Posted on 03/29/2008 1:26:20 PM PDT by Ernest_at_the_Beach
Two days ago, I wrote here on the widely-reported $30 billion loan that the Federal Reserve made as part of brokering the acquisition of the Bear Stearns Companies by JP Morgan Chase (the "St. Patrick's Day Massacre").
I now have much more information on what this deal is all about. I guessed quite wrong about the deal structure. The $30 billion loan is not a term repo as I originally thought. Nor is it likely to generate monetary losses for taxpayers. (In fact, the opposite is true.)
But it is something bold and different that's worth understanding. In fact, it's a major milestone event in the monetary and financial history of the United States.
Before I launch into this, let me set the context by reminding you why all this financial mumbo-jumbo is important: it's because of politics. Even before the full effects of the credit crisis make themselves felt, we're already deeply into a paroxysm of "the sky is falling! What is the government going to do about it?" I'll be posting as much as I can on this subject in the coming days and weeks, because there is at least as much danger to the real economy from a mad dash toward new regulations and Federal involvement, as there is from the financial-system disorders themselves.
Keep reading...Some of my information comes from this somewhat-cryptic press release by the Federal Reserve Bank of New York, and some from private sources.
During the critical days of March 14, 15, and 16, while Morgan was madly trying to discern the outlines of what they were being asked to buy, they identified a portfolio of assets that they were not willing to finance. They asked for the Fed's help in guaranteeing the value of the portfolio. Several accounts agree that Bear Stearns hurriedly marked this portfolio to market as of March 14, producing a valuation of $30 billion, and the Fed agreed to lend this money to Morgan as a condition of agreeing to the acquisition.
Relatedly, it appears that the Fed (both the Reserve Board in Washington and the New York Fed that directly participated in the negotiations) was involved heavily in setting the lowball price of $2/share offered to Bear Stearns shareholders. (In interviews, Morgan CEO Jamie Dimon will only say that "a lot of factors were involved.") The Fed knew very, very well that the Bear deal would be perceived as a government bailout of a Wall Street firm, so they went out of their way to ensure a smackdown of Bear's shareholders.
How the public sees this is one thing. (The mendacious news media have done nothing to dispel the impression that the fatcats made out like bandits.) Much more importantly, however, the Fed sent Wall Streeters a brutally clear warning not to expect that they will be made whole the next time they get into trouble. The sight of Jimmy Cayne going from near-billionaire to 60-millionaire in just over a year will keep a lot of plutocrats under control for a long time to come.
At any rate, the Fed's $30 billion loan was announced as part of the acquisition on the evening of March 16 in New York. Over the following week, everyone got a chance to catch his breath and re-examine the asset portfolio that was guaranteed by the loan. And as a result, the Fed restructured that transaction. They announced the restructuring on March 24, and this is where things get really interesting.
The New York Fed has created a new limited-liability company, and they hired BlackRock Financial Management to run it. (BlackRock, the division of Merrill Lynch Investment Managers, not BlackStone, the publicly-owned private-equity firm.)
The New York Fed lent $29 billion to the new LLC, for a term of 10 years, which may be renewed at the Fed's option. Morgan put in $1 billion, in the form of a subordinated note. This is a key feature of the re-structured March 24 transaction, since in the original March 16 deal, the Fed was going to speak to the whole $30 billion.
The LLC will use the loan proceeds to acquire the Bear asset portfolio. And they plan to sell out the assets gradually as market conditions improve, over the next ten years or less.
Morgan's $1 billion note will take the first losses on the portfolio, if there are any. In essence, Morgan owns a 10-year call-spread on the deal, long at $29 billion and short at $30 billion. The first people to be paid out (after the LLC's operating expenses) will be the Fed. They get back their $29 billion, plus interest at the discount-window rate.
After the Fed get their money back with interest, Morgan will get back their $1 billion, plus interest at a rate equal to the Fed's discount rate plus 450 basis points (totalling 7% at the moment). That's the most that Morgan can make on the deal. Anything left after the principal and interest payments all goes to the Fed.
Depending on the liquidation value of the portfolio (which in turn depends on the original valuation and future market conditions), the New York Fed stands to make a significant amount of money here, well beyond their $29 billion investment.
Now there is still a big question mark: no one I've corresponded with knows for sure what the composition of the asset portfolio actually is. It appears to be a mixture of residential and commercial mortgage-backed securities, some with agency guarantees and some without.
And here is the key thing that makes this different from anything the Fed has ever done: the deal is essentially a trade. The New York Fed has funded the purchase of assets for a significant amount of time, in the full expectation that they will make a profit.
This is exactly the kind of deal that private actors like Bill Gross and Warren Buffett have been eyeing for months now. We do not know the specifics of the mark-to-market that Bear applied to the portfolio on March 14. It would be exceptionally interesting to know if they valued parts of it at 95 cents on the dollar, 70 cents, or somewhere else. Because the Fed's ratification of that valuation would put a floor under the MBS market as a whole, and potentially go a very long way toward resolving the overall credit crisis.
On the other hand, the New York Fed are very savvy traders. If they intend to make a profit with this vehicle, they don't necessarily want people to know their basis.
The transaction has been described by several of my correspondents as essentially a SIV ("structured investment vehicle"). This description strikes me as only superficially valid. A traditional SIV is dependent on continuous access to short-term repo funding, at low enough interest rates to finance the long-term paper held by the SIV. It therefore faces significant market and liquidity risk as interest rates move up and down.
I don't think the Fed's new LLC faces any risk that they will lose their short-term funding. (Even though there is mysterious language in the Fed's press release about an obligation of the LLC to pay the Fed interest at the current discount rate.) If anything, this is more like a hedge fund or a private equity fund than a SIV. I'd like to know if BlackRock got the standard two-and-twenty compensation structure for managing the vehicle.
To sum up, the New York Fed has entered the market for mortgage-backed securities as a direct participant, going far beyond their traditional role as a lender of last resort. This is a deeply significant and historic change, destined to have major repercussions. I've heard much apprehension and outright fear about the ultimate results, but so far, no one has been able to predict what they might be.
And in addition, many are questioning whether it needed to be done at all. In the days between March 16 and March 24, the Fed opened up its discount window to investment banks and broker-dealers. Some people believe the $30 billion probably could have been funded in the normal repo market after March 17, making the new 10-year LLC unnecessary. I'm not convinced of that.
Much of the general public is still going to react to this story as if the Fed has wantonly and illegally flushed $30 billion in tax money down the toilet. This sweet delusion will continue as long as the media can use it to sell fishwrap.
Forget about that. The real question, and the real danger, is: have the Fed embarked on an eyes-open strategy of direct participation in financial markets that will have extraordinary consequences?
We live in interesting times.
My question is how did JPM come up with the $2 price and a few days later after the market did not seem to buy that, determine that it was now worth $10? Lots of questionable option buying going on before and after too. There is a lot of stuff that went on behind closed doors.
Repayment of the loans will begin on the second anniversary of the loan, unless the Reserve Bank determines to begin payments earlier. Payments from the liquidation of the assets in the LLC will be made in the following order (each category must be fully paid before proceeding to the next lower category):
* to pay the necessary operating expenses of the LLC incurred in managing and liquidating the assets as of the repayment date; [I wonder what the "operating expenses" incurred for managing this LLC will be?]
* to repay the entire $29 billion principal due to the New York Fed;
* to pay all interest due to the New York Fed on its loan;
* to repay the entire $1 billion subordinated note due to JPMorgan Chase;
* to pay all interest due to JPMorgan Chase on its subordinated note;
* to pay any other non-operating expenses of the LLC, if any.Any remaining funds resulting from the liquidation of the assets will be paid to the New York Fed.
They said, "We'll pay you $2". The officers of Bear said okay.
and a few days later after the market did not seem to buy that, determine that it was now worth $10?
The officers can vote their shares, but it's up to all the shareholders to decide. They didn't think they'd get enough votes at $2.
In other words they wring up more debt.
Yes. But, they are currently loaning a lot of their T-Bill portfolio in exchange for illiquid bonds. They certainly did not send those illiquid bonds to fund the new LLC.
That just blows my mind that their officers would have accepted an offer that appears to have been at least 5 times too low.
In other words, no.
They are not issuing the bonds, they're selling already-issued bonds.
That was a good question. Do you have a source the Bear Stearns said "okay"? I didn't see that.
LOL!
But, they are currently loaning a lot of their T-Bill portfolio in exchange for illiquid bonds.
They've got over $800 billion. The swaps I thought were going to be about $200 billion.
But you and your merry band never explain it.
Source?
I already did. New debt is created when the bonds are issued.
If own 10k of Allegheny County IDA muni bonds, do you create new debt if you sell them? No. You transfer the right to collect on existing debt.
I already did. I'm sorry that you still don't understand. Ask me a specific question and I'll answer it.
For which?
Source?
Which were mostly bought with money printed by the Treasury. It's pointless to argue whether they are using newly printed money or previously printed money to fund the LLC.
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