FYI | Mar 25 2008
By Greg Peel
Last Wednesday shares in Halifax Bank of Scotland fell 17% as rumours circulated that the bank, with 20% of the UK’s mortgages, had sought emergency talks with the Bank of England over Easter. A newspaper article would appear on the Thursday, the rumours suggested, which would trigger another Northern Rock-style “run”.
It would seem that these rumours were false. Both HBOS and the BoE have denied any such “emergency talks”. The finger has been pointed at a speculator – as yet unknown – who took a big short position in HBOS just prior to an anonymous email doing the rounds. The trade would have netted 100 million pounds.
While this case may end up being one of fraud on the grandest scale, what is unsettling is the environment which has created the capacity for such a simple deception to be perpetrated for a significant profit. The financial world is in irrational fear mode, and is jumping at every shadow. The world’s central bankers are greatly troubled.
It is this environment which saw Bear Stearns go down in the space of two days. There is no talk of fraud in Bear’s case – it was simply a cascading string of events which led to the evaporation of market confidence, all of which can be traced back to Bear’s original hedge fund collapses in June. Of the five big US investment banks, the fifth largest was the most exposed to the mortgage security crisis. The US is supposedly the bastion of free market capitalism, and under such a regime the Fed could quite easily have allowed Bear to go down without any lifeline – but it didn’t.
The Fed hastily arranged for JP Morgan to act as its agent in preventing a complete Bear Stearns collapse. But to do so the Fed had to be seen as preventing a full financial market meltdown, rather than a specific bank “bail-out”. For the latter implies a morally hazardous rescue of greedy Wall Street bankers at the expense of Main Street taxpayers, while the former implies a prevention of that which may have ushered in another Great Depression for everyone. This is possibly why JP Morgan offered Bear a scrip swap that equated to US$2 per Bear share. It was a nominal figure only – one which suggested Bear was indeed bankrupt and that its employees who perpetrated the firm’s risk position, and who own 30% of the stock, would indeed be punished as they should.
But there was a severe shareholder backlash. The perception was that this once venerable 85-year old firm had been made the sacrificial lamb in order to prevent a run on fourth largest US investment bank Lehman Bros, and a subsequent tumbling of dominos. Speculators jumped in and bought Bear shares up to US$5, punting on another buyer seeing a lot more value in Bear than just the nominal US$2.
It worked, but it was JP Morgan which upped the bid, not some white knight. It is likely that JPM was never all that comfortable with the US$2 bid, as the perception was the large US deposit bank (the Chase in JP Morgan Chase) was being given what amounted to a freebie. It has now offered US$10 per share, and the Fed has agreed. This lifts the valuation of Bear from US$236m to US$1.2bn, which should make scapegoated non-employee shareholders slightly happier. The Fed was no doubt frustrated that it hadn’t quite put the Bear debacle to bed, and thus it has redefined its terms.
Bear has issued new shares to JPM which represent 39.5% of the company, and the board has approved the takeover. This all but ensures the deal is in the bag, although punters were still buying shares up to US$14 last night. The Fed will put up US$29bn to guarantee the disposal of Bear’s US$30bn portfolio of distressed assets. Hence JPM gets a US$1bn risk – but it does get Bear Stearns. The Fed gets any profit from the disposal of the portfolio. What is unclear at this point is how long this facility is being offered, but either way the Fed has as good as nationalised Bear Stearns in the short term. JPM has moved to guarantee all of Bear’s prime brokerage contracts and short term loans. This has also added to market confidence.
We have now seen the forced nationalisation of Northern Rock in the UK and pretty much the same thing with Bear Stearns in the US. Germany also effectively nationalised IKB Bank right back at the very beginning of the credit crisis. Speaking to the London Financial Times, Professor William Buiter of the London School of Economics predicted “Central banks will be managers for years to come of rather interesting portfolios”.
The central banks of the US, UK and Europe held further emergency talks over the Easter break. The rumour is that discussions were held over whether there should be an even more decisive further coordinated step taken – that of the direct purchase of troubled mortgages. According to the rumours, the Bank of England is dead keen, the Fed is not closed to the idea while the European Central bank is not keen. The BoE has strenuously denied the rumours, but it will not say just what was discussed, suggesting it is early days.
So far, central banks have been prepared to lend against troubled mortgages, but not buy them outright. The idea is to provide liquidity to the banking system so it can return to normal function, not to simply have the taxpayer step in to rescue the day. The Fed has thrown everything at the problem, starting slowly last year but building up to the unusual step of the Bear Stearns deal and the opening of the discount window to investment banks. Yet nothing had worked so far, and despite some renewed market confidence there are plenty of commentators who believe the inevitable is still only being dragged on to a later date. Central banks must bypass the banks and buy the mortgages, they rail, as the money is not getting to where it’s needed – to distressed mortgage holders who entered into their deals in reasonable good faith.
The response from the opposite camp has been visceral. This amounts to a socialisation of the banking system, they scream. We might as well all become communists. There is still a strong belief the perpetrators of the credit crisis, one in which greed and questionable due diligence were mitigating factors, should be hung out to dry for their crimes. The problem is, what would happen if this were the case?
In theory, the global derivatives market has a nominal value of US$516 trillion, according to The London Daily Telegraph’s Ambrose Evans-Pritchard. This is a number so large as to seem fantastical. Bear Stearns total positions amount to US13.4 trillion, which is still greater than the US national income and equal to a quarter of the world’s GDP, and which was built on an asset base of about US$80 billion. But as mind boggling as these numbers appear, one has to realise that derivatives positions are set both ways. Trillions cannot be lost, in theory, because some positions will benefit and some will lose given one event. Indeed, the bank of International Settlements works on a “gross market value” risk of only 2% of that number. For Bear that means about US$270 billion – still a significant number nevertheless.
JP Morgan, on the other hand, shows US$77 trillion of its own derivative positions. Add in Bear Stearns and it will be managing US$90 trillion – one sixth of the global derivatives market. JPM would want to be fairly sure that those positions balance out, but then no one is entirely confident in the collateral that sits behind.
In the lead up to the crash of 1987, global stock markets were booming. In Hong Kong, the recently introduced futures contract over the Hang Seng index had been pushed out to a substantial premium. The local business family heavyweights who controlled Hong Kong were long both shares and futures in the seemingly ever-rising market. These were not people experienced in derivatives. They were, however, well experienced in power, and maintaining “face”.
There were plenty of US investment bankers in Hong Kong who were experienced in derivatives however, and they were piling into to the opportunity the market distortion was providing. They bought shares on the Hong Kong stock market and simultaneously sold futures over the Hang Seng index at the Hong Kong Futures Exchange. When the stock market crashed in October, the stock market closed for four days. When it reopened, the index futures had fallen to a steep discount to the physical. The US investment bankers had cleaned up on the “index arbitrage” trade. They had lost a fortune on their share positions, but made a significantly greater amount on their short futures. It was a trade with little risk.
Until the Hong Kong heavies walked away. The fledgling Hong Kong Futures Exchange was not supported by government regulation, and as such it could not prevent the refusal of the big long-futures holders to pay up. Nor could it chase them. The US investment banks were left holding only long stock positions. They were crucified.
Which just goes to show that if you are claiming an offset of derivative positions, such that trillions in nominal risk only amounts to mere billions on a net basis, you’d want to be damned sure the paper you’re holding on both sides will be honoured. Otherwise you have a big problem.
Much has been made of mortgage CDOs (a form of derivative) as the root of the credit crisis, but where a real danger has been looming is in that of the credit default swap market (another derivative). A credit default swap allows a buyer of corporate bonds to insure against default risk by passing that risk onto a seller of the CDS for a premium. So just as you hit an insurance company for the replacement cost if your house burns down, a buyer of a CDS should be able to hit a seller for the cost if a company in which it has bought debt goes under and the loan is not retrieved.
But what happens if the seller of the CDS hasn’t got the money?
In this environment, that scenario is eminently possible. For as there has been a propensity for extreme levels of leverage on everything else in this market, the CDS market is no exception. This time what the leverage translates to is that a lot more CDSs have been sold on any particular company than the actual amount of the underlying debt. This is a bit like everyone you know also taking out insurance against only your house burning down, and then everyone expecting to collect the same payout from the insurance company – the house’s value multiplied many times.
Had Bear Stearns been allowed to go down, what would have been the ramifications for the seller of CDSs over the firm? Spreads on a Bear CDS jumped from 246 basis points over Treasury to 792 basis points over Treasury two Thursdays ago alone. Now that Bear has been rescued, that spread has dropped to 175 points. But no one is really sure just how many times the default insurance would have been multiplied prior to the Bear “run”, and as such how many sellers of the CDSs would have themselves been bankrupted by their leveraged exposures. This would in turn have possibly bankrupted the buyers of the CDS who would have been left high and dry with worthless Bear Stearns debt, just like the investment bankers in 1987 Hong Kong.
And it doesn’t stop there. If Bear had gone down, the spreads on all other CDSs would have blown out substantially, prompting an overwhelming need for a reduction in risky positions. This would have had yet another cascade effect through the financial market. A Barclays report last week suggested the potential losses from one CDS breakdown alone could total US$80 billion, but the ramifications across the whole market could be much, much greater.
So far the world has focused on some US$125 billion in CDO write-downs.
Twenty years ago a the Fed could have easily let Bear Stearns go. But the growth of the derivatives market in the meantime has meant that every bank, investment bank, broker and hedge fund has outstanding derivative positions so interwoven as to make today’s Wall Street look like a bowl of spaghetti. If one goes, they could all go.
As Evans-Pritchard put it, “This time Washington’s pre-emptive shock and awe may have been well-advised”.
