Continue on the Bear Stearns Debacle
In my last week’s post, I have cited the article, “On the brink of disaster”, from Fortune
Bear had about $13 trillion of derivatives deals with counterparties, according to its most recent financial filings. If Bear had croaked, large parts of the world could have croaked. And the economic damage could have been catastrophic.
Why is that? The secret has been uncovered by MARTIN MAYER on this week’s Barron’s in the article “The Fed Has Power, but No Will”.
In the OTC (over-the-counter) derivatives market, people who want to get out of their previous trades have to offset the obligations of that trade by creating a new instrument with a new counterparty. Take a credit-default swap, by which each party guarantees to accept the payout on a debt instrument held by the other party. It’s an insurance instrument, with some differences: The holder of the insured instrument can sell it, and the new owner becomes the beneficiary of the insurance. And the insurer may find someone who will accept a lower premium to take the burden of the insurance, allowing him to lay off his risk at an immediate profit.
The one trade thus generates two new instruments, with four new counterparties, and as the daisy chain of reinsurance expands, the numbers become ridiculous: $41 trillion face value of credit-default swaps.
BEAR STEARNS APPARENTLY had created trillions of dollars of positions this way, which is why it had to be kept in business. Once you begin to remove individual flower girls from the daisy chain of credit swaps, you don’t know who will wind up with obligations they thought they had insured against and they can’t meet. Suddenly, all counterparties for all sorts of trade become suspect. We should note in passing that the big beneficiaries of the Fed’s action on Bear Stearns were the sellers of credit derivatives insuring Bear’s obligations. The counterparties’ paper had been worth very little on Thursday night and quite a lot on Sunday afternoon.
Wow, that’s a whopping $41 trillion. Obviously, the Fed was pushed to the corner when facing a collapsing Bear. The bailout prevented the Domino effect from happening in the global financial market. Unfortunately, the buyout story doesn’t stop here. Another piece of interesting fact was revealed by Bill Cara at “Investment Banks and the Fed”
Which investment bank is widely believed to be the next weakest on Wall Street, after Bear Stearns? It is Lehman Brothers (LEH). Lehman Brothers sits on the Board of Directors of the Federal Reserve Bank of New York.
As I understand it, the Federal Bank of New York has, in the past month or so since the latest lending facility was created by the Board, lent almost $200 billion (about half its balance sheet, which used to be fully liquid and hence a tool for monetary policy) to Bear Stearns and Lehman Brothers, accepting in return illiquid securities, the very type that almost crashed Bear Stearns when no other bank would buy or lend against them.
Yap, Morale Hazard could be a good companion for activism by government. More interestingly, FDIC Chairwoman calls for activism:
Federal Deposit Insurance Corp. Chairwoman Sheila Bair said Monday policy makers needed to consider a more “activist” government response to prevent an escalation of foreclosures even if such measures aren’t “politically popular.”
……
“We’ve got a real problem. And I do think we need to have more activist approaches. And I think it will be something we need to be honest with the American public about. We do need more intervention. It probably will cost some money.”
The funny part is that “it probably will cost some money” from taxpayers, on top of weak dollar, high energy cost, and a bubble-popping real estate market. Oh well, the ride will be bumpy down the road.
