Anatomy of a coup: Part 1, Thursday
All right, Colonel. Let’s sum it up, shall we? You’re suggesting what?
I’m not sure, Mr. President: just some possibilities, what we call, uh “capabilities” in military intelligence…
You got something against the English language, Colonel?
I’m suggesting, Mr. President, there’s a military plot to take over the government. This may occur some time this coming Sunday.
Countdown stories make great suspense, which is why Seven Days in May and Three Days of the Condor are among the best political thrillers going. But with the rapidly increasing pace of information and finance – which are, by the way, two attributes of the same element [Topic worthy of a blog post – Ed.] – the Feiler Faster Thesis means that financial crises can be whipped up with the speed of a flash mob.
I went to the stock market …
And a pie fight broke out
A while back, I posted in Banking on value, the explanation, an expanded followup to my history-as-it-happens post Banking on value, which pointed readers to a monthly essay I write called State of the Market:
whose most recent issue deals with this topic in depth:
The financial coup of the new century
The revolution that occurred over the Saint Patrick’s Day weekend of March 15-16 was quiet, swift, and decisive – so much so that even today the major media do not realize just what’s happened.
To secure financial liberty, we have to take a financial risk
In funding JPMorgan’s hasty adoption of Bear Stearns and backstopping the major banks, the Federal Reserve (with the support of four other global central bankers) called a halt to the runaway markdowns plaguing our industry, by allowing the beleaguered institutions to pledge – not sell – their complex if illiquid assets in exchange for cheap short-term Federal cash.
In so doing, the Fed’s move changes the rules for every major institution in ways that will permeate all asset classes, including residential rental.
Technically oriented readers or practitioners are urged to read the whole thing.
How permanent revolutionary change in global banking was wrought over one long weekend, and described in gripping detail in the Congressional testimony offered by Timothy F. Geithner, CEO of the Federal Reserve Bank of New York. We can call it Three Days to Meltdown, the St. Patrick’s Day Coup, or Anatomy of a coup:
Don’t worry, it has a happy ending
Reading over the testimony and reconstructing the events, I found myself caught up in the suspense. Personally, I think it was brilliant — coup as in masterstroke, not coup as in overthrow – but either way, a coup it indubitably was.
But first, let’s set the scene, a crisis that’s been building for a decade:
The intensity of the crisis we now face in
Considerable growth in leverage
Greater reliance on ratings on structured credit products, and
A marked deterioration in underwriting standards.
These three things are worked to reinforce each other. Higher leverage came of the false confidence that ratings were accurate. Handing the risk onward to someone who understood nothing but the label encouraged declining underwriting standards.
The innovation in financial products was accompanied by a dramatic increase in the amount of financial intermediation occurring outside the core banking system. The importance of securities broker-dealers, hedge funds, and mutual funds in the financial system rose steadily.
Off-balance-sheet vehicles of various forms proliferated, and increased concentrations of longer-dated assets were held in funding vehicles with substantial liquidity risk.
Risky? What’s risky?
Over the past 30 years, we have moved from a bank-dominated financial system to a system in which credit is increasingly extended, securitized and actively traded in a combination of centralized and decentralized markets. In many ways, the business models of banks and non-bank financial institutions—especially large securities firms—have converged, with banks playing a greater agency role in the credit process, and securities firms doing more of the financing.
Because depositors losing their life’s savings in a bank failure is too systemically catastrophic to be allowed to occur, deposit-taking institutions have been underpinned with federal insurance that brings with it strong regulation. Yet investment banks and merchant banks — basically, any financial institution that gets its money from the capital markets – are not regulated in the same way. Until recently – say, the last decade – the potential for investment banks to do global ecosystemic harm was limited because the sums they had in play were largely dependent on their capital base. Massive though their failures could be in isolation, by themselves no one failure put the whole global credit markets at risk.
Ah, but things are so much better now
Then came Long-term Capital, and we discovered that you could bet 100x your net worth through complicated matching strategies labeled ‘hedges’ (as in ‘hedging your bet’) that were good only as long as reality stayed within three standard deviations of normality.
Fully hedged, fully comprehensible
Except that hedge-fund private equity moved out of its small areas and became an ever-larger force in the capital markets …
Part of the dynamic at work was that banks were forced to provide financing for—or take over—the assets in a range of structured investment vehicles and conduits financed by asset-backed commercial paper. As some investors attempted to liquidate their holdings of these assets, many of the traditional providers of unsecured funding to banks pulled back from their counterparties in anticipation of the potential withdrawals of funds by their own investors.
Banks were funding themselves at shorter and shorter maturities. As unsecured term funding markets deteriorated, the premium on liquid, marketable collateral—such as Treasury securities—rose considerably.
The machine was running at higher RPM’s, with ever-smaller margins for error or hiccups.
Are those diaphragm spasms, or Latin exercises? You decide!
Thursday, March 13, 2008
Let me begin with the market situation in which Bear was operating in the days leading up to March 13. Fixed income traders had begun hearing rumors that European financial institutions had stopped doing fixed income trades with Bear.
Credit is based on confidence. Speed fuels rumor. Electronic speed makes the world’s trading desks a single global village.
Fearing that their funds might be frozen if Bear wound up in bankruptcy, a number of U.S.-based fixed-income and stock traders that had been actively involved with Bear had reportedly decided to halt such involvement.
That’s always the trick with Greater-Fool theories of investing: you have to be the G-1 Fool.
That’s what Greater Fools always hope
Many firms started pulling back from doing business with Bear. Some hedge funds that had used Bear to borrow money and clear trades were withdrawing cash from their accounts. Some large investment banks stopped accepting trades that would expose them to Bear, and some money market funds reduced their holdings of short-term Bear-issued debt.
Unfortunately, everybody thought he could be the G-1 Fool.
The rumors of Bear’s failing financial health caused its balance of unencumbered liquidity on March 13 to decline sharply to levels that were not adequate to cover maturing obligations and funds that could be withdrawn freely.
The game begins:
On the evening of Thursday, March 13, 2008, I took part in a conference call with representatives from the Securities and Exchange Commission, the Board of Governors of the Federal Reserve, and the Treasury Department.
Risk of bankruptcy? Is that a bad thing?
On that call, the SEC staff informed us that Bear Stearns’ funding resources were inadequate to meet its obligations and that the firm had concluded that it would have to file for bankruptcy protection the next morning. The SEC said it concurred in that judgment, and it would spend the evening discussing with Bear what kind of bankruptcy filing was appropriate.
Going totally broke, ages 8 and up!
What’s so remarkable is that Bear, a major firm, with potentially vast resources, found itself suddenly, instantly, out of cash. That’s when Chapter 11 is called ‘insolvency’ – the firm is not necessarily destitute, not necessarily lacking in net worth, but it lacks the liquidity to meet its obligations in the ordinary course of business.
What we were observing in
Asset price declines—triggered by concern about the outlook for economic performance—led to a reduction in the willingness to bear risk and to margin calls.
Borrowers needed to sell assets to meet the calls; some highly leveraged firms were unable to meet their obligations and their counterparties responded by liquidating the collateral they held. This put downward pressure on asset prices and increased price volatility.
Dealers raised margins further to compensate for heightened volatility and reduced liquidity. This, in turn, put more pressure on other leveraged investors.
A self-reinforcing downward spiral of higher haircuts forced sales, lower prices, higher volatility, and still lower prices.
It ends with insolvency
The news that Bear’s liquidity position was so dire that a bankruptcy filing was imminent presented us with a very difficult set of policy judgments.
One must admire both Mr. Geithner’s sang-froid and his understatement.
In our financial system, the market sorts out which companies survive and which fail. However, under the circumstances prevailing in the markets the issues raised in this specific instance extended well beyond the fate of one company.
It became clear that Bear’s involvement in the complex and intricate web of relationships that characterize our financial system, at a point in time when markets were especially vulnerable, was such that a sudden failure would likely lead to a chaotic unwinding of positions in already damaged markets. Moreover, a failure by Bear to meet its obligations would have cast a cloud of doubt on the financial position of other institutions whose business models bore some superficial similarity to Bear’s, without due regard for the fundamental soundness of those firms.
In On Her Majesty’s Secret Service, James Bond plays the cigarette game with a bevy of beauties at Blofeld’s mountaintop ski chalet. Dip a glass in water, then stretch a paper napkin over it so the surface is drum tight, and drop a dime in the middle. Now start touching a lighted cigarette tip to the napkin, one player at a time, each burning a small spot on the napkin. Whoever drops the dime loses.
Whoever drops the dime, loses me
A game something of this sort had been played for months and years. Bear’s bankruptcy would be the strand whose breaking dropped the global dime.
[Continued tomorrow in Part 2.]
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