Sunday, March 16, 2008

The fable of the bear and the dodo

Don't miss today's Debt Rattle, March 16 2008: Will the doors open on Monday?

Ilargi: You know what this means?

Bear Stearns just got 'marked to market'!!

At 6 percent of its closing market value on Friday, and 1 percent of its capitalization 2 weeks ago. And that simple fact will reverberate the coming week, like there's no tomorrow. Literally. The value of every single firm on Wall Street and the City will now be subject to severe scrutiny. Which for about every single one of them is very bad news. Shareholders will want answers now, or sell out. The answers won't be there.

Man, this is just way out there. First thing that crossed my mind was: UK very rich man Joe Lewis had lost $800 million Friday, when the Bear share price was at $27, down 40%. Now he's lost, what, $4.5 billion? Bear execs also lost an incredible lot.

Plus, a Fed rate cut on a Sunday. Like that Andrew Lloyd Webber tune: Tell me on a Sunday, please. Now it's certain that Tuesday, rates will be cut by another 0.75%. At least. Game is Over, guys. They have no more. But the doors might open tomorrow morning. Talking about doors, the Bear Stearns building on Michigan Avenue was valued recently at $1.2 billion. The company was sold tonight for $230 million.

You Aren’t Misreading. Bear Stearns Is Worth $2 a Share
That means $236 million. Effectively zero. And with J.P. Morgan’s risk somewhat limited by the Fed, which is taking the extraordinary step of funding up to $30 billion of Bear Stearns’ less-liquid assets. This is what they call on the Street “going donuts.” But there is nothing sweet about the thousands of employees who have lost much of their life savings and most likely their jobs, too.

The $2 per share basically sets down an important market marker: For now, being a Wall Street trading house is no longer a license to print money. It’s a license to absorb plenty of risks. Risks so presumably so toxic and unknown that J.P. Morgan had to turn to the Fed in the way it did.

The Fed responded by broadly opening its window to non-depository institutions, the kinds of trading houses such as Lehman, Goldman Sachs, and Morgan Stanley that could each be picked off by a similar a run on the bank. Unprecedented as they are, the Fed’s moves should give the market some comfort Monday morning.

But as the market saw with Bear, the moment you have to convince someone your credit is good is the moment it’s perceived not to be. Which perception will prevail in the market? Are the dealers extra protected? Or extra vulnerable? Monday’s markets are going to be an incredible laboratory for finding out.

JPMorgan buys Bear Stearns for $2 a share
JPMorgan Chase on Sunday night agreed to buy Bear Stearns, the stricken US investment bank, for around $230m in shares in a deal that puts an end to Bear’s 85 years of independence and highlights the serious risks faced by banks during the credit crunch. JPMorgan’s cut-price takeover of Bear, which has the backing of the Federal Reserve and the Treasury, was agreed before the opening of Asian markets on Monday morning in an attempt to stave off a run on other banks.

However, the deal, which values Bear at just $2 per share, compared with the $169 hit in January last year and the $30 reached on Friday, will wipe out the value of the investments of Bear’s shareholders including some of its senior management.

JPMorgan said that in addition to the emergency loans extended to Bear on Friday, the Fed had agreed to provide fund up of $30bn of Bear’s less liquid assets.

The rare arrangement significantly decreases JPMorgan’s risks and underlines the authorities’ concerns at the prospect of seeing one of the largest US investment banks go under. The Federal Reserve and the Treasury feared that unless the Bear crisis was resolved promptly, there was an increased risk traders might turn their sights on other US and European banks.

“The Fed is most nervous about the systemic risk,” said one senior executive at Bear, the fifth largest investment bank in the US, before the deal was announced “The government needs to stabilise the financial system.”

U.S. Fed Cuts Discount Rate, Says Dealers May Borrow
The Federal Reserve, in an emergency weekend decision, cut the rate on direct loans to commercial banks and opened up borrowing at the rate to primary dealers in government securities.

In an announcement before the start of trading on the Tokyo Stock Exchange, the Fed lowered its so-called discount rate by a quarter of a percentage point to 3.25 percent. The central bank also approved the financing of JPMorgan Chase & Co.'s purchase of Bear Stearns Cos., including support for as much as $30 billion of Bear's assets.

Fed Chairman Ben S. Bernanke is stepping up efforts to keep strains in financial markets from spiraling into a full-blown meltdown. Last week the central bank agreed to emergency loans to a non-bank, Bear Stearns, for the first time since the 1960s. Fed officials also announced a program to swap $200 billion in Treasuries for debt including mortgage-backed securities.

Investors expect the Fed to lower its benchmark rate by as much as a full percentage point, to 2 percent, when policy makers meet March 18. That would exceed the 0.75-point emergency reduction on Jan. 22, which is the largest Since the overnight interbank lending rate became the main tool of monetary policy about two decades ago.

"Clearly, the Fed is trying to provide more liquidity to prevent a more vicious cycle and race to the bottom," said Gary Schlossberg, senior economist at Wells Capital Management in San Francisco, which oversees $200 billion. "The problem is there's so much concern about credit quality that now there are solvency issues, and it's something the Fed has a more difficult time dealing with."

Ilargi: The best background piece I've seen on the demise of Bear Stearns, for some reason coming from England.

Frantic race to save Wall Street giant
Shortly after lunch on Thursday, James Cayne settled down at a card table in Detroit and eyed his opponents. He was one of 4000 people who had come to play in the North American Bridge Championship, but the chairman of Bear Stearns, seeded fourth in a group of 130 in the Imp Pairs, had every reason to be confident.

The session was scheduled to last until 5pm and, although Cayne's mobile phone was ringing constantly, there was no way the competitive 74-year-old could be disturbed.

Some 800 kilometres east in Bear Stearn's office in New York's Madison Avenue, Alan Schwartz, its chief executive, was racing to keep up with the numbers in front of him, too. But this was no game. Bear Stearns's share price was tanking and, even by the roughest estimation, the bank that Cayne had built into Wall Street's fifth largest was in big trouble.

Schwartz, who just the day before had appeared on US television to confirm his bank was not running out of money, called an emergency meeting with top management. Sam Molinaro, the chief financial officer, gave a frank summary.

Schwartz's statement had made no difference: over the previous 24 hours Bear Stearns's biggest customers had effected a run on the bank. Millions of dollars had been demanded by hedge funds, banks and traders, and the total was simply more than the bank had.

One glance at the share price screamed that the situation would not improve: by 4pm $US3.8 billion had been wiped off the bank's value and the stock closed 47 per cent down at a nine-year low of $US30. Schwartz, who had taken over the helm from Cayne in January, knew that without an immediate cash injection the 85-year-old institution, which had survived the Great Depression, was bust.

He called his key adviser, Gary Parr, the deputy chairman of Lazard and one of a handful of men on Wall Street able to raise serious cash at short notice. Parr immediately drew up a list of those who could help. One of his first calls was to Jamie Dimon, the chairman and chief executive of JPMorgan. Once Dimon heard the extent of Bear Stearns's difficulties, it was clear he would have to help somehow.

The President, George Bush, was notified and Chris Cox, the chairman of the Securities & Exchange Commission, was put on alert. Calls were made to Tim Geithner, the president of the New York Federal Reserve, and Ben Bernanke, the chairman of the Fed. The men gathered their teams and began trying to work out how they would react.

In an attempt to improve liquidity, just three days earlier the Fed had pledged to make $US236 billion of credit available to the financial system. But it was not going to be available until March 27. With Wall Street in the grip of the credit crisis, few banks could be called on to help.

Discussions between Schwartz and Dimon were struggling to make progress. Insiders said the pair had recently talked about a tie-up but, with worsening markets and investor fears, it would be a huge risk for JPMorgan to buy its rival.

Then Parr devised a plan: if the New York Fed would provide the funding, JPMorgan could be a conduit through which a government-backed cash injection could be delivered. The loans provided by JPMorgan would be backed with collateral guaranteed by the Fed.

It was not an easy decision: not since the 1960s had the US central bank authorised the provision of funds to institutions other than a regulated depository bank. Bear Stearns, a brokerage, was not one. At 7am on Friday, after a long night of talks, another conference call resumed to pull together the lending agreement.

At 8.38am the announcement was made that the Fed, in conjunction with the Treasury and the SEC, had authorised a rare lifeline to Bear Stearns.

Horrified traders soon grasped the reality: the Fed had been forced to throw out four decades of monetary history in order to support Bear Stearns. Its justification was not that Bear was too big but that it was too "interconnected" to be allowed to fail with the markets in such as fragile state.

As advisers work to find a long-term solution by tonight, bosses on Wall Street and in the City of London are trying to gauge what all this means for the market. Will panic, limited so far to the credit markets, transfer to equities? And if Bear Stearns was in dire straits, how many other financial institutions are too?

Bear Stearns's fall from grace has been spectacular. Just nine months ago its three main areas - mortgages, prime brokerage and clearing - were riding high on the global financial boom, particularly in housing and hedge funds. But last summer two of the bank's hedge funds, which were heavily exposed to mortgage-backed securities, imploded.

The losses of $US1.6 billion were the first signs of the crisis in the credit markets. One insider said: "From that moment, Bear was almost synonymous with the crisis. Any rumours of write-offs or liquidity issues hit us first."

The pressure, exacerbated by criticism of the bank's risk controls, led to tensions between Cayne and his senior managers. Cayne formed an alliance with CITIC, the Chinese banking group, whereby the two banks would invest $US1 billion in each other.

But it wasn't enough. The subprime crisis got worse and that Bear Stearns, the second largest trader in such loans, had a sizeable problem was no secret. At its fourth-quarter results, released just before Christmas, Bear Stearns was forced to write down a further $US1.9 billion in subprime and leveraged assets, leading to a $US854 million loss.

Change was urgent and under extreme pressure Cayne relinquished power to Schwartz.

By mid-February some hedge funds were beginning to grow suspicious of its balance sheet. As one of the biggest prime brokers, Bear Stearns looks after and administers millions of dollars of hedge fund money. As rumours mounted, managers started demanding their money back.

Bear Stearns relies on short-term funding, particularly lending securities for cash in the "repurchase" market. As markets have deteriorated, interbank lending has got tougher for everyone, but particularly for Bear Stearns. It has been forced to stump up more collateral and accept lower margins for its business, heaping yet more pressure on its image and its balance sheet. The situation was exacerbated by the fact that, as a pure investment bank, it had no customer deposits to call on.

As the credit crunch took another savage turn, some of the world's best-known hedge funds were the new victims. Peloton imploded three weeks ago; Focus Capital started liquidating its funds days later. But the biggest calamity came last week when Carlyle Capital, the Amsterdam-listed arm of the US private equity giant, announced a $US16 billion debt default.

Suddenly a crisis in the high-rolling hedge fund sector seemed on the cards. Once again Bear Stearns was hit the hardest. Hedge funds and other counter-parties scrambled to reclaim their money.

One hedge fund manager said: "Explaining to investors that you're down 10 per cent on the year is hard enough. Telling them you've lost 90 per cent of their cash because you left it with a bank that was obviously screwed would be a nightmare. We weren't taking the risk."

Brad Hintz, an analyst at Sanford Bernstein, the Wall Street firm, said on Friday: "Bear Stearns was the weakest player and as lenders demand their money a broker has no choice but to sell assets and shrink its balance sheet. At some point the liquid assets are all gone and the firm cannot sell the illiquid ones."

At the beginning of last week, rumours that Bear Stearns had a liquidity crisis swirled around the market. On Monday Alan Greenberg, a former chief executive of Bear Stearns and current board member, said the rumours were "totally ridiculous".

Bear released a statement to back him up. Henry Paulson, the Treasury Secretary, joined senior Fed officials in trying to persuade other banks to keep the lines open and trade with Bear Stearns.

On the weekend, stunned Bear Stearns managers were working with bankers, politicians and regulators to salvage the bank and market confidence. In London, traders are concerned that this could be the tipping point that knocks the US economy into a full-blown recession.

"Is this a step forward in the resolution of the credit crunch - with a move towards greater clarity - or a step back, with banks and financial institutions becoming even more reluctant to lend money?" said Jeremy Tigue, the head of global equities at F&C Investments.

Last week few were taking chances: as investors fled stocks, money washed through the commodities market, where assets such as gold, wheat and oil are considered safer bets.

The worry is that if Bear Stearns is in trouble, it is not the only one. And that sentiment, more than any billion-dollar writedowns or hedge fund collapses, could yet plunge the entire financial system into a meltdown the like of which would make Schwartz's problems pale in comparison.

Louise Armitstead and James Quinn


The Lizard said...

To Ilargi:

Do you truly believe the financial system is being deliberately destroyed?

If so, to what end?

Cui bono?

Edgy said...

"Good grief," says Charlie Brown. Exactly.

My partner wants to move all his 401K to a money market... tomorrow. Are MM at investment houses, like TRowePrice, insured through FIDC?

I gotta bad feeling about all us who have 'retirement' investments that could take days to liquidate. I'm anticipating a call with my broker and how she will discourage me from cashing out my IRA. Of course, if she doesn't I'll really be worried.

Good grief.

Anonymous said...

"When I get to the bottom
I go back to the top of the slide
Where I stop and turn
and I go for a ride
Till I get to the bottom and I see you again
Yeah, yeah, yeah
Do you don't you want me to love you
I'm coming down fast but I'm miles above you
Tell me tell me come on tell me the answer
and you may be a lover but you ain't no dancer..."

Helter Skelter--Beatles

Anonymous said...

You won't believe it, but today a man asked me what he should do with his $100,000 investment ... I didn't answer the question. I told him to follow the advice of his financial adviser.

It is already too late. I think that this is the end of the world.

But we'll have to see what happens tomorrow.

Would anyone care to guess the legitimate value of the stock market within the context of Bear Sterns selling for $2 a share? I'd guess: Dow 4,000!

James Howard Kunstler should have an interesting column tomorrow.

The Lizard said...

I asked of Ilargi: Cui bono?

But the Existentialist Cowboy answered: