Saturday, March 15, 2008

Beware Of Feds Bear-ing Gifts

With Bear Stearns having to be rescued by the Fed (i.e. the government), the credit crisis is entering the seriously ugly phase. And I say this now because we Street types exhibit sangfroid when a sub-prime family gets thrown out of its home ("they should have been more responsible in managing their debt"), but when the sheriff comes calling to our neighborhood "it's the market's fault". Come to think of it, I have never seen a mirror at a bank/broker/investment bank office - I wonder why..?

Anyway, prior to rescuing Bear Stearns yesterday, there were only two prior occasions when the Fed used the obscure provision about funding non-bank institutions through the Discount Window. As The Economist points out, the last time was in the 1960s - and before that in the 1930s. References and parallels to the Great Depression are getting all too frequent lately, it seems.

While the failure of one major-bracket investment bank to get funding on its own is bad enough, worse is yet to come. Broker/dealers are entirely dependent on ample short term loans and trading lines to carry their securities' inventory and to clear transactions. Any hint of trouble and counterparties pull their lines and customers pull their accounts. The end comes instantly, usually no more than a few hours: Sudden Debt, to coin a phrase*..

The trouble at Bear will now cause every firm to become even more cautious with counterparty risk, clamping down on credit lines to trading partners and customers. The immediate reaction is "Bear is history, who's next?". Unlike the isolated 1998 LTCM snafu - one bad apple threatening to contaminate many otherwise healthy apples - the current crisis is fundamentally more serious and widespread. We know that many healthy-looking apples are already wormy inside, but we don't know which ones. The result is less trust in "apples" overall, a major problem in an industry where trust is the cornerstone of daily business.

Bottom line: short-term market credit (aka margin) is going to get squeezed much harder in days and weeks to come, forcing the Fed into even more "gifts" of TAFs, TSLFs, etc. That's too bad: to use mythological parallels, Pandora has opened the box... or the Trojans have wheeled a certain horse into their city.

Finance Goes To The Fed


* Yes, hours. To provide an example, during the 1987 crash my then firm (a major bracket, too) asked that customer margin calls be satisfied immediately - as in "wire or bring a check to the cashier by 2 pm or you will be sold out". Fun, eh? When survival is at stake in the Street, noblesse never oblige.


  1. I thought it seemed to take a while to get from the comment last Monday by the Bear Sterns CEO "we don't have a liqudity problem" (a 'get your funds out quick' signal if ever there was one) for things to deteriorate to bail out stage on Friday.

    After seeing this occur over a few days, I would expect the next institution to take only hours (as Hell says) to a day to go from a whisper/rumour to full blown run and default. And there is no way of really identifying what's rumour and what's fact for those souls at the consoles. It will be trigger fingers at the ready everywhere. First hint of a problem - immediate sell from now on. No other choice. Receipe for disaster.

    I also notice that Emporer Dubya continues to talk things up in denial of what is really going on. Sooner or later someone will tell him he is not wearing any clothes.

    I was thinking recently what is the easiest way to measure the performance of a leader without getting too complicated. I think simplest way is to ask 'did he/she leave their country (or, in the case of a US president given their superpower status - the world) in a better state than when they found it?'

    Dubya is leaving alot to his last few months of office methinks..

  2. My biggest "no-no" in government is incompetence.

    If there ever was a gang that couldn't shoot straight, that would be the Bush-Cheney administration. And that holds even literally, for unfortunate US soldiers, Iraqis, Afghans and quail-hunt partners.

    To add to your single performance measure question: Would you trust a government that handled the New Orleans emergency the way it did, to be successful in containing the credit contraction?

  3. Do I detect a leftish bias here? The Federal government (especially parts other than FEMA, and particularly the military) performed fine in regards to Katrina (not counting the engineering of the levees - a problem that has existed through several presidential administrations).

    The State government on the other hand (even aside from not requesting help from the Federal government) screwed up everything imagineable, and deserves almost of the the blame for the poor response to the situation.

  4. H.

    Bear Stears going belly up almost over-night gives another look to the name of your blog.

    After weeks and months of slow-motion implosions we get this quite impressive case of 'sudden debt'.

    Now things may go downhill quite fast.

  5. Amusing comments from people about the "responsibility" of shareholder ownership in American companies, in the previous comment section. In a complex society you depend on professionals to managed specialized tasks. Our "professionals" have betrayed our trust, malpractice is the norm.

    Our whole system is corrupt and when the deckhands figure out the carrier group has been led into a massive whirlpool there may be (bloody) hell to pay.

  6. .
    For engineers or scientists, systems that react non linearly to input are fascinating.

    There are such systems in the real world even if they are counter intuitive. And sometimes they cost lives too. I still remember from school days (more than 20 years ago!) the examples of Liberty Ships sinking because they had to sail too far into the north to avoid german U-Boots. IIRC the american engineers/scientist had simply not understood well enough how ductile steel very suddenly becomes brittle when temperature falls under a certain threshold.

    A bank run and a crash at the stocks markets just look like such fascinating systems.

  7. Question:

    What about Lehman?

  8. Leading the list of companies that saw the prices of their CDS (default protection) surge significantly this week were GMAC, Bear Stearns, Ford, Sallie Mae, Countrywide, and Lehman Brothers. These six companies combine for (as of their most recent financial statements) Total Assets of almost $2.0 TN, supported by Shareholders Equity of about $75bn. Or, stated differently, these six companies were leveraged (mostly in financial assets) to “capital” at a ratio in the neighborhood of 25 to 1.

    One down more to go, all the attempts to stop this are going to lead to the dollar falling like a stone, commodity prices exploding, increasing the downward spiral. Watch out below.

  9. There are two bubbles left, US Treasury's and commodities the forward question is which blows first.

  10. Who actually owns the Fed? I heard that the government owns 20% and the balance is held by a consortium of major US banks. Is that true?

  11. From the SIPC website regarding their purpose:

    "Restoring funds to investors with assets in the hands of bankrupt and otherwise financially troubled brokerage firms."

    I truly don't understand why Bear Sterns was bailed out if the gov (via SIPC) was going to protect the individual investors anyway. Cronyism? Keeping up appearances so they don't have to deal with the bubble burst under the Bush administration? Corrupt individuals in the system with balances higher than the SIPC max?

    Sigh. With borderline-treason financial choices such as bailing out these criminals I don't think there is a question that the gov is going to have to default on some of the 9.4 trillion national debt.

  12. Hel,

    Assuming CDS prices reflect trouble to come at major firms, where can one get daily prices for CDS contracts? I mean not just values for CDS indexes but values for individual firms.

  13. Anonymous--reality has a well-known liberal bias.

    Hellasious--the TAF/TSLF were at least nominally subject to margin calls if the collateral was insufficient (whether you believe the Fed actually would do that is a separate question.). The JPM/BSC loan is officially non-recourse. To me, this seems like a line has been crossed.

    I suspect that JPM won't want to be pissing off the Fed at a time like this, so I'm not sure that it's a practical risk. But even taking on the nominal risk seems like we've just kicked it up a notch.

  14. What about Lehman?

    What about Morgan Stanley?

    Morgan Stanley has US$74 billion of Level 3 assets, over 200 times its equity which is the highest amongst its peers. Although the Level 3 assets have declined from the previous quarters owing to huge writedowns, the reclassification of assets from from Level 2 to level 3 category continues as the liquidity for the troubled mortgage paper drys up.

  15. Great post, however you really caught me on "sangfroid". I had to look it up in the dictionary.

    I guess that us back wood, country boy types ain't as smart as we think.

    Geezzzz....! It ain't lookin pretty out there is it....?

    Best regards,


  16. "I truly don't understand why Bear Sterns was bailed out if the gov"

    Cross party risk my dear boy, Bear failed they would take Morgan and a lot of others with them. They are joined at the hip and the risk is concentrated in the banking system. Think domino's

  17. One down more to go, all the attempts to stop this are going to lead to the dollar falling like a stone, commodity prices exploding, increasing the downward spiral. Watch out below.

    I agree with this assessment. Damned if they do and damned if they don't. Next week is going to be a doozy.

  18. I am unwinding every ITM CDS on Monday with all my counterparties.

  19. The Feds have screwed up our crisis response. For some reason the fact that people loot (or salvage, if they're white) after a natural disaster makes them very worried and concerned. A few million dollars worth of looting after Katrina was less than .1% of Katrina losses.
    But that is the government's priority after a crisis.
    They were blocking volunteer aid after Katrina for fear that it would interfere in their slow and insufficient response. Insane.

  20. I love your blogs and the people that post here, Hell.

    My question is, like the Japanese Feds in the 90s, are the US Fed trying to acheive a "soft landing" by flooding the markets with cash? Are they just delaying the crash? Or is a stagnant economy like Japan's in the 90's better than a viscious thud?
    I was fortunate enough to move my money in RRSP's (your equivalent to 401's, I believe) to commodities.
    Someone from the Great White North had posted that they invested all of their money in US companies, which is ILLEGAL in Canuck-land.


  21. Be on the lookout for another upbeat report on the economy by David Malpass, Bear Stearns economist ;)

  22. h...
    delightful rendering of you know who the artist is?..i can't find the print on the web.