First, from Michael Lewitt, writing last week before the Fed bailout of Bear:
The Risks of Systemic Collapse
by Michael Lewitt
The failure of a firm of the size and stature of Bear Stearns would be as close to an Extinction Level Event as the world's financial markets have ever seen. Bridgewater Associates, Inc. writes that, "...the counterparty exposures across dealers have grown so exponentially that it is difficult to imagine any one of them failing in isolation." While not the world's largest financial institution, Bear is a major counterparty to virtually every important financial player in the world. Its insolvency would effectively freeze the assets of many hedge funds and other liquidity providers and cause the financial system to seize up. Even an after-the-fact government bailout would do little to prevent such a meltdown scenario since the value of all of Bear's counterparty obligations would be thrown into question for some period of time. The resulting cascade of hedge fund failures and financial institution write-offs in today's mark-to-market world would be nothing less than catastrophic.
The only way to avoid such a scenario would be for the Federal Reserve or the Treasury to step in before the fact and engineer a merger with a larger institution. For that to happen, the firm's management has a responsibility to the markets to work with the authorities sufficiently in advance to arrange a private bailout.
The risks of a systemic collapse have risen to uncomfortable levels. The complete withdrawal of credit from the financial system has led to a series of implosions of hedge funds and other leveraged investment vehicles. At some point - and nobody knows when that point is - the system is not going to be able to withstand further failures. It will not be the sheer volume of failures that brings the system to a standstill; the system is enormous and can sustain huge dollar losses before becoming impaired. The problem is that the global financial system is a case study in chaos theory. This is truly a case where a butterfly flapping its wings in West Africa could lead to a Category Five hurricane thousands of miles away. There are an incalculable number of derivative contracts and counterparty relationships on which the stability of the financial system hinges. All it would take is the collapse of the wrong firm or the wrong derivative contract at the wrong time to throw the wrong financial institution into crisis and force the entire system into a death spiral.
As noted above in the discussion about Bear Stearns, we may not need the largest institution in the world to fail to cause the calamity - it may just be a matter of something bad happening at the wrong firm at the wrong time to trigger a systemic collapse. This is the risk implicit in a highly leveraged financial system financed by unstable financial structures. These scenarios may sound like the ravings of a paranoid, but we will remind our readers that even paranoids have enemies, and the greatest failure that investors, lenders and regulators seem to suffer from in perpetuity is a failure of imagination. They remain incapable of imagining that the worst can happen, and as a result they behave in a manner that keeps that possibility alive. At some point, all of the king's horses and all of the king's men will not be able to put Humpty Dumpty back together again. We are not at that point yet, but we are closer than we've ever been.
The current market collapse was the result of an abject failure to regulate the mortgage and derivatives markets. The extent of this failure cannot be overstated. HCM still sees great opportunities being created in assets being sold for reasons unrelated to their underlying value. But caution must be the byword until the system shows greater signs of stability.
And from Bob Eisenbies of Cumberland Advisors (www.cumber.com). Bob Eisenbeis is Cumberland's Chief Monetary Economist. Before retirement, he was the Executive Vice President of the Federal Reserve Bank of Atlanta. He is a member of the U.S. Shadow Financial Regulatory Committee and a veteran of many FOMC meetings.
The Fed Will Do What It Takes!!
By Bob Eisenbeis, Cumberland Advisors
In a stunning announcement on Sunday the Federal Reserve Board of Governors announced three steps to address the continuation of last week's financial turmoil.
First, the Board approved a recommendation by the Federal Reserve Bank of NY to cut the discount rate by 25 basis points to 3.25%. Presumably it will approve similar recommendations by the other 11 Federal Reserve Banks today.
Secondly, the Board voted to authorize the Federal Reserve Bank of NY to create a temporary 6 month lending facility for the 20 prime broker dealers. This enables them to pledge a wide range of investment grade collateral for loans at the new 25 basis point penalty rate. This takes effect today, March 17, 2008. The first transaction has been done in Asian markets as this commentary is being released.
Finally, the Board also ordered and also approved a $30 billion special financing to facilitate JP Morgan's purchase of Bear Stearns Companies, Inc. Both Morgan and Bear boards have unanimously approved the transactions. A shareholders vote is still needed. Meanwhile, Bear Stearns is operating under the new provisions today.
These actions demonstrate the extreme lengths, if there was ever any doubt, that the Board of Governors are willing to go to. There singular purpose is to prevent the collapse of a prime broker dealer and the potential fall out to counter parties that such a collapse might entail.
The actions are important for several reasons. The new facility trumps the recently announced Term Securities Lending Facility (TSLF) that was to go into effect later this month on March 27th. Yesterday's action provides direct loans to both banks and non-bank primary dealers. It is intended to facilitate their ability to liquefy what might otherwise be relatively illiquid assets. But it also means that the Fed is willing to take on credit risk to broker dealers. Whether there will still be a stigma associated with this borrowing, which would not have accompanied the borrowing of securities through the TSLF is not known.
The new actions also demonstrate that the perceived problems in financial markets were sufficiently critical so as to not warrant waiting for the TSLF to go into effect later in March. Why implementation of the TSLF wasn't accelerated is an interesting question.
The actions also demonstrate that the so-called liquidity problems (which this author has previously suggested may be actually solvency issues) are mainly a problem for the prime brokers who were also the main players in proliferating securitized debt securities based on sub-prime mortgages and other assets. It is still a major question as to what the values of these securities are and how much of an actual liability they represent for the intuitions in question.
Whether those risks were real or imagined may never really be known but we now know that too-big-to fail is still alive and well, even in the US, and despite FDICIA. Federal Deposit Insurance Corporation Improvement Act (FIDICIA) was enacted in 1991. FIDICIA requires that management report annually on the quality of internal controls and that the outside auditors attest to that control evaluation.
Finally, the Fed has also taken the extraordinary step of helping to finance the takeover of a private sector firm by one of the nation's largest banking organizations. The implications of this will be explored in a future Commentaries when more of the details become public.
What may be lost in the excitement of the moment, as markets attempt to digest these latest actions, is that were taken by the Board of Governors through the Federal Reserve Bank of NY to address issues of financial stability. These were NOT actions taken by the Federal Open Market Committee (FOMC). Their main responsibility is the conduct of monetary policy for the country.
In other words, the story will not end today, Monday, March 17, 2008. We will get a separate and important assessment of the implications of these attempts to insulate the real economy from the potential negative feedback effects of these financial disruptions when the FOMC releases its decisions on whether and by how much to cut the Federal Funds rate on Tuesday. Stay tuned, there is more to come.
And one further brief note from Bob written late last week:
It is time to stop pretending.
Since last August the assertions regarding the turmoil in financial markets have been characterized as a temporary liquidity problem. The problems first surfaced last year with BNP Paribas and Bear Sterns' hedge fund collapse. More than 7 months have passed and, once again, another Bear Sterns shoe has dropped today as it has been forced to go to the NY Fed discount window through a JP Morgan conduit. This follows on the heels of the collapse of the Carlyle Group sponsored hedge fund in London. For months institutions, politicians and regulators have been in denial. Witness, for example, the proposals currently being floated by the SEC that would enable institutions to offer alternative "explanations" for how they value their assets. Pundits have been suggesting that uncertainty and loss of confidence are the roots of the problem, but this isn't the way to think about the problem.
It is time to step back and recognize that the current situation isn't a liquidity issue and hasn't been for some time now. Rather there is uncertainty about the underlying quality of assets which is a solvency issue driven by a breakdown in highly leveraged positions. Many of the special purpose entities and vehicles are comprised of pyramids of paper assets supported by leverage whose values are now unknown.
If it were a simple liquidity problem the actions that the Federal Reserve has taken would have dealt with the problems by now. If one doubts this observation, think about what the Federal Reserve has done over the past several months in an attempt to provide liquidity to those who need it. The Federal Funds rates have been cut by 225 basis points. Significant liquidity has been injected into markets by major central banks around the world. The Federal Reserve created the Term Auction Facility and recently announced the Term Security Lending Facility. These actions have had only temporary impacts on both market sentiment and on credit spreads.
This is also not an "animal spirits" problem but rather is the classic example of George Akerloff's "market for lemons." Essentially what Akerloff tells us is that, absent better information, it is rational for potential buyers of assets to assume that the assets offered for sale are "lemons," hence the flight to quality.
Finance theory clearly tells us that in such circumstances, firms facing questions about their assets, which typically are manifested by temporary problems of access to liquidity, will quickly find ways to reveal to the market the true condition of its assets. Smart institutions have ample mechanisms to deal with these problems - simply open up the books and show them to potential investors. At this time there are also several actions that the Fed should take to ease market questions about what has been happening.
First, there is a danger in anointing one institution to be the white knight to deal with the Bear Sterns problem. Second, there is a pressing need to provide more information and details about what the arrangements are with JP Morgan and Bear Sterns. That means being more forthcoming with its communications on what it is doing and why. Third, it is clear that there are many potential buyers for troubled firms, if it is easy to see what they are worth. This means that the Fed and Treasury should take the lead in forcing increased transparency on the part of all institutions that might be experiencing financial difficulties and those that are not. Finally, there needs to be the recognition that the problems at this time are confined to financial firms and have not contaminated the market for securities of firms in the real sector. |
