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Given that Bear held trading contracts with an outstanding value of
$2.5 trillion with firms around the world, "we were talking about the
possibility of a global run on the bank." -
Bear had a hand in a whopping $10 trillion worth of transactions, by some estimates.
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Bear Stearns had total positions of $13.4 trillion.
Unfortunately lost in these gigantic numbers are the risk mitigating factors written
into most trades. ISDA documentation provides for the netting of positions across
derivative products, the ability to cancel negative mark to markets in case of
counterparty default, and makes any remaining claims pari passu to other creditors.
Most counterpartys of Bear also have credit portfolio groups that charge desks a fee for
doing a trade and, supposedly, hedge the firm’s exposure.
I am not sure how effective these mechnanisms would have proven in a financial crunch,
but I do think its a bit misleading to quote these statistics without keeping this
in mind.
I just read Ender’s Game for the first time, because it seemed to be on top of everyone’s “Best Sci-Fi” list, and I had never read it.
What a HUUUUUGE disappointment. It was just a a big Mary Sue story. One boy overcomes many woes by himself, and is — by himself — smarter (in every way) than every single individual in the military, and doesn’t need to learn anything from anybody.
Total and complete dreck.
To follow up on my bankruptcy adjudicator idea, in the example of BSC what could happen is that BSC would declare bankruptcy.
The financially trained adjudicator would then be in charge of an operating company assuming it had a positive cash flow as an operating entity. Otherwise the company would operate strictly for the purpose of liquidation.
The operating terms would be: 1) “Old credit”, i.e. prebankruptcy credit, would be divvied up proportionately instead of via seniority. 2) “New credit”, i.e. credit issued to the formally bankrupt BSC entity, would be guaranteed by the Fed. For clarification the Fed wouldn’t guarantee any prebankruptcy obligations.
Part 1 is important to discourage runs on an investment bank that seems to have enough capital to cover an orderly unwinding of its assets.
Part 2 is important for the ability of the new BSC entity to actually have counterparties willing to take the other side of a trade as BSC unwinds its positions.
For the Fed’s backstopping of bankruptcy liquidation, it receives any equity left over once creditors are paid off, or once the company is sold off to a third party at a reasonable market price once it had sufficiently deleveraged. The original BSC shareholders would get exactly $0 upon filing bankruptcy, regardless of how much the company is worth after deleveraging under Fed backstopping.
This whole idea is designed to avoid what actually happened, namely the Fed being on the hook for $29 billion of assets of unknown quality, and where BSC’s shareholders come out with perhaps $10 per share of equity (I want $0 for moral hazard reasons), and where original creditors possibly come out with on 95 cents on the dollar (or whatever), thus avoiding moral hazard on the creditor end.
Finally, this might reduce scenarios where companies undergo a bank run.
Ender’s Game is full of things that would only work once, it’s like writing a book about a guy who invents circle-strafing in Doom or brings a rogue deck to a Magic tournament. Still a great read though, just gave my friend a copy this year.
The “trillions” of notional amounts are silly – an economics professor posted this?
Daily margining with zero thresholding of all positions in a clearing house for derivatives is the way forward.
Where were all these people during the Savings and Loan crises? Then there were worthless mortagages on overvalued real estate that led to the elimination, for the most part, of the entire Savings and Loan inductry. If you take a bunch of worthless mortgages and bundle them they become a worthless bundle of paper. Are there no adults on Wall Street?
One more thing to my 9:13pm post:
Under what happened to BSC, the Fed, and by extension the taxpayers, are on the hook for some fraction of $29 billion dollars. Maybe the Fed will make a profit, and maybe it will post a loss.
Unfortunately we have no idea of knowing what the $30 billion special LLC holds, the Fed made clear today that they don’t want the public to know. My guess is mortgage backed securities from Fannie Mae and Frddie Mac, with perhaps some Thornburg jumbo mortgage paper too. Stuff like that.
If I’m right then I suspect that at this point it will turn out to be a profit over the ten years or less it takes to unwind that $30 position. However I still don’t think the US government, or any of its arms or quasi-arms, should be in the business of owning assets at all, let alone distressed assets that someone like jamie Dimon doesn’t want on his books. Although I do think he made a good case that he didn’t want to be too leveraged today during the hearings, even if he he pretty lame in explaining that point.
One other little detail on the JPM/BSC deal. The handout at the press conference mentioned $6 billion in transition costs.
Included on this list was something called ‘conforming accounting’. I don’t know what this is, but it is possible (likely?) that on all trades between the firms that *should* net to zero, the net of the booked marks was a positive number. That is, on a given transaction, BSC booked +10m and JPM booked -9m. Over all transactions, if these systems worked perfectly, the marks would net to $0. If the errors were evenly distributed around $0, then the net differences would be small, since they had a lot of business.
However, I think its likely that there is always a bias toward booking losses more slowly then gains, so when everything netted out, there was an extra billion of profits booked. Who knows.
Extrapolating over all credit derivatives, a small error over trillions is a big number. And how would we ever know? Other then the come to Jesus moment where things that ‘should’ net are actually netted via a takeover.
Also, interest rate derivatives are typically ‘linear’ products — the price sensitivity moves smoothly from day to day. That is, if the market value is $1 million today, it will most likely be between $990,000 and $1,010,000 tomorrow. Daily margining to control risk is feasible.
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