April 7, 2008
Bear Stearns Customers Were Not at Risk
Thursday's Senate Banking Committee hearing regarding the Fed's involvement in the purchase of Bear Stearns by J.P. Morgan was somewhat enlightening, but also disturbing. Probably the most important and responsible statements came from Christopher Cox, the head of the Securities and Exchange Commission, who correctly noted that "Despite the run on the bank to which Bear Stearns was subjected, its customers were fully protected." Cox continued "At no time during the week of March 10th through the 17th were any of the customers of the Bear Stearns' broker-dealers at risk of losing their cash or their securities."
Cox also clarified the distinction between capital (a solvency buffer) and liquidity, noting that SEC regulations are designed to ensure the adequacy of both. But he noted that the surprise in the Bear Stearns case - not well covered by existing regulations - was the unforeseen possibility that the markets would be unwilling to provide capital that was fully collateralized even by Treasury securities and the mortgage securities of government sponsored entities like Fannie Mae.
My impression is that this is exactly the situation in which the Fed has an important role - the short-term provision of liquidity against government-backed collateral. The Fed always had the ability to provide funds to Bear Stearns, fully collateralized by Treasury and agency securities of the type and quality regularly accepted by the Fed, with the expectation of being made entirely whole even in the event that Bear Stearns went bankrupt.
The troubling aspect of the Fed's action was not that it lent to a non-bank entity. That ability is clearly authorized by Section 13(3) of the Federal Reserve Act. The problem is that it made its "loans" as "non-recourse" funding - meaning that it would not stand to be repaid if the collateral itself was to fail, even if Bear Stearns and J.P. Morgan survived. This feature converted the "loans" by the Fed into unauthorized "put options," benefiting private entities at potential public expense. This is a terrible precedent, and it deserves far more scrutiny and reluctance before we accept that this was the only available option.
Another troubling aspect was that shortly after making an initial non-recourse loan to Bear Stearns, and indicating the funds would be available for "as much as 28 days," the Fed pulled the funding over the weekend. By doing so, the Fed itself forced the de facto collapse of Bear Stearns.
Bear Stearns' CEO Alan Schwartz testified "We believed at the time that the loan and corresponding back-stop from the New York Fed would be available for 28 days. We hoped this period would be sufficient to bring order to the chaos and allow us to secure more permanent funding or an orderly disposition of assets to raise cash, if that became necessary."
As the New York Times summarized, "by the end of the day, with continuing problems surfacing and the downgrading of the firm's credit rating, he said he was told by the Federal Reserve of New York that he had misunderstood the terms of the deal. He was told that the loan would expire on Sunday, and that he had to find a buyer for the bank by then — before the Asian markets opened. The decision, Mr. Schwartz testified, left him with no negotiating leverage as talks proceeded with JPMorgan.
"On Friday night, we learned that the JPMorgan credit facility would not be available beyond Sunday night," Mr. Schwartz said. "The choices we faced that Friday night were stark: find a party willing to acquire Bear Stearns by Sunday night, or face what my advisers were telling me could be a bankruptcy filing on Monday morning, which could likely wipe out our shareholders and cause losses for certain of our creditors and all of our employees."
Note that Schwartz didn't say "losses for our customers and counterparties." He didn't, because he couldn't. As SEC Chairman Cox noted previously, there was never a point where Bear's customers and counterparties were at risk.
What's in that $30 billion "portfolio"?
The odd secrecy and vague description of the portfolio of assets held by the Fed is, let's say, curious. On what might be called the "bright side," evidently, a good portion of the collateral taken by the Fed in the Bear Stearns deal represents government mortgage obligations, including those of Fannie Mae and Freddie Mac. The portfolio also includes non-agency securities rated BBB- or higher among its "cash assets." The characterization of these as "investment grade" is not reassuring, given that many such structured mortgage securities maintain such ratings only because of bond insurance from companies that are themselves increasingly in question.
More troublesome is the part of the portfolio described as "related hedges." The question here is that the net value of a so-called "portfolio" might be $30 billion, but the gross or "notional" value of the portfolio can conceivably be a substantial multiple of that. If you own $100 billion in assets, but have $70 billion in offsetting liabilities against that, then sure, you've got a portfolio "worth" $30 billion, but as Long-Term Capital Management discovered, you could end up losing a whole lot more than $30 billion, depending on how well those assets and "hedges" offset. The description is just unclear - I would be a lot more comfortable about this if we were assured that the total notional value of the portfolio held by the Fed does not exceed $30 billion. We should also know what portion of that $30 billion represents strictly government agency obligations. That would clarify how large the maximum potential loss might be on this portfolio of "cash assets and related hedges."
If the collateral was just a plain vanilla portfolio of securities, literally the only reason for the Fed to do the "non-recourse" loan would be to protect Bear Stearns' bondholders from losses, since J.P. Morgan was willing to assume all customer accounts and counterparty liabilities of Bear Stearns, plus over $75 billion in debt obligations to Bear Stearns bondholders, yet needed only $30 billion of Federal assurances to do it.
Think of Bear Stearns' assets as being divided into two boxes. One box holds $45 billion worth of valuable customer relationships (the actual customer securities are segregated and are not at risk even if the company fails) and a "book" of investment positions and transactions, including claims and obligations to counterparties. In the other box is either $30 billion in mortgage-backed securities, or a pile of packing peanuts. The only thing not in one of those two boxes is a $75 billion liability to Bear Stearns own bondholders (we'll assume that shareholder equity has already been wiped out). How much would an acquirer pay? Well, if you were J.P. Morgan, you would say: I'll take the $45 billion worth of known, valuable stuff, and the Fed can have the mystery box in return for $30 billion. That gives me $75 billion in assets. I'll also take on the $75 billion in Bear Stearns debt. And of course, since the assets I'm getting are worth the same as the liabilities, I'm going to pay essentially nothing for the deal. If you were Ben Bernanke, you would say, "I can't lose! I love packing peanuts!" This is the deal that was actually struck.
But why didn't J.P. Morgan say: I'll take the $45 billion of valuable stuff, and the mystery box. In that case, even if J.P. Morgan thought the box contained packing peanuts, it would still have been willing to pay a minimum of $45 billion for those boxes, provided it did not take on any of the debt to Bear Stearns bondholders. Customers and counterparties would have been protected, and despite "technical" default for Bear Stearns' bonds, there would have been enough to pay at least 60%, and possibly 100% of bondholder claims, without the need for public funds. In this case, if you were Ben Bernanke, you could have said, fine, we'll stand behind that deal and provide a loan of $30 billion, or even $45 billion in medium-term liquidity to facilitate that outcome. But you, J.P. Morgan, the bank, will have to put up Treasury and government agency collateral, and assume all risk of the deal. The Fed's only risk, in that case, would have been the risk that J.P. Morgan itself would default. Instead, Bernanke's actual response was apparently "Nope! I want a shot at those packing peanuts! And we ought to be using public funds to bail out Bear Stearns' bondholders!" So that's what they did.
In any event, the markets do not care about Bear Stearns' stockholders or its bondholders. The only thing they care about is that J.P. Morgan is willing to stand behind all the customer accounts and counterparty obligations of Bear Stearns. That commitment could have been achieved without the commitment of public funds, because the value of that book was unquestionably positive. As I noted last week, Title IX of the 2005 Bankruptcy Act includes expanded provisions for the rapid transfer and netting of derivatives and over-the-counter obligations of the sort to which Bear Stearns was a party. Current law does not allow broker-dealers to cherry pick counterparties that owe them, and default on counterparties that are owed. There was no risk of a long delay or "automatic stay" even if Bear had nominally defaulted on its bonds.
As for actions that might have prevented Bear's sudden collapse, Timothy Geithner, the president of the Federal Reserve Bank of New York, indicated that the Fed had not made funds available to Bear earlier in the week, saying "I would not have been comfortable lending to Bear at that time. We only lend to sound institutions. Lending freely to Bear would not have been a prudent act." Evidently it was prudent to commit $30 billion in public funds without the assurance of being made whole.
On Friday, former Fed official Robert McTeer gave high marks to Geithner on CNBC for his performance during the Senate hearing. Adding to the impression that the hearings had not been entirely illuminating, McTeer's praise included an odd compliment that Geithner had "answered the questions that he answered very well, and he dodged some questions very beautifully too, and he got away with it."
Among those was a question by the Committee to the effect that while it was clear that Bear Stearns' shareholders had not been "bailed out," the same could not be said for Bear Stearns' bondholders - didn't this send a signal to the credit markets that could encourage excessive risk taking in the belief that the government stood behind the bonds of private companies? Geithner gave a general response that credit spreads among financial companies remained relatively wide, so the market had not been provided with that sort of confidence. There was no follow-up question.
The Senate Banking Committee never put two and two together that the primary beneficiaries of the Fed's action had been Bear Stearns' bondholders, while Bear's customers were never at risk.
The upshot is that the Fed could have provided early, fully-collateralized liquidity to Bear Stearns, but failed to do so. It then provided emergency funding to Bear Stearns as a "non-recourse" loan, but promptly called in those funds over the weekend, forcing Bear Stearns into a corner. Though customers and counterparties were never at risk of loss, Bear Stearns feared for its own shareholders, its bondholders and its employees. The Federal Reserve could have provided Bear with short-term, fully collateralized funds through the weekend, allowing Bear Stearns more bargaining time, but instead, it provided public funds in return for a long-term investment in questionable collateral to finance a private transaction between Bear Stearns and J.P. Morgan. The effect of this public guarantee was to defend the value of a private company's bonds.
But we're all OK with this, I guess, so barring any substantial new developments, this is the last I'll write extensively about it.
In any event, SEC Chairman Cox is right - Bear Stearns' customers and counterparties were never at risk of loss. Though counterparties don't have the SIPC protections, they did in the Bear Stearns instance have a substantial capital wall and legal safe harbors specifically designed to limit systemic problems. There was a willing buyer for Bear's entire book, so the book didn't need to be unwound, just sold in its entirety on day one. Major U.S. financial companies have enough capital (shareholder equity and bondholder debt) to provide a cushion in the event of substantial writeoffs, without customers or counterparties being at risk of loss in the event of outright bankruptcy. The only instance where there would be a question would be if the book value of the failing company was negative after entirely zeroing out all shareholder equity and bondholder debt, or if the only way to liquidate the book was to unwind it. That was not the case for Bear Stearns.
As I said a couple of weeks ago, if we keep on believing that the default of Bear Stearns bonds ("bankruptcy") would have caused a global financial crash, then I expect that we are in for a global financial crash anyway. Not because there is any true risk to customers and counterparties, but because investors are misinformed about how the financial markets work, and they will panic as foreclosures and writedowns inevitably soar in the months ahead. A financial panic is fully avoidable if Wall Street and the media stop propagating the utterly false belief that a Bear Stearns bankruptcy would have led to a "chain reaction" of financial losses. While we might very well see some over-leveraged firms go bankrupt, with substantial losses to their own stockholders and bondholders, the customers and counterparties are generally not at risk if there is enough stockholders equity and bondholder capital to eat through without leaving the remaining book value negative. Bankruptcy or no bankruptcy, the underlying book of assets and liabilities can be transferred quickly. The only question is how much the bondholders come away with. That "chain reaction" theory is just utterly irresponsible fearmongering.
Look. I would welcome lower stock market valuations because they would increase prospective long-term returns enough to accept a significant amount of market risk, but I have no desire to see the financial markets in distress. The U.S. economy will get through this, but the credit problems are not over. Even if they were, the U.S. stock market would still be vulnerable because the valuations of recent years have been based on unsustainably high profit margins. Unfortunately, profit margins are cyclical, and competitive forces bring them down over time. So even if investors are inclined to celebrate the Fed's intervention over the near term, it does not alter the broader risk to stock market values.
In short, stocks are still vulnerable, but there is no need for an outright financial panic, and no need to misuse public funds to benefit the bondholders of individual companies. I am very concerned that investors and even Congress have swallowed the "chain reaction" theory hook, line and sinker. The fact that they have makes me more concerned about crash risk, not less. In any event, it is wishful to believe that a $30 billion misuse of public funds has suddenly put problems of mortgage foreclosures, profit margin risks, rich valuations, and an oncoming (not outgoing) recession behind us.
As of last week, the Market Climate in stocks was characterized by unfavorable valuations and still unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance. Market action has been relatively good even in the face of poor employment numbers and upward revisions in job losses. Moreover, new claims for unemployment shot above 400,000 last week, as is characteristic of early recessions. The first chart on Bill Hester's recent piece (Recessions and the Duration of Bad News) provides a good picture of where the economy probably stands. New claims are an early, not late indicator of recessions. Counter to the assertions that the current job losses are simply a delayed reflection of a credit crisis that is now averted thanks to Uncle Ben, my impression is that the difficulties in the job market and in profit margins are early in the making.
Nonetheless, we'll respond to the evidence as it emerges. If market action improves, we would expect to reduce the short-call side of our hedges moderately. Unfortunately, valuations are still too rich to remove hedges outright, but lifting off a portion of the short calls would open up the potential to participate in any sustained speculative run. I use the word "speculative" because the elevated valuations suggest there is no compelling long-term "investment" merit in accepting market risk.
While we are willing to lift a moderate portion of our short calls if the recent improvement in market action broadens further, my guess (and it's presently only a guess) is that the market may be vulnerable to a steep break here. From the fact that I have an opinion on market direction, you can immediately infer that the market is either a) overbought in an unfavorable Market Climate, or b) oversold in a favorable Market Climate. At present, of course, the answer is a). Such conditions don't guarantee a market slide, but the average outcomes are not good. We are hedged and defensive here.
The only thing that would improve the current picture would be for the Market Climate itself to shift as a result improved market internals. In effect, further strength would tend to confirm and reinforce a speculative mood among investors. With earnings season upon us, a great deal will depend on guidance about coming quarters. This could be an Achilles' heel, but we'll take our evidence as it comes, and respond accordingly.
In bonds, the Market Climate remains characterized by unfavorable yield levels and relatively neutral yield trends. The StrategicTotal Return Fund continues to have an unusually short duration of about 1 year, largely in Treasury bills. The Fund also has just over 15% of assets in precious metals shares, where the Market Climate remains favorable. As I've noted before, at the point where real interest rates become positive and trend higher, we may observe a softening in commodities. Presently, we don't observe that, but it is important to keep in mind that the strength in commodities largely mirrors a persistent decline in U.S. real interest rates, and in the value of the U.S. dollar. As the downward pressure on real interest rates abates, so most probably will the upward pressure on commodity prices, particularly as measured in US dollars.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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