Bearly Alive

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On Friday,
Bear Stearns blew up. It was the worst possible news at the worst
possible time. A day earlier, the politically-connected Carlyle
Capital hedge fund defaulted on $16.6 billion of its debt. Carlyle
boasted a $21.7 billion portfolio of AAA-rated residential mortgage-backed
securities, but was unable to make a margin call of just $400 million.
(Where did the $21.7 billion go?) The news on Bear was the last
straw. The stock market started reeling immediately; shedding 300
points in less than an hour. Then, miraculously, the tide shifted
and the market began to rebound.

If there was
ever a time for Paulson’s Plunge Protection Team to come to the
rescue; this was it. For weeks, the markets have been battered with
bad news. Retail sales are down, unemployment is up, consumer confidence
is in the tank, inflation is rising, the dollar is on the ropes,
and the credit crunch has spread to even the safest corners of the
market. Facing these fierce headwinds, Washington mandarins and
financial heavyweights had to decide whether to sit back and let
one small investment bank take down the whole equities market in
an afternoon or stealthily buy a few futures and live to fight another
day? Tough choice, eh?

We’ll never
know for sure, but that’s probably what happened.

We’ll also
never know if Bernanke’s real purpose in setting up his new $200
billion auction facility was to provide the cash-strapped banks
with a place where they could off-load the mortgage-backed junk
that Carlyle dumped on the market when they went belly-up. That
worked out well, didn’t it? Now the banks can trade these worthless
MBS bonds with the Fed for US Treasuries at nearly full value. What
a deal! That must have been the plan from the get-go.

The Bear Stearns
bailout has ignited a firestorm of controversy about moral hazard
and whether the Fed should be in the business of spreading its largess
to profligate investment banks. But the Fed had no choice. This
isn’t about one bank caving in from its bad bets. The entire financial
system is teetering and a failure at Bear would have taken a wrecking
ball to the equities market and sent stocks around the world into
a violent death-spiral. The New York Times summed it up like this
in Saturday’s edition:

"If the
Fed hadn’t acted this morning and Bear did default on its obligations,
then that could have triggered a widespread panic and potentially
a collapse of the financial system."

Bingo.

So, what makes
Bear so special? How is it that one of the smallest investment banks
can pose such a threat to the whole system?

That’s the
question that will be addressed in the next couple weeks and people
are not going to like the answer. For the last decade or so the
markets have been reconfigured according to a new "structured
finance" model which has transformed the interactions between
institutions and investors. The focus has been on maximizing profit
by creating a vast galaxy of exotic debt-instruments which increase
overall risk and volatility in slumping market conditions.

Derivatives
trading which, according to the Bank of International Settlements,
now exceeds $500 trillion, has sewn together the various lending
and investment institutions in a way that one failure can set the
derivatives dominoes in motion and bring down the entire financial
scaffolding in a heap. That’s why the Fed got involved and (I believe)
approached Congress in a closed-door session (which was supposed
to be about FISA legislation) to inform lawmakers about the growing
possibly of a major economic meltdown if conditions in the credit
markets were not stabilized quickly.

The troubles
at Bear and the danger they pose to the overall system were articulated
in an article by Counterpunch co-editor, Alexander Cockburn in a
November, 2006 article "Lame
Duck: The Downside of Capitalism
":

"In
a briefing paper under the chaste title, ‘Private Equity: A discussion
of Risk and Regulatory Engagement,’ the FSA raises the alarm.

"Excessive
leverage: The amount of credit that lenders are willing to extend
on private equity transactions has risen substantially. This lending
may not, in some circumstances, be entirely prudent. Given current
leverage levels and recent developments in the economic/credit
cycle, the default of a large private equity backed company or
a cluster of smaller private equity backed companies seems inevitable.
This has negative implications for lenders, purchasers of the
debt, orderly markets and conceivably, in extreme circumstances,
financial stability and elements of the UK economy."

Translation:
It’s about to blow!

"The
duration and potential impact of any credit event may be exacerbated
by operational issues which make it difficult to identify who
ultimately owns the economic risk associated with a leveraged
buy out and how these owners will react in a crisis. These operational
issues arise out of the extensive use of opaque, complex and time
consuming risk transfer practices such as assignment and sub-participation,
together with the increased use of credit derivatives. These credit
derivatives may not be confirmed in a timely manner and the amount
traded may substantially exceed the amount of the underlying assets."

Translation:
"The world’s credit system is a vast recycling bin of untraceable
transactions of wildly inflated value."

The problem
is that the oversight and stability of the world credit system
is no longer within the purview of familiar international institutions
like the International Monetary Fund or the Bank of International
Settlements. Private traders are now installed at all the strategic
nodes, gambling with stratospheric sums in such speculative pyramids
as the credit derivative market which was almost nonexistent in
2001, yet which reached $17.3 trillion by the end of 2005. Warren
Buffett, America’s most famous investor, has called credit derivatives
"financial weapons of mass destruction."

Cockburn’s
article anticipates the current problems at Bear and shows why the
Fed cannot allow them to fester and spread throughout the system.
The investment banks and brokerages all do business with each other,
taking sides in trades as counterparties. If one player goes down
it increases the likelihood of more failures. So the problem has
to be contained.

The volume
of derivatives contracts, that are not traded publicly on any of
the major exchanges, has exploded in the last few years. These unregulated
transactions, what Pimco’s Bill Gross calls the shadow banking system,
have taken center-stage as market conditions continue to deteriorate
and the downward-cycle of deleveraging begins to accelerate. The
ongoing massacre in real estate has left the structured investment
market frozen, which means that the foundation blocks (i.e., mortgage-backed
securities) upon which all this excessive leveraging rests; is starting
to crumble. It’s a real mess.

Derivatives
trading, particularly in credit default swaps, is oftentimes exceeds
the value of the underlying asset many times over. Credit Default
Swaps are financial instruments that are based on loans and bonds
that speculate on a company’s ability to repay debt (a type of unregulated
insurance). The CDS market is roughly $45 trillion, whereas, the
aggregate value of the US mortgage market is only $11 trillion;
four times smaller. That’s a lot of leverage and it can have a snowball
effect when the CDS trades begin to unwind.

In truth, the
biggest risk to the financial system is counterparty risk; the possibility
that some large investment bank, like Bear, goes under and sucks
the rest of the market with it from the magnitude of its losses.
Last year, Bear was the 12th largest counterparty to CDS trades
according to Fitch ratings. If they were to suddenly disappear,
the effects to the rest of the system would be catastrophic.

Fed Chairman
Bernanke sat on the board of the FOMC when the investment gurus
and brokerage sharpies customized the markets in a way that enhanced
their own personal fortunes while increasing the risks of systemic
failure. The SIVs, the conduits, the opaque derivatives, the off-balance
sheets operations, the dark pools, the massive leverage, and the
reckless expansion of credit; all emerged during his (and Greenspan’s)
tenure. The Federal Reserve has its own large share of responsibility
for the brushfire it is presently trying to put out.

Now, in capitalism’s
extreme crisis Bernanke, acting beyond his mandate, invokes a law
that hasn’t been used since the 1960s so the Fed can become the
creditor for an institution that attempted to enrich itself through
wild speculative bets on dubious toxic investments which are now
utterly worthless.

March
17, 2008

Mike Whitney
[send him mail] lives
in Washington state.

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