BSC Bailout: Fed Prevented a Domino Effect

In my last week’s post, I cited the article, “On the brink of disaster," from Fortune:

Bear (BSC) had about $13 trillion of derivatives deals with counterparties, according to its most recent financial filings. If Bear had croaked, large parts of the world could have croaked. And the economic damage could have been catastrophic.

Why is that? The secret has been uncovered by Martin Mayer on this week’s Barron’s in the article “The Fed Has Power, but No Will”.

In the OTC (over-the-counter) derivatives market, people who want to get out of their previous trades have to offset the obligations of that trade by creating a new instrument with a new counterparty. Take a credit-default swap, by which each party guarantees to accept the payout on a debt instrument held by the other party. It’s an insurance instrument, with some differences: The holder of the insured instrument can sell it, and the new owner becomes the beneficiary of the insurance. And the insurer may find someone who will accept a lower premium to take the burden of the insurance, allowing him to lay off his risk at an immediate profit.

The one trade thus generates two new instruments, with four new counterparties, and as the daisy chain of reinsurance expands, the numbers become ridiculous: $41 trillion face value of credit-default swaps.

BEAR STEARNS APPARENTLY had created trillions of dollars of positions this way, which is why it had to be kept in business. Once you begin to remove individual flower girls from the daisy chain of credit swaps, you don’t know who will wind up with obligations they thought they had insured against and they can’t meet. Suddenly, all counterparties for all sorts of trade become suspect. We should note in passing that the big beneficiaries of the Fed’s action on Bear Stearns were the sellers of credit derivatives insuring Bear’s obligations. The counterparties’ paper had been worth very little on Thursday night and quite a lot on Sunday afternoon.

Wow, that’s a whopping $41 trillion. Obviously, the Fed was pushed to the corner when facing a collapsing Bear. The bailout prevented the domino effect from happening in the global financial market. Unfortunately, the buyout story doesn’t stop here. Another piece of interesting fact was revealed by Bill Cara at “Investment Banks and the Fed”:

Which investment bank is widely believed to be the next weakest on Wall Street, after Bear Stearns? It is Lehman Brothers (LEH). Lehman Brothers sits on the Board of Directors of the Federal Reserve Bank of New York.

As I understand it, the Federal Bank of New York has, in the past month or so since the latest lending facility was created by the Board, lent almost $200 billion (about half its balance sheet, which used to be fully liquid and hence a tool for monetary policy) to Bear Stearns and Lehman Brothers, accepting in return illiquid securities, the very type that almost crashed Bear Stearns when no other bank would buy or lend against them.

Yes, Moral Hazard could be a good companion for activism by government. More interestingly, FDIC Chairwoman calls for activism:

Federal Deposit Insurance Corp. Chairwoman Sheila Bair said Monday policy makers needed to consider a more “activist” government response to prevent an escalation of foreclosures even if such measures aren’t “politically popular.”
……
“We’ve got a real problem. And I do think we need to have more activist approaches. And I think it will be something we need to be honest with the American public about. We do need more intervention. It probably will cost some money.”

The funny part is that “it probably will cost some money” from taxpayers, on top of the weak dollar, high energy costs, and a bubble-popping real estate market. Oh well, the ride will be bumpy down the road.

Comments

[venividivici]

America's financial system doesn't have a shed of credibility. Smoke and mirrors are all that's keeping this teetering sham on two legs.

[Britishsteel]

you forgot to mention that JP morgan stood to lose really big if they did not get the bailout. Dimon testifying before congress said when asked if the bailout was needed and saved the whole finacial system then how would it have effected your company and he said not at all But JP morgan if that were true then the previous statement of every one being taken down had to inclue JP Morgan they are part of our financial system no? And least we forget JP Morgan is the federal rerserve and if they knew cause they had to know through discussions over that weekend that they would open the discount window to non regulated banks then why not let Bear Sterns borrow from the discount window? Sounds to me that JP Morgan had some serious expousure that they did not want to let see the light of day . And least you all think this rally is a bottom do not buy it.The non regulated Banks meaning [ investment banks ] are now able to hit up the discount window and buy stocks and currency with the money they are now allowed to borrow without congressional approval being given in the first place. their is no volume and no breadth to this move and the downside has been a tightly controlled drop . WE NO LONGER HAVE A FREE MARKET IN THIS COUNTRY AND OUR FREEDOMS ARE BEING STRIPPED DAY BY DAY AND EITHER CONGRESS IS IN COLLUSION OR THEY HAVE NO CLUE AND BOTH IDEAS FRIGHTEN ME!

[58robbo]

makes you wonder who really won the cold war! i'm starting to believe that the strategy used against the west was to give us enough rope! sure enough we used it and now have to resort to SOCIALIST measures to bail ourselves out! in this house of cards economy we have lost all sense of real value from a moral and economic stand point. orwell may have been 24 years late but the ideas are on the money!
absolutely frightening!

[flow5]

We will eventuall operate within a command economy and into an increasingly totalitarian mold.

[helplessobserver]

Lets look at the future. As a result of all this turmoil we will see:
a. all derivative contracts will be moved to and traded on public exchanges
b. margin will be required for sellers of contracts
d. all derivative contracts will be settled in cash
As it now stands counterparty risk is unacceptable. Big players do not have to post margin, other lesser players may have margin waived. Delivery of securities as required in a default event is cumbersome if not impossible.

[iThinkBig]

The FDIC Chairwomen loves Socialism. All women in power love Socialism. Of course, in 6,000 years of modern history it has never worked. Of course, men have there pride. Arrogance attempting to control the globe through it have global ramifications when it fails. We get both gender problems magnified as far right and far left occuring at the same time. Not a good political system right now - very very bad.

[58robbo]

helplessobserver that's wishfull thinking. the bear bailout has set a precedent. i look into the future and see business as usual!