Category / Broker/dealers

Bye bye Bear May 29, 2008 at 7:00 pm

From Bloomberg:

JPMorgan Chase & Co. won approval of its purchase of Bear Stearns Cos., shuttering an 85-year-old firm whose collapse ranks along with Drexel Burnham Lambert as one of the biggest in Wall Street history…Bear Stearns shareholders endorsed the sale during a 10- minute meeting today

Don’t say a prayer for me now, save it ’til the quarter after… Apart from the Bear’s employees, I don’t see many tears being shed about this one.

Whither US financials? May 25, 2008 at 7:54 am

I am convinced that there will be a good buying opportunity for financials at some point in the Crunch. Has it arrived? It would be a brave person who was certain it had, and events of the last few weeks are curious. Consider (courtesy of Bloomberg) first two of the hardest hit large broker/dealers, Merrill and Lehman:


This underperformance contrasts with the broker/dealers who seem to have higher market confidence – Morgan Stanley and Goldman – and the Bank who ate the Bear, JPM. Even Citi has not been as hard hit recently as MER and LEH:


This strikes me as odd. Thain had every incentive to kitchen sink the Merrill write down, and we could easily see write ups in coming months if Merrill’s prices predict lower default rates than are actually experienced. Lehman has skillfully negotiated a crisis of confidence and shown itself to be better managed than the Bear. I’m not sure I’m ready to be outright long US financial yet. But one could be tempted to consider a long in the harder hit broker/dealers vs. a short in the other two.

Awake the harp May 8, 2008 at 7:57 am

The broker dealers still have laughably generous capital requirements and access to the FED window. But in a step that suggests more of a snore than being full awake to the issues, the SEC is going to make Wall Street investment banks disclose their capital and liquidity levels according to Bloomberg. Not yet of course, but soon. Really.

JP’s capital raising April 18, 2008 at 8:29 am

Why is JPM raising new capital? Better commentators than me seem confused, but isn’t it just the Bear portfolio? JPM’s sweetheart deal with the FED amortises over eighteen months and so they need new capital to support the extra Bear assets. And the cost of this capital?

The non-cumulative securities priced to yield 419 basis points more than U.S. Treasuries due in 2018 and pay a fixed rate of 7.9 percent for 10 years.

The importance of non-deposit-taking financial institutions April 17, 2008 at 7:54 am

I’m away from my desk at the moment so posting volume is reduced, but I do want to draw attention to an excellent piece by David Roche in the FT. Firstly he points out the importance of non banks to the liquidity of the US financial system:

The Federal Reserve has belatedly recognised that investment banks, hedge funds and other non-deposit-taking financial institutions are as vital as banks to both the financial and “real” economies. The Fed is lending them massive amounts of capital through newly created facilities. It is right that central banks should be able to do so; NDFI’s create more “asset money” than banks but are much riskier institutions.

NDFIs, though, are not regulated as deposit takers, and in particular the broker/dealers benefit from SEC supervision. As David continues:

What is wrong is that the Fed is doing so without having oversight or supervision of the borrowers.

He then looks at both the size and the velocity of NDFI money:

Investment bank, hedge fund and broker balance sheets are about half the size of the commercial banks in the US and about one-quarter the size in Europe. Both assets and liabilities of NDFIs are dominated by repos, meaning that NDFIs lend and borrow based upon collateral of assets that are constantly marked to market. As asset prices fluctuate, leverage must constantly be adjusted.

This is related to the procyclicality of a leveraged fair value player as I discussed here. As David explains:

In a bear market, as asset prices fall, leverage is reduced. This causes lenders to ask for more collateral on existing loans and borrowers to sell assets so as to reduce the need for such loans and for additional collateral.

The opposite happens in a bull market when rising asset prices cause the balance sheets of NDFIs to expand. The liquidity this creates is used to invest in assets, boosting their prices and creating demand and collateral for more borrowing to make more investments.

So the balance sheets of NDFIs are highly geared to asset price cycles. They act in a pro-cyclical manner, reinforcing bull and bear market cycles and through them economic cycles. So the effect on “asset money” is greater than that of deleveraging by banks, which lend for a wider range of purposes than NDFIs.

The backlash continues April 8, 2008 at 9:40 am

Joan's ChurchCommenting on the Paulson proposals for overhaul of the US system of financial regulation, I said:

I still think the political battles will be prolonged, that they are likely to result in watering down of even these fairly modest proposals, and that this is not nearly enough.

The next round of those battles has started. Bloomberg reports:

Three former leaders of the U.S. Securities and Exchange Commission say the Bush administration’s proposed overhaul of financial regulation threatens to weaken the agency, a process that may already be under way with help from the SEC itself.

David Ruder, Arthur Levitt and William Donaldson, all former SEC chairmen, said a Treasury Department push for the agency to adopt the regulatory approach of the much smaller Commodity Futures Trading Commission would be a mistake.

It’s “not useful” for the SEC to have “a prudential-based attitude in which regulators solve problems by discussing them informally with market participants and ask them to change,” Ruder, a Republican SEC chairman under President Ronald Reagan, said in an interview. “We have to have an enforcement approach.”

Levitt, who led the SEC from 1993 to 2001 under President Bill Clinton and who supports an SEC and CFTC merger, says the terms proposed by Treasury are “wrongheaded” because they would give the trading commission “primacy.”

SEC Chairman Christopher Cox, 55, hasn’t endorsed a merger between the two agencies, said SEC spokesman John Nester. “He would insist on a system of oversight that best protects investors, promotes fair markets and facilitates capital formation.”

Culture wars are inevitable in any merger. Personally I think an old style SEC (rather than the watered down current version) made for an effective conduct of business regulator.

Its regulatory capital regime is, however, badly flawed and potentially imprudent, and taking that aspect away from the SEC would make a lot of sense. Presumably none of this is going to happen before Bush departs so the wars will last a while. So talking of old conflicts, here is the church which currently occupies the site where Joan of Arc died.

Inadequate broker/dealers? April 7, 2008 at 11:42 am

A ratBloomberg has an interesting article on Goldman which again highlights the preferential capital position of the US broker/dealers vs. the banks.

Less than 48 hours after a government-backed deal rescued Bear Stearns Cos. from bankruptcy, David Viniar, Goldman Sachs Group Inc.’s chief financial officer, was asked if the crisis would have “permanent implications” for Wall Street’s appetite for leverage. His answer: “No, I don’t.”

Tell that to his rivals, most of whom are selling assets, raising additional capital and hoarding cash as they grapple with unprecedented losses. The financial industry has booked more than $230 billion of writedowns and losses, as debt securities, mostly held with borrowed money, plummeted in value.

Goldman alone is holding course, refusing to trim its leverage, a measure of how reliant a firm is on debt. The adjusted leverage ratio of assets to equity jumped to 18.6 at the end of February, from 17.5 at the end of November. “We have no need as we sit here right now to shrink our balance sheet,” Viniar told analysts on the March 18 conference call.

Now we don’t know what the composition of Goldman’s BS is. But it is safe to suggest most of it will be assets that are 100% weighted under Basel 1. On that crude basis, Goldman’s capital ratio is roughly 5.4% (= 1/18.6) vs. a minimum of 8% for a bank. Surely this at least suggests the possibility of smelling a rat?

Update. Another Bloomberg article puts a more diplomatic version of the same question:

The U.S. has allowed a number of institutions such as Bear to emerge that really are in the business of doing what banks do but haven’t been folded into the banking system in a way that affords them the same kind of protection from runs that banks have.

Paulson puts scissors in drawer, ignores loaded Uzis March 31, 2008 at 10:08 am

The NY Times has a useful summary of the Treasury proposals for regulatory reform. Consider this:

The optimal structure should establish a new prudential financial regulator, PFRA. PFRA should focus on financial institutions with some type of explicit government guarantees associated with their business operations. Most prominent examples of this type of government guarantee in the United States would include federal deposit insurance and state-established insurance guarantee funds.

In other words, the PFRA will not include the broker/dealers as they do not have guarantees (except for the relatively small bank subs of some broker/dealers). I was wrong, then, when I said these proposals were positive: they really suck. So, in honour of this totally failing to see the big picture moment, I offer you the first annual DeM lookalike competition. One plays a government official who uses unethical but often ineffective methods to try to enforce his will. The other’s a bit better at protecting the interests of his buddies. Which is Vic, which is Hank?

Hank and Vic

JP loves the Bear March 24, 2008 at 10:25 am

Perhaps it will not be entirely unrequited at $10 a share. The NYT has the scoop, the FT has additional details, and some amusing speculation can be found on Naked Capitalism.

Update. It’s official (or at least on Bloomberg). JP ups the offer to roughly $10/share, and buys 39.5% of the firm in newly-issued stock (40% or more requires a shareholder vote). That’s done then. Who caught the bride’s bouquet?

What a bargain? March 18, 2008 at 4:34 pm

If the JP deal to buy the Bear holds at $2 a share, they have got themselves a rather attractive looking deal. It must have taken courage to get to this point, and I’m sure they will find some nasties once all the stones are lifted, but the overall impression from the call is of a transaction that works well for JP, if not for Bear shareholders, especially given their option on the Bear’s HQ. If the Bear can go for $2, though, it makes one wonder what Lehman is worth.

Build a bear

Update. BSC closed on Wednesday at $5.33, well over JP’s offer. Will Joseph Lewis, one of the largest shareholders, be able to arrange a better deal? The cultural fit with JP can’t be good, but at $2 they probably are not too concerned about that. Barclays might be a better fit, but are they in a position to find the cash, especially without FED support? One rumour doing the rounds is that Deutsche were interested. In any event, the consensus seems to be that JP has got it more or less sown up: see here for a discussion from Dealbreaker.

Meanwhile, Felix Salmon has a nice discussion on why the Bear share price is so far above JP’s offer. The argument is that the bond holders have a lot to lose if the purchase does not go through and much to gain if it does. So they are buying the stock in order to vote for the merger.

No more BS? March 15, 2008 at 8:14 am

Liquidity depends on confidence, and the Bear lost it. Rumours have been circulating all week – see here for a summary from Naked Capitalism – and finally the Bear had to be bailed out on Friday. The SEC comments:

The decision by the Federal Reserve Bank of New York to provide The Bear Stearns Companies temporary funding through J.P. Morgan Chase & Co. today followed a significant deterioration in Bear Stearns’ liquidity on Thursday. The Division of Trading and Markets has monitored both the capital and the liquidity of the firm on a daily basis in recent weeks. […]

“As of its most recent capital calculation as of the end of February 2008, Bear Stearns’ holding company capital exceeded relevant regulatory standards. According to the information supplied to the SEC by Bear Stearns as of Tuesday, March 11, the holding company had a substantial capital cushion. In addition, as of March 11, the firm had over $17 billion in cash and unencumbered liquid assets.

“Beginning on that day, however, and increasingly throughout the week, lenders and customers of Bear Stearns began to remove funds from the firm, despite its stable capital position. As a result, Bear Stearns’ excess liquidity rapidly eroded.

As so the FED stepped in and we have the current back-to-back rescue via JPM.

There are several interesting questions about this. One is why the FED acted at all. Bear Stearns is not one of the largest firms – it does not feature on the Bank of England list of systemically important institutions for instance – but it is a key player in three areas of stress at the moment, prime brokerage, muni bonds and MBS trading. Certainly the failure of the Bear would have had an impact on confidence, and it might well have caused some knock on hedge fund failures. But if BSC is too big to fail then the CEOs of a range of institutions across the US must be sleeping easier at the moment.

The second is how the FED acted. Apparently it could have lent to BSC directly (at least after a board vote in favour) but instead it chose to lend to JPM with JPM on-lending to BSC. JPM has no risk here so one obvious reason for their involvement is that they want to buy some or all of the Bear. Certainly the Bear’s HQ, the prime brokerage operation, perhaps parts of the mortgage business, and apparently asset management are interesting potential suitors. (Why anyone would want an asset management operation involved in a recent hedge fund collapse is another question.) Anyway, perhaps ‘suitor’ is the wrong word. Do we have a term in English for the man you are about to be forced into an arranged marriage with?

Now if I were you, I’d move straight on and check the successor language in your ISDA docs and/or prime brokerage agreement. Figuring out who your new counterparty is might take a little work as this story plays out.

Prising apart the Merrill writedown January 17, 2008 at 7:04 pm

The headline is Merrill Posts Record Loss on $16.7 Billion Writedown. Let’s take the Merrill earnings release and pull it apart a bit. Specifically, consider the CDO positions.

A first glance, the position seems fairly benign.

But now consider the footnotes:

(2) Primarily consists of principal amortization for U.S. super senior ABS CDO net exposures, as well as changes in hedges and increases due to ineffective hedges.

Now, amortisation reduces exposure. But the high grade number is up. So the increase must be due to ineffective hedges. This emphasises that these are net numbers.

(3) For total U.S. super senior ABS CDOs, long exposures (including associated gains and losses reported in income and other net changes in net exposures) were $46.1 billion and $30.4 billion at September 28, 2007 and December 28, 2007, respectively. Short exposures (including associated gains and losses reported in income and other net changes in net exposures) were $31.3 billion and $23.6 billion at September 28, 2007 and December 28, 2007. Short exposures primarily consist of purchases of credit default swap protection from various third parties, including monoline financial guarantors, insurers and other market participants.

Ah. Those would be the monolines that are doing so well at the moment. I don’t want to rain on Merrill’s parade, but if I were an investor, I might want to know a bit more about those hedge counterparties other than their ratings. The weighted average spread they trade at in the CDS market perhaps. That would give some idea of where between a net $4.8B and a gross $30.4B the exposure really lies.

Spread wide November 16, 2007 at 4:23 pm

Friday market update: from Bloomberg, we learn that

Merrill’s 6.4 percent notes due in 2017 pay a spread of 2.24 percentage points, almost double the premium of 1.21 percentage points a month earlier


Citigroup paid 1.90 percentage points more than Treasuries of similar maturity to sell $4 billion of 10-year notes on Nov. 14

That’s nothing compared with the monolines in the CDS market. According to FT alphaville there is a one in three chance of monoline default, while Bloomberg gives more detail:

Credit-default swaps on MBIA more than tripled to 410 basis points since Oct. 15, according to CMA Datavision in New York. The price suggests that investors see a 28 percent chance MBIA will default, according to JPMorgan Chase & Co. valuation models. Contracts on Ambac have climbed to 620 basis points, CMA data show. They imply a 40 percent chance of default.

Things are interesting out there. Have a good weekend folks.

Update.Naked Capitalism estimates the likely cost of a monoline downgrade as $200B. (Is that all of them or just a big one?) Anyway, with the kind of impact, we had better hope someone at the FED plays golf with someone at the New York State Insurance department this weekend.

Buying a broker November 14, 2007 at 10:16 pm

Should any of the large European banks seriously consider buying a Wall Street investment bank? Matthew Lynn at Bloomberg thinks so, arguing that Lehman, the Bear and Morgan Stanley are easily affordable by banks like Deutsche, Santander or HSBC. He has one delightfully acid little dig:

[…] it is very hard to understand what Royal Bank of Scotland Group Plc is doing taking control of ABN Amro Holding NV of the Netherlands with its partners — let’s remember, ABN is a fairly dull bank, with no great growth prospects — when it could be buying Morgan Stanley instead.

Abuse aside, though, the case is less clear. A firm like the Bear has a uniquely American culture that would be a very poor match with a retail bank like HSBC or Santander. Even a closer cultural fit – Deutsche with Lehman for instance – would still be a massive integration challenge. Perhaps Lynn’s really out of the money option is actually the one that would work best: ICBC using its inflated stock to buy American. I wonder what kind of protectionism would be wheeled out if the Chinese really did bid?

How linear is Goldie? November 1, 2007 at 1:29 pm

A non-linear position translates a normal distribution of market returns into a non-normal distribution of P/Ls. It used to be reasonable to assume that trading revenues were normally distributed. For instance, here is Goldman from Q3 2004 (picked up via Alea):

Now, though, some of the broker dealers are strongly non-linear. Here’s Goldman Q3 2007:

Morgan Stanley for the same period is similarly non-normal:

There’s nothing inherently wrong with this, but it does mean that any old style investment model (CAPM, for instance) which relies on normal returns won’t deal with stocks like this correctly, and concepts like beta with the market are less meaningful.