Anatomy of a coup: Part 3, Sunday
[Continued from yesterday’s Part 2 and Part 1.]
I know what Scott’s attitude on the restructuring is, what’s yours?
I agree with Scott, sir. I think we’re being played for suckers. But I think it’s really your business. Yours and the Treasury’s. You did it, and they agreed so, well, I don’t see how we can question it. I mean we can question it, but we can’t fight it. We shouldn’t, anyway.
So you stand by the Constitution?
Well, that’s what we got and I guess it’s worked pretty well so far. I sure don’t want to be the one to say we ought to change it.
Neither do I.
– Seven Days in May, Colonel Casey and the President, translated from milspeak into finspeak
On that long Saint Patrick’s Day weekend, as reported in the Congressional testimony offered by Timothy F. Geithner, CEO of the Federal Reserve Bank of New York, by Saturday night the Fed had agreed to lend JPMorgan $30 billion for it to buy a bundle of assets from Bear Stearns, which was a step toward giving Bear emergency liquidity — but even that would not necessarily be enough to keep Bear viable when the Asian markets opened Sunday night New York time.
More was needed.
Sunday, March 16, 2008
I may be wounded, but you shouldn’t be shaking hands over me yet
Bear, though severely wounded, wasn’t the problem in itself. The whole system needed a jolt of confidence.
Just pop the cap and take a big swig of confidence
Following the announcement on March 12 of the Term Securities Lending Facility, which allowed primary dealers to pledge a wider range of collateral in order to borrow Treasury securities, we had consulted with market participants on how to structure the auctions to maximize their potential benefits to market functioning. Those discussions yielded a number of helpful suggestions. In view of those suggestions, and after considering the greater risks to the financial system posed by the Bear situation, we were able to work quickly on a companion facility that would transmit liquidity to parts of the market where it could be most powerful.
This is what led the Board of Governors of the Federal Reserve System to approve the establishment of the Primary Dealer Credit Facility on March 16.
They met on Sunday, and on Sunday they underwrote $200 billion in new lending. Until this happened, I had no idea the governors had such power – did you?
Under Section 13(3) of the Federal Reserve Act, the Board of Governors is empowered to authorize a Federal Reserve Bank like the New York Fed to lend to a corporation, such as an investment bank, in extraordinary circumstances under which there is evidence that the corporation cannot “secure adequate credit accommodations from other banking institutions.”
The Board of Governors needed to make the statutory finding that the circumstances were exigent and extraordinary, and it did so, based on the situation prevailing in the financial markets and the distinct possibility that absent an assurance of liquidity to major investment banks the deterioration in financial conditions likely would have continued with substantial effects on the economy.
That, dear readers, is called guts.
Not that kind of guts
We recognized, of course, that the use of this legal authority was, in itself, an extraordinary step. At the same time, we were mindful that Congress included this lending power in the Federal Reserve Act for a reason, and it seemed irresponsible for us not to use that authority in this unique situation.
I have occasionally been involved with regulators who believe that capital reserves, held for ‘a rainy day,’ are never to be drawn on for any reason. You can imagine my reaction.
Just follow these simple instructions
Even with an agreement in place that might reduce the probability of a default by Bear, we decided that independent of that outcome, it was important to get assured liquidity to primary dealers by Monday morning, to address the accelerating process of deleveraging and tightening liquidity seen in the financial system.
Then there’s the morning-after remorse:
On Sunday morning, executives at JPMorgan Chase informed us that they had become significantly more concerned about the scale of the risk that Bear and its many affiliates had assumed. They were also concerned about the ability of JPMorgan Chase to absorb some of Bear’s trading portfolio, particularly given the uncertainty ahead about the ultimate scale of losses facing the financial system. In this context, we began to explore ways in which we could help facilitate a more orderly solution to the Bear situation.
Part of being a good partner is saying what you cannot do:
We did not have the authority to acquire an equity interest in either Bear or JPMorgan Chase,
Nor were we prepared to guarantee Bear’s very substantial obligations.
Another tip for negotiating: always distinguish “I can’t” from “I won’t” and never confuse the two. The Fed could not buy a stake in either company, and it would not nationalize bear by guaranteeing its obligations.
The Fed would lend its strongest possible credit to a strong credit, and the strong credit could buy the weak credit, but the Fed was neither going to lend to the weak credit nor buy a stake in it..
That, dear reader, is called prudence.
And the only feasible option for buying time would have required open ended financing by the Fed to Bear into an accelerating withdrawal by Bear’s customers and counterparties.
By agreeing to lend to JPMorgan, but not to step into JPMorgan’s shoes, the Fed stopped exactly where it should have. JPMorgan had to make the business decision that buying Bear was wise as a business matter.
On the evening of Sunday the 16th, I sent a letter to James Dimon, the CEO of JPMorgan Chase, to memorialize the fact that we had reached a preliminary agreement that the New York Fed would assist the acquisition with $30 billion in financing, with the understanding that the parties would continue working during the week towards a formal contract.
Mr. Geithner glides by JPMorgan’s decision to buy Bear, and the price at which Bear would be bought (which was originally $2 a share, then became $10 a share). The Fed let them decide on their own to get married, but gave its blessing:
We also provided regulatory approvals, including under Section 23A, to assist with the merger and a transitional period for phasing in the assets under our capital rules.
It’s your money to work out, my dears, but I give my blessing
The announcement of the agreement between Bear Stearns and JPMorgan Chase and the announcement of the Primary Dealer Credit Facility were finalized just before Asian markets opened on Sunday night, and the announcement of these actions helped avert the damage that would have accompanied default.
Aftermath
In
Alcohol may have been imbibed
the markets opened, and business carried on.
On Monday morning, March 17, the $13 billion back-to-back non-recourse loan through JPMorgan Chase to Bear was repaid to the Fed, with weekend interest of nearly $4 million.
The Primary Dealer Credit Facility was made available to the market.
The PDCF is the world-changing tool.
And at the request of and with the full cooperation of the SEC, examiners from the New York Fed were sent into the major investment banks to give the Federal Reserve the direct capacity to assess the financial condition of these institutions.
At the same time, several infirmities became evident in the agreement between JPMorgan and Bear during the week of March 17th that needed to be cured.
During the ensuing week, the by-now-completely-committed parties ironed out their wrinkles:
Let’s smooth out those wrinkled millions
All the parties shared an overriding common interest: to move toward a successful merger and avoid the situation in which they found themselves on March 14.
Negotiations between the two sets of counterparties proceeded almost immediately between the New York Fed and JPMorgan Chase on the one hand, and between JPMorgan Chase and Bear Stearns on the other. The New York Fed and JPMorgan discussed the details for the secured financing. Bear Stearns and JPMorgan continued to negotiate changes to the merger agreement that would tighten the guarantee and provide the necessary certainty that the merger would be consummated.
This included JPMorgan quintupling its price.
The deal, finally struck in the early morning hours on March 24, held benefits for all parties.
Another Sunday late-nighter, just before the markets opened Monday.
At least this time we knew what we were trying to do
That deal included a new, more precise guaranty from JPMorgan, which lifted the cloud of default risk that had been hanging over the transaction.
Bear stockholders were to receive a higher share price. In addition to fixing the guaranty, JPMorgan gained assurance that its merger with Bear would take place.
The New York Fed obtained significant downside protection on the loan and a tighter guaranty on its exposure. The new Fed financing facility will be in place for a maximum of ten years, though it could be repaid earlier, at the discretion of the Fed. This is an important feature: the assets that are being pledged as collateral can be managed on a long-term basis so as to minimize the risks to the market and the risk of loss. They can be held or disposed of at any time over the next decade. A summary of Terms and Conditions is attached as Annex III.
As I said at the time, the Fed deserves kudos.
Ten days ago, the Federal Reserve made a bet that economic students will be studying for decades. Under Ben Bernanke, the Fed pushed $200 billion – that’s your money and my money – into the global capital markets pot, in effect making a bet that assets the market won’t buy have the value their originators say they do.
Stepping up and buying with hard cash while everyone around you is selling is the mark of folly, wisdom, courage, or self-delusion.
If Ben Bernanke and the Fed are right, their moves will unjam the gridlock and get capital moving again.
I think he hopes he’s right, too
If they’re wrong, the consequences could be disastrous for all of us.
I hope they’re right. Fortunately, I think they’re right.
So did the Fed, testifying with remarkable grace and patience to a Congressional committee that wanted to complain about bear’s ‘bailout.’ As Fed New York governor Geithner summed up:
I believe that the actions taken by the Federal Reserve on a number of fronts in recent months have reduced some of the risk to the economy that is inherent in this adjustment in financial markets. By reducing the probability of a systemic financial crisis, the actions taken by the Fed on and after March 14 have helped avert substantial damage to the economy, and they have brought a measure of tentative calm to global financial markets.
And the proof? The markets are calmer:
Relative to the conditions that existed on March 14, risk premia have narrowed, foreign exchange markets are somewhat more stable, energy and commodity prices are lower, perceptions of risk in the financial system have diminished, and the flight to quality is less pronounced.
Though it’s a Hobbesian world, everything will be fine anyway
Mr. Geithner also observes, in his own way, that catastrophe is a precondition to fundamental reform:
The financial crises around the turn of the century were the historic catalyst for the Federal Reserve’s creation by Congress. It is panic or fear that drives depositors en masse to the door of the banking house to demand their money back. In such a case, even an institution that is fundamentally solvent—i.e., whose assets (mostly longer-term loans) are worth more than its liabilities—may find that it does not have enough cash on hand—that is, enough liquidity—to satisfy its customers.
A driving force behind Congress’s creation of the Federal Reserve System in 1914 [after the Panic of 1907 – Ed] was its recognition of the need for a public institution to perform the role of lender of last resort.
The financial landscape in 1914 (and continuing until relatively recent times) was one dominated by traditional banks. When the Federal Reserve was founded, there was no deposit insurance, so the willingness of individuals and businesses to hold deposits at a particular bank depended wholly on their degree of trust that the bank would be able to promptly furnish them with the money they had deposited—whenever they might request it.
But—as Congress understood—the business of banking involves making loans as well as taking deposits.
If you want to take deposits, you’ve got to lend these out
Because banks, in order to make money, needed to extend long-term credit to customers for things like the purchases of homes or investments in business equipment, not all of the money taken in by banks could be readily available to be paid out if depositors were to request it. In fact, only a small fraction of a typical bank’s assets were kept in liquid enough form to be immediately paid to depositors upon demand. This fundamental fact of bank operation left banks—and the banking system—open to liquidity shocks that, nearly a century later, have their echoes in recent market developments.
That’s a surprise to my liquidity!
Are there risks here? Yes, but the risks are modest in comparison to the substantial damage to the economy and economic well-being that potentially would have accompanied Bear’s insolvency. Congress created the Federal Reserve after the Panic of 1907 with broad authority and a range of instruments to assume precisely this type of risk, in support of overall financial stability and economic growth. Assisting the JPMorgan Chase merger with Bear was the best option available in the unique circumstances that prevailed at the time.
Bravo Zulu, Federal Reserve
Reading over the record, I see nothing to criticize. The Fed handled it beautifully, in an unprecedented – but not entirely unanticipated – situation.
There’s been abroad in this land in recent months a whisper that we have somehow lost our creditworthiness, that we do not have the strength to make our markets work throughout the world. This is slander, because our country is strong, strong enough to be a guarantor. It is proud, proud enough to be patient. The hedge funds and the short-sellers are wrong. We will remain solvent and active, and we will see a day when on this earth all men will walk out of the long tunnels of downgrades into the bright sunshine of transparent and reliable ratings.
– Seven Days in May, the President, translated from milspeak into finspeak
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