Bear Stearns Roundup
My friend Scott, who actually worked for Bear Stearns years ago, sent me one of the more down to earth explanations of a liquidity trap that I have heard of late. Imagine that you had a mortgage on your house for 50% of its current value. Then suppose that in this alternate mortgage world, you had to renew your mortgage every week. Most of the time, you are fine -- you still have good income and solid underlying asset values, so you get renewed with a rubber stamp. But suppose something happens - say 9/11. What happens if your renewal comes up on 9/12? It is very likely that in the chaos and uncertainty of such a time, you might have trouble getting renewed. Your income is still fine, and your asset values are fine, but you just can't get anyone to renew your loan, because they are not renewing anyone's loan until they figure out what the hell is going on in the world.
Clearly there are some very bad assets lurking on company books, as companies are still coming to terms with just how lax mortgage lending had become. But in this context, one can argue that JP Morgan got a screaming deal, particularly with the US Government bending over and cover most of the riskiest assets. Sigh, yet another government bailout of an institution "too big to fail." Just once I would like to test the "too big to fail" proposition. Why can't all those bankers take 100% losses like Enron investors or Arthur Anderson partners. Are they really too big to fail or too politically connected to fail?
Anyway, Hit and Run has a good roundup of opinion.
Update: I don't want to imply that everyone gets off without cost here. The Bear Stearns investors have taken a nearly total loss - $2 a share represents a price more than 98% below where it was a year or two ago. What I don't understand is that having bought Bear's equity for essentially zero, why an additional $30 billion guarantee was needed from the government.
Xmas:
Actually, that's a good question at the end there. If JP Morgan has bought all of Bear Stearns for under $300 million, does that mean that it can sell of the good parts and simply through away the bad paper? Or even if it keeps the bad paper where 10 or 15 percent of the mortgages are paying, won't it still be making a profit?
I supposed the main concern for JP Morgan will be that the cost of administering the bad paper is more than the income from the MBSs.
"Those big companies just write it off." (paraphrasing Kramer)
March 17, 2008, 12:04 pmMike:
I assume the $30 billion is to pay Bear Stearns staff their bonuses for their outstanding performance and make sure they don't flee the ship. Like most in the financial services business they get paid regardless of what happens to investors money.
March 17, 2008, 12:20 pmMarcus:
To run with your analogy, the 9/11 event you are speaking of that caused the credit turmoil is, after housing prices began to fall and defaults began to happen, came the realization the ratings from the government anointed ratings firms (S&P and Moody's) were worthless.
That is why there is a liquidity crises. Nobody trusts the ratings. The ratings are how risk is priced and if you can't trust the ratings you can't price the risk. So no one wants to buy.
Going back to your post comparing Bear Stearns to Enron there is a key difference. The off book risk Enron took, they themselves were responsible for evaluating and pricing the risk they took. They were wrong.
In the sub-prime mess we see, the risk was priced based on the ratings from the government anointed ratings firms.
March 17, 2008, 1:09 pmdearieme:
When Nick Leeson ruined Barings, the british government let it fail, and quite right too. I suspect that it ought to have allowed Northern Rock to fail too.
March 17, 2008, 2:22 pmGorgasal:
I could imagine that Bear Stearns had some highly leveraged positions on their books, so their total equity could right now be actually negative. In this case, an additional government guarantee would make sense.
March 17, 2008, 3:27 pmMesa Econoguy:
The additional guarantee was mostly to back existing non-liquid assets on its books, and further reduce counterparty risk.
Counterparty risk is a major reason why J.P. Morgan stepped in to buy Bear – as Bear’s clearing agent, if Bear went under, Morgan was at substantial risk themselves of enormous losses.
March 17, 2008, 6:14 pmDWPittelli:
If an additional $30 billion guarantee was needed to get JP Morgan to pick up the pieces of Bear Stearns, that's probably because no one with deep pockets was willing to do the job for $25 billion.
March 17, 2008, 6:33 pmMGW:
Just to preface my remarks, I work for one of Bear's competitors in corporate finance.
Fundamentally this is just a case of a run on the bank (though it works a bit different since it is an investment bank). Essentially, Bear's ongoing business requires that other people believe in its continued solvency in order to take the opposite side of bets from Bear (the counterparty). Bear also depends loans from others to keep the doors open and meet its capital raitos. Just like runs on the bank, this can be self-perpetuating collapse. One company can decide not to do business with Bear (the cost of switching to another prime broker is not very significant) and another can decide not to lend Bear money and set off a cascade event.
The real problem with Bear (and potentially other banks that may meltdown in the future) are the "level 3" assests. These are "mark to internal model", meaning that they are valued essentially at whatever the company says they should be valued at (there is no external market for these assets, so there isn't a readily available market price). If Bear is unable to continue securing financing, it has to sell some of these assets to meet its capital adequacy ratios. Unfortunately, selling highly illiquid assets in a hurry results in selling them for steep discounts and once some of these are sold for steep discounts, the rest have to be marked down to reflect this new pricing reality, resulting in a rapid diminuation of book value.
Keep this risk in mind when you invest in companies that depend on a suspension of disbelief to exist (basically all financial institutions).
As for Bear's employees. I've heard from some of my friends over there that whole groups have left for other banks and that the Wall Street job market is saturated with resumes since the word is that Bear will lay off a huge portion of its workforce.
March 17, 2008, 8:39 pmLawrence:
I heard it explained that the $30B commitment from the Fed covers the riskiest portions of BS assets and that this commitment was needed by JPM in case the estimated credit quality of BS assets was really AFU.
It should also be noted that this deal was worked out over a weekend and that the Fed imposed a time limit as to when the deal had to be done - i.e., Monday morning opening of Asian financial markets. Hence the Fed had to announce a completed deal by early Sunday evening.
Probably JPM got a very good deal taking over BS because of the short period of time available to do the deal. That was the clear view of Mr Market yesterday.
Time waits for no Bear.
March 18, 2008, 4:47 am