March 16, 2008 TCM Observations
Friday was a stunning day in the recent history of the global capital markets. Apparently Bear Stearns suffered what one might have called a "run on the bank." However, this time, instead of depositors wanting their deposits back, creditors of Bear Stearns, particularly those involved with derivative transactions such as mortgage swaps and credit default swaps ("CDS") asked for hard cash rather than the pledges of securities through repurchase agreements that has been the normal course of financing investment banks. Coupled with the many relatively savvy hedge fund client firms that cleared through Bear Stearns who simultaneously reduced the excess cash in their account balances, Bear Stearns faced a liquidity crisis and turned to JPMorgan Chase and the New York Federal Reserve Bank on Friday for an emergency 28-day loan from the discount window. Since that announcement was made early Friday morning, a number of people have contacted Lars Toomre for his thoughts and observations on where do the markets and credit crunch progress from here.
- First, I will repeat what I have said all weekend. Bear Stearns is effectively dead. I am not sure how the end game might play out. However, after both Moody's and Standard and Poor's downgrade Bear Stearn's debt to the lowest levels of investment grade, Bear Stearns has effectively been locked out of the derivatives business. I say effectively because they may be able to do some "pair off" trades that net reduce their exposure with various counter-parties. However, few, if any, counter-parties will want to take on additional Bear Stearns credit risk without at minimum having it (and likely any existing derivative positions with Bear Stearns) fully collateralized by T-bills.
- From the The Independent in London in an article entitled Wall Street fears for next Great Depression: A Goldman Sachs trader in New York said: "Everyone is in a total state of shock, aghast at what is happening. No one wants to talk, let alone deal; we're just standing by waiting. Everyone is nervous about what is going to emerge when trading starts tomorrow."
- Clearly Monday March 17th 2008 is going to be a very stressful day in the global capital markets. Much like that Sunday before the October 1987 crash, there is a sense of foreboding and many knowledgeable participants, particularly those experienced in the fixed-income or derivative sectors, are experiencing extreme unease about will come in the hours ahead. Will Lehman Brothers suffer the same fate as Bear Stearns? What about Merrill Lynch, Morgan Stanley or even the mighty Goldman Sachs? Surely the rumors are going to be flying fast and furious about just who is suffering what and how.
- Perhaps missed in all of the discussion about Bearn Stearns and how quickly its liquidity problems arose is what is happening with many hedge funds focused on the fixed-income markets and particularly those that are focused on fixed-income arbitrage. With all spread products widening relative to Treasuries, such funds are suffering tremendous amounts of losses. The question is when will they be forced to throw in the proverbial towel and fully liquidate their leveraged positions so that they can return what little funds might be left to their investors? It certainly will be interesting to see who joins the list that now includes
- Key phrases that people no doubt are going to be hearing more and more in the coming days include:
- counter-party risk,
- concentration risk, and
- liquidity risk.
- Reggie Middleton's BoomBustBlog has a historical posting that is well worth reading: The Riskiest Bank on the Street. Telling insight… The bank is not either Bear Stearns or Lehman Brothers!!!
- Late on Sunday afternoon it looks as if JPMorgan will acquire Bear Stearns before the start of Monday morning trading for something in the range of $15 to $20 per share. That is sharply below the Friday afternoon closing price of $30.85, and something like a third of where the Bear Stearns shares closed on Thursday night.
- The Financial Times has details in the story Hedge funds keep safe distance from Bear that Davidson Kempner Partners and Fir Tree Partners were among the hedge funds that sought to cut their ties with Bear Stearns on Friday. The article ends with an interesting reflection on the future of the prime brokerage business:
Robert Sloan, founder of S3 Partners, a US hedge fund advisory company, and a former head of prime brokerage at Credit Suisse [1996-2002], said the situation at Bear Stearns could usher in a new era in financing. “Recently, prime brokerage, though around for a long time, has become a cornerstone business for Wall Street. These events demonstrate that financing is a cornerstone to hedge fund’s capital structure and is the pressure point that all managers and investors should address.”
One leading hedge fund manager questioned whether the prime brokerage business as a whole could survive in its present form given the situation at Bear and the dependence of hedge funds on financing from unstable sources.
“I think we might need to consider a system that is fundamentally different from prime brokerage. Maybe it is the clients; large pools of money such as endowments and pension funds that should be providing the liquidity and stepping into the breach. We need to rethink the financing model.”