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Part of the Problem
Given that Bear held trading contracts with an outstanding value of $2.5 trillion with firms around the world, "we were talking about the possibility of a global run on the bank."
Bear had a hand in a whopping $10 trillion worth of transactions, by some estimates.
Bear Stearns had total positions of $13.4 trillion.
Posted by Alex Tabarrok on April 3, 2008 at 07:10 AM in Current Affairs, Data Source, Economics | Permalink
Comments
Unfortunately lost in these gigantic numbers are the risk mitigating factors written
into most trades. ISDA documentation provides for the netting of positions across
derivative products, the ability to cancel negative mark to markets in case of
counterparty default, and makes any remaining claims pari passu to other creditors.
Most counterpartys of Bear also have credit portfolio groups that charge desks a fee for
doing a trade and, supposedly, hedge the firm's exposure.
I am not sure how effective these mechnanisms would have proven in a financial crunch,
but I do think its a bit misleading to quote these statistics without keeping this
in mind.
Posted by: BML at Apr 3, 2008 7:51:42 AM
BML,
The problem is in bankruptcy proceedings even if the positions do net cancel who the hell knows how the legal system will treat them. Say Bear has outstanding positions 6.7 trillion net short on swaps and 6.67 trillion net long on swaps. Its over-simplified, but this shouldn't be an unusual characterization of a trading houses, most of those "positions" are really just Bear selling offsetting positions to two people and being the intermediary. They even had a motto they told people working there "We're a moving company, not a storage company."
Anyway in the event of insolvency that position should only result in 30 billion in losses, but here's the kicker once you go into Chapter 11 some judge has very complete and highly arbitrary power to decide who gets paid off and who doesn't. The optimal thing to do would just be to agree to distribute the losses evenly among the position holders, then you're only talking about a very small percent loss in value. However we all know that would never happen, all of the position holders would all lawyer up and go to battle and the money will be tied up for years in court with massive loss due to fees.
Its really a prisoner's dilemma if you're a counter-party to a bankrupt bank the best thing would be for everyone to just agree to efficiently split the losses. However if you know the other counter-parties are going to lawyer up then you will have to lawyer up to or else they might take all your money.
Posted by: Douglas Colkitt at Apr 3, 2008 10:35:03 AM
I just read Ender's Game for the first time, because it seemed to be on top of everyone's "Best Sci-Fi" list, and I had never read it.
What a HUUUUUGE disappointment. It was just a a big Mary Sue story. One boy overcomes many woes by himself, and is -- by himself -- smarter (in every way) than every single individual in the military, and doesn't need to learn anything from anybody.
Total and complete dreck.
Posted by: Rich B. at Apr 3, 2008 11:00:38 AM
I want to second Douglas Colkitt's sentiment. Bankruptcy court is simply not set up to rationally handle a bankrupt investment bank.
For all those people who seem to think that we need new regulations because of "the financial crisis" (for lack of a better phrase), I strongly suggest setting up provisions for a competent financial adjudicator in bankruptcy of a company such as BSC in the future.
If this could be done in a credible manner trusted by creditors, one might not even have a "run on the bank" similar to what happened to BSC in the first place. I don't know how realistic it is to come up with such a system, but I do know that different countries (such as the UK) have very different methods that are tried and true for handling bankruptcy that might work better for a financial company than some lawyer/judge who doesn't really have the qualifications to handle a BSC bankruptcy.
Posted by: happyjuggler0 at Apr 3, 2008 11:57:52 AM
To follow up on my bankruptcy adjudicator idea, in the example of BSC what could happen is that BSC would declare bankruptcy.
The financially trained adjudicator would then be in charge of an operating company assuming it had a positive cash flow as an operating entity. Otherwise the company would operate strictly for the purpose of liquidation.
The operating terms would be: 1) "Old credit", i.e. prebankruptcy credit, would be divvied up proportionately instead of via seniority. 2) "New credit", i.e. credit issued to the formally bankrupt BSC entity, would be guaranteed by the Fed. For clarification the Fed wouldn't guarantee any prebankruptcy obligations.
Part 1 is important to discourage runs on an investment bank that seems to have enough capital to cover an orderly unwinding of its assets.
Part 2 is important for the ability of the new BSC entity to actually have counterparties willing to take the other side of a trade as BSC unwinds its positions.
For the Fed's backstopping of bankruptcy liquidation, it receives any equity left over once creditors are paid off, or once the company is sold off to a third party at a reasonable market price once it had sufficiently deleveraged. The original BSC shareholders would get exactly $0 upon filing bankruptcy, regardless of how much the company is worth after deleveraging under Fed backstopping.
This whole idea is designed to avoid what actually happened, namely the Fed being on the hook for $29 billion of assets of unknown quality, and where BSC's shareholders come out with perhaps $10 per share of equity (I want $0 for moral hazard reasons), and where original creditors possibly come out with on 95 cents on the dollar (or whatever), thus avoiding moral hazard on the creditor end.
Finally, this might reduce scenarios where companies undergo a bank run.
Posted by: happyjuggler0 at Apr 3, 2008 12:20:54 PM
My experiences as a creditor in bankruptcy court have taught me that you can lawyer up all you like and bicker over valuations and call the other parties every name in the book. But once the gavel falls, you're getting what the judge says you're getting and that's the end of it.
Posted by: spongeworthy at Apr 3, 2008 1:58:50 PM
Ender's Game is full of things that would only work once, it's like writing a book about a guy who invents circle-strafing in Doom or brings a rogue deck to a Magic tournament. Still a great read though, just gave my friend a copy this year.
Posted by: Noumenon at Apr 3, 2008 2:29:52 PM
"Ender's Game is full of things that would only work once, it's like writing a book about a guy who invents circle-strafing in Doom or brings a rogue deck to a Magic tournament. Still a great read though, just gave my friend a copy this year."
That gets my vote as the nerdiest comment ever written on this blog. Excellent work.
Posted by: Matt at Apr 3, 2008 4:37:47 PM
The "trillions" of notional amounts are silly - an economics professor posted this?
Daily margining with zero thresholding of all positions in a clearing house for derivatives is the way forward.
Posted by: Mesa at Apr 3, 2008 6:38:43 PM
happyjuggler -- for all practical purposes isn't JP Morgan serving exactly the same function as the adjudicator you propose creating? The big difference is that the market will end up valuing all that bad paper rather then some government official.
Posted by: spencer at Apr 3, 2008 8:49:29 PM
Where were all these people during the Savings and Loan crises? Then there were worthless mortagages on overvalued real estate that led to the elimination, for the most part, of the entire Savings and Loan inductry. If you take a bunch of worthless mortgages and bundle them they become a worthless bundle of paper. Are there no adults on Wall Street?
Posted by: WS Grizzard, MD at Apr 3, 2008 8:56:46 PM
Spencer,
For the purpose of avoiding a third party meltdown leading potentially, and realisticly to a depression, what the Fed actually engineered works.
However I have several problems with the status quo regarding BSC. First, the shareholders have equity. To be sure it is a lot lower than the $30 that they thought they had Friday the 14th, and far less than they had about a year ago. Not to be cruel, but I want them to have $0 for their part in bringing us to the brink of disaster, and to hammer away at those thinking heads I win, tails you lose.
Second, similarly the creditors to BSC essentially are assured of coming out whole. While it is true under my scenario that BSC creditors would also come out whole, I'd be happier if it was clear that the Fed won't bail out creditors either, merely the system. My proposal bails out the system, and maybe the creditors too, but maybe they only get 95 cents or so on the dollar in some situations. No more heads I win, tails you lose.
Third, my scenario tends to reduce runs on investment banks, or at least in my mind it does, thanks to assurance of their money not being tied up in bankruptcy court under someone who trained as a lawyer and who is in over his head.
Fourth, while the Fed would be backstopping the credits issued under the workout, the risk would be virtually nada as the risk would basically be limited to clearinghouse functions. One could even make the Fed the senior creditor to the old assets now that I think of it, meaning zero credit risk for taxpayers.
In essence the libertarian in me is horrified by the federal government rescues that comes every 7 to 10 years. This restructuring of the financial company bankruptcy system essentially makes bankruptcy a viable option from the point of third party risk. All without sweaty all night (or weekend) sessions devoted to desperately saving us all from a depression thanks to an investment bank that didn't want to deleverage via "diluting" shareholder equity.
Posted by: happyjuggler0 at Apr 3, 2008 9:13:05 PM
One more thing to my 9:13pm post:
Under what happened to BSC, the Fed, and by extension the taxpayers, are on the hook for some fraction of $29 billion dollars. Maybe the Fed will make a profit, and maybe it will post a loss.
Unfortunately we have no idea of knowing what the $30 billion special LLC holds, the Fed made clear today that they don't want the public to know. My guess is mortgage backed securities from Fannie Mae and Frddie Mac, with perhaps some Thornburg jumbo mortgage paper too. Stuff like that.
If I'm right then I suspect that at this point it will turn out to be a profit over the ten years or less it takes to unwind that $30 position. However I still don't think the US government, or any of its arms or quasi-arms, should be in the business of owning assets at all, let alone distressed assets that someone like jamie Dimon doesn't want on his books. Although I do think he made a good case that he didn't want to be too leveraged today during the hearings, even if he he pretty lame in explaining that point.
Posted by: happyjuggler0 at Apr 3, 2008 9:30:13 PM
One aspect of the credit derivatives market is that people can go net short another entities debt. One would think that people would be hedging, but once you create the market, it is as easy to use for speculation as hedging.
The other thing about credit derivatives is that unlike a short sale on an exchange, you don't have to borrow the securities. You just buy 'protection' on the reference debt entity.
It is likely that there was significant activity on Bear CDS's for hedging purposes. It is also popular that people (hedge funds) jumped in heavily and bought protection on BSC debt as a speculation that the firm would fail.
By keeping BSC out of BK, the debt holders are protected. If someone owned BSC debt and were hedged by CDS's then they are indifferent. But, if they were buying credit protection as a speculation, they are out of luck. The firm has disintegrated, just as they bet -- but the debt didn't default, so the CDS's are no longer going to pay out.
They could have shorted the stock, but the entire market Cap of BSC was under $10 billion, and by Friday, maybe $3 billion. They could have owned many times this in CDS's. But we won't know, since the markets are unregulated. The same people that could have bought the speculative CDS's could have been starting rumors, and maybe pulling business etc. Sort of like George Soros concept of reflexivity. Or maybe more like buying life insurance on a stranger and then walking into their hospital room and pulling the plug.
I don't know if anything like this happened, but I would be glad if it were true.
Posted by: Ziggurat at Apr 3, 2008 9:57:37 PM
One other little detail on the JPM/BSC deal. The handout at the press conference mentioned $6 billion in transition costs.
Included on this list was something called 'conforming accounting'. I don't know what this is, but it is possible (likely?) that on all trades between the firms that *should* net to zero, the net of the booked marks was a positive number. That is, on a given transaction, BSC booked +10m and JPM booked -9m. Over all transactions, if these systems worked perfectly, the marks would net to $0. If the errors were evenly distributed around $0, then the net differences would be small, since they had a lot of business.
However, I think its likely that there is always a bias toward booking losses more slowly then gains, so when everything netted out, there was an extra billion of profits booked. Who knows.
Extrapolating over all credit derivatives, a small error over trillions is a big number. And how would we ever know? Other then the come to Jesus moment where things that 'should' net are actually netted via a takeover.
Posted by: Ziggurat at Apr 3, 2008 10:08:24 PM
"Total and complete dreck."
Yes!
Posted by: zak822 at Apr 4, 2008 3:44:36 PM
