Bear Stearns Bailout: A Credible Signal?

One theme that I have been eager to introduce to this blog, but have been thus far unable to do on account of limited time is the issue of credible signals in this tumultuous environment. The lemon's problem, an important theme in finance, is an apt framework to understand the Fed's actions in the past few weeks. In a world characterized by asymmetric information, with the Fed being one of the largest sources of the asymmetry, any action taken by them should be carefully analyzed for the motive. They have taken two actions recently. First, the 75 bp cut in the fed funds rate, and second the engineered bailout of Bear Stearns. I believe both are credible signals. In this article I look at the latter.

To recap, Bear Stearns became insolvent two Friday's ago and was picked up by JP Morgan for $2 a share over the weekend before open on Monday. However, the stock continued to trade above $2, and it was yesterday announced that JP Morgan will up its offer price to $10. $236 million does seem a bit of a steal for the number one prime brokerage business on the street, not to mention that Bear's building alone, conveniently located where JP Morgan was looking for real estate, is alone worth over 5 times that amount. Read all about it here:

When J.P. Morgan and Bear Stearns announced the deal on Sunday, they had already obtained "all necessary approvals" from federal regulators. It was no surprise to have the blessing of the Federal Reserve, which had agreed to help finance the transaction. But these approvals included "all other federal agencies"—meaning that antitrust regulators signed off on the bailout before the ink on the deal was dry.

At the same time, the merger agreement gives J.P. Morgan an option to buy Bear Stearns' new headquarters in Manhattan at the discounted price of $1.1 billion if the deal does not go through. The option for the real estate, on its face, is worth more than the $236 million price to buy all of Bear Stearns at $2 a share.

"Everything about this deal is unprecedented," said a person with knowledge of the negotiations. And, in fact, many aspects of it are "on the edge of the applicable law."

What I found most unusual was the haste with which the Fed engineered the deal, the fire sale price, and the structure of the financing it provided JP Morgan. As per article 13-3 of the Federal Reserve Act, the Fed's "non-recourse" loan falls outside their legal abilities barring "exigent circumstances".

In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.

(emphasis mine)

Accepting "exigent circumstances", the phrases I bolded should raise a few questions. John Hussman points out that the loan was secured by the least credible mortgage debt on Bear's balance sheet. He has gone so far as to call this a "free put option" and a "tax-payer bailout":

The Fed did not act to save a bank, but to enrich one. Congress has the power to appropriate resources for such a deal by the representative will of the people – the Fed does not, even under Depression era banking laws. The “loan” falls outside of Section 13-3 of the Federal Reserve Act, because it is not in fact a loan to either Bear Stearns or J.P. Morgan. Bear Stearns is no longer a business entity under this agreement. And if the fiction that this is a “loan” to J.P. Morgan was true, J.P. Morgan would be obligated to pay it back, period. The only point at which the value of the “collateral” would become an issue would be in the event that J.P. Morgan itself was to fail. No, this is not a loan. It is a put option granted by the Fed to J.P. Morgan on a basket of toxic securities. And it is not legal.

The deal was made under duress, to the benefit of a private company, on the basis of financial assurances that the bureaucrats involved had no business making. The Federal Reserve is going to put up public assets and accept default risk so that Bear Stearns' own bondholders are effectively immunized?! That's not sound monetary policy – it's a picnic for insiders, bought and paid for through the abuse of public funds by government officials too unprincipled even to recognize the abuse. The only good thing about this deal is that it buys time while principled ways of busting and restructuring it can be settled.

That last sentence is particularly thought provoking. Why would the Fed need to buy time? It's almost as if they pushed through any deal they could to avoid Bear failing while markets were open. They knew the deal wouldn't mature on those terms, yet they showed desperation in their action. They invoked article 13-3, yet overlooked some if its key provisions. Why the haste? My guess is to prevent the chain of counter-party obligations from unraveling. Bear Stearns is holding $13.4 trillion (with a 't') worth of derivatives on its books. In addition their are the CDS contracts written on Bear itself. Had Bear failed, it would have caused two issues:

1. $13.4 trillion in derivatives cannot be honored with $80 billion in equity. Anyone exposed to Bear would have found themselves holding the short end of the stick. Besides the lawsuits, the write-downs would have been immense. The system simply cannot handle write downs on that magnitude. It would have seized up all markets and caused the contagion everyone fears.
   
2. The CDS contracts on Bear are worthless protection. Unfortunately I couldn't find numbers for Bear, but the notional on the CDS contracts of Bear, I am guessing, far exceeds its traded debt (look at the example of GM, with $1 trillion in CDS and $15 billion in traded debt). Anyone writing these contracts cannot possibly be hedged as the sizes of the two markets are completely out of sync. Anyone attempting to collect on Bear CDS's would find themselves facing an insolvent counter-party. Compound this with the fact that many of the CDS contracts themselves are not clearly defined. Even if the counter-party is solvent, one may not be able to collect due to technicalities in the contract itself. All in all, it appears to be the case that CDS contracts are written to be traded, but never collected on. One can profit from widening or tightening spreads, but not actual default. Had Bear gone under, the myth of CDS insurance would have been shattered.
   

These two scenarios are not either/or cases. Both would have likely transpired. Either one would have caused a systemic crisis that could have frozen all markets. This was successfully averted (postponed?) by the Fed.

Credible Signals and Nationalizing Insolvency

There are three credible signals that one can infer from the Fed's actions:

1. The markets cannot sustain a major failure. The unraveling of the counter-party claims should a major investment bank fail will create the systemic crisis that everyone fears. A cursory look at the CDS market itself with a notional of $45 trillion should raise some concerns. There is a clear possibility of severe contagion. But this observation is nothing new. Warren Buffet has gone on record dubbing credit derivatives "weapons of mass financial destruction". However, it is good that the Fed has finally come out and admitted it.
2. Bear is insolvent or near insolvent. What is not mentioned in the articles I linked to earlier is that JP Morgan itself is holding $77 trillion in derivatives contracts. Pooling Bear's derivatives with JP Morgans, paints the Fed's actions in an interesting new light. Recall that the $30 billion non-recourse loan was collateralized by the lowest tranche on Bear's mortgage debt. Bear claims that its book value is closer to $80 per share. Apparently, JP Morgan affirmed that in a conference call. However, actions speak louder than words. Even with the new offer, the Fed is still in for $29 billion in non-recourse loans. Bear is levered through the roof on assets that have more write-down to come. If even a small fraction of the "level 3" assets are sold, the losses could be staggering. The banks know this and are eager to prevent such a situation from arising. This deal is a clear indication that Bear is insolvent and that the "level 3" debt held on all books across the street is due for a significant revaluation.
   
3. They will nationalize to prevent insolvency. I refrain from speculating too much in the absence of any concrete moves to this effect, but, with the TSLF and PDCF, as well as the changes to Fannie Mae and Freddie Mac, both the Fed and Congress are signaling that they will take large steps to prevent a systemic crisis from firmly taking hold. They will nationalize if necessary, thereby socializing the fallout and bailing out the banks at the tax payers expense. As I predicted in a previous article, they have now expanded the acceptable collateral for the TSLF. Some commentators have questioned whether this is covert nationalization. Again, I don't wish to speculate, but I will say that barring nationalization of all the "toxic waste" in the system, I don't see how -- since the issue is solvency, not liquidity -- the market can navigate the storm that would result from a major investment bank failing.
   

It remains to be seen how this plays out...

(Some trivia: there's a rumor going around that Citadel was negotiating terms for a loan with Bear prior to the collapse, realized that Bear was in trouble, and shorted the stock for a nice 1 day gain.)