fixed income at BlackRock Financial Management in New York. “It’s not deep and liquid the way we normally think of that — it’s more like an insurance market in which few want to write insurance and many want to buy.”
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In a normal world or in a world where the derivative is closely tied to the underlying cash security, if the price of the derivative became utterly divorced, market operators would step in to trade away the difference, Mr Fisher adds.

But volumes in the credit derivatives market exploded precisely because most of the bonds hardly trade at all. At Goldman Sachs, for example, for every three dollars of trading in bonds, the firm trades $97 in credit default swaps.

As I mused on February 21:

Despite my interest in the asset class, I’m not convinced that the CDS market is ready for prime time. If their main attraction is the ability to lever up a portfolio significantly, then a huge degree of uncertainty is introduced into pricing, in addition to the uncertainty introduced by debt decoupling. I continue to wrestle with the idea, but these twin, undiversifiable uncertainties probably introduce a required risk premium that makes inclusion of these instruments, long or short, in a fixed income portfolio uneconomic.

Treasury Secretary Paulson has announced an initiative to make everybody feel good:

The group also will propose directing credit-rating firms and regulators to differentiate between ratings on complex structured products and conventional bonds. In addition, it wants rating firms to disclose conflicts of interest and details of their reviews and to heighten scrutiny of outfits that originate loans that are enveloped by various securities.
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Mr. Paulson also is planning to encourage the development of a domestic market for “covered bonds,” bonds issued by banks that are secured by mortgages. Popular in Europe, these could be an alternative to securitization. When mortgages are securitized, they generally leave bank balance sheets and banks don’t hold capital against them; covered bonds remain on bank books, and banks must set aside capital to back them.

Covered bonds will be familiar to PrefBlog’s Assiduous Readers. The separate credit rating scale for structured securities is cosmetic nonsense and simply represents more political interference with credit ratings. “Don’t downgrade XYZ, it’s a big employer in my district!”.

In yet another disturbing development, it is felt that indices might attract shorts, therefore don’t have indices:

Markit Group Ltd. shelved plans to create an index that would have allowed investors to bet on the $200 billion market for securities backed by auto loans.

Markit Director Ben Logan confirmed the index was put on hold because of a lack of support from dealers.

The decision follows criticism from analysts at Merrill Lynch & Co. and Wachovia Corp., who said the index would drive down prices of the underlying bonds. Markit had been in talks with firms including Lehman Brothers Holdings Inc., Morgan Stanley, and Bear Stearns Cos. to create and index allowing investors to speculate on auto-loan securities from issuers such as Detroit-based GMAC LLC and Ford Motor Credit Co.

In happier news, S&P opines that the worst of the write-downs is over:

Standard & Poor’s said the end is in sight for subprime-mortgage writedowns by the world’s financial institutions.

Writedowns from subprime securities will probably rise to $285 billion, New York-based S&P said today in a report. The ratings company previously estimated losses of $265 billion in January. S&P raised its estimate because of increased loss assumptions for collateralized debt obligations.

“The positive news is that, in our opinion, the global financial sector appears to have already disclosed the majority of valuation writedowns” on subprime debt, S&P credit analyst Scott Bugie said in an accompanying statement. Losses on other debt such as leveraged loans are still likely to increase, the report said.

The actual report is available from S&P – thanks to Accrued Interest, who found the link and commented on the implications:

Anyway, so people love to talk about what inning we’re in when it comes to the subprime crisis. But let’s be more positive about it, shall we? We’re in the first inning of the healing process. The subprime contagion has decimated broker/dealer capital. That phase is probably wrapping up.

Bank of Canada Governor Mark Carney gave a speech today that was also soothing in its message:

some of the world’s largest financial institutions have recorded substantial losses, the cost of borrowing has increased, and the availability of credit has decreased. More than seven months on, the end is not yet in sight, although it is safe to say that we have reached the end of the beginning of this turmoil. This is not because the dislocations in markets have eased; in fact, strains in financial markets have intensified recently, but rather because we are entering a new phase where policy-makers and market participants have a better understanding of both the shortcomings in the current financial system and what needs to be done – by both groups – to address them.

Mr. Carney gave some very strong indications of his desires for financial market reforms going forward; the speech is important enough that I will attempt to review it thoroughly tomorrow.

The preferred market was weak again on more light volume, with the general malaise resulting in some violent pricing moves when some players absolutely had to get some selling done (RY.PR.F was particularly noteworthy). The PerpetualDiscount index has had only one up-day in the twelve trading days following February 26 and is currently down 2.78% from its 2/26 level.

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