The Miraculous Catastrophe of Bear Stearns

Quotes of the week:
1. "Notionally called hedges, in reality they were a series of free-standing bets that Bear executives dubbed The Chaos Trade"
2. "The Fed's role in the deal suggests federal officials fear a systemic collapse of the U.S. financial system were Bear Stearns to fail. The fear stems from Bear central role in a multitrillion-dollar web of interconnecting derivative contracts." - Roddy Boyd on CNN Money.
3. "Bear is a counterparty to some $10 trillion of over-the-counter swaps. With the broker's collapse, the fear that these and other contracts would no longer be honoured would have infected the world's derivatives markets." - The Economist

Quote 1 is how Bear Stearns was financing its cash flow once their losses became known internally. They were making trades betting against their other portfolios and betting (sorry, 'investing') on things to go really haywire. I think some hedge funds that bet against the financial sector are going to announce amazing results in the next few weeks.


Commentary for the Week:
The Miraculous Catastrophe:

Something so awesome happened over the last two weeks that quite possibly every human on Earth has been adversely affected. No, it was not Godzilla's escape from its wintery prison, nor was it yet another discovery of King Kong. It was something that sounds so innocuous that it probably escaped most people's work-a-day attention. Of course, if I had a life outside that of finance, it would have escaped mine as well, but I am chained to the desk here at Ittihad and am required to know such things. On the surface, what happened was quite simple. An investment bank in the US called Bear Stearns was bought out by a full-fledged bank called JP Morgan for a relatively small amount. This was reported in many places and some surface treatment was given to how there were several 'Risks' in the financial system which were brought to light by the whole episode. The exact nature of the risks, however, was generally left to our imaginations, so here I go.

Let me start by saying that the annual GDP (nominal basis 2008) of the entire world is around $57 Trillion. This means that all of our collective effort as humanity over the course of a year adds up (if one were to use money as a yardstick) to $57,000 Billion. Relative to that, the Bear Stearns buyout, at a mere $1.5B is of course peanuts and quite unremarkable.

But try and look at it from this perspective for a minute and see if you feel a sinking feeling in your gut. Had Bear Stearns not been bought out by JP Morgan and had JP Morgan not guaranteed Bear's obligations, there would have been a ... wait for it ... a bit more ... a $10 Trillion hole in the financial system. How can this be, you ask? Surely it cannot be, you say? How can a company that is worth $1.5B now (and was worth $3.5B before the crisis) create a $10 Trillion gap in the entire system of what passes for wealth, you ask yet again? Well, the official answer is that these are all unsophisticated questions and we shouldn't worry our pretty little heads about it too much. It is best to go back to refinancing the house so we can buy the Broccoli that now costs almost as much as a pound of Silver. The big men (such as Big Ben) are in charge and with their humungous brains, surely they can find a way out of this mess. So much for the official answer. The only-somewhat-varnished truth is quite different, and your earlier questions may not be so unintelligent after all.

A company with less than a few hundred million in actual assets (which were also quite faulty to begin with) is a counterparty to over $10Trillion of derivatives. If you suddenly remove this company from the system, all of humanity would have to work for two whole months to make up for the just the first order loss. As other, second-order losses would surely follow, this calculation does not even include any downstream and domino effects. To your earlier questions, I would add two more - How can be this be a sane way of handling humanity's finances? Isn't there something wrong with a system that allows one company (which was only the 5th largest Investment bank in the US) the ability to enter into performance contracts worth more than 75% of the US economy?

One reason this is difficult to wrap our heads around is that we have been conditioned into thinking that finance is complicated and best left to experts with many ill-fitting consonants behind their name. The other reason that this seems unreal is the fact that there are more zeroes in these figures than there are hairs on my head, which is confusing us needlessly. So let us un-complicate this Gordian Knot and get to the heart of the matter. Let us say I have $200 in my chequing account, which is all I have to pay for all sorts of bills such as the lights, heat, Broccoli etc. Let us then say that I calmly and coolly write people 'certificates' (an easier way to think about derivatives) in the amount of $10,000,000. Even though these 'certificates' are strange in the sense that only a limited amount of people actually submit them for actual payment back to me (think Canadian Tire Money or gift cards), the fact that I have promised $10 Million when I have only $200 to my name is boldness bordering on lunacy. In simpler times, it was called fraud.

In the modern economy, however, what happens if people suddenly wise up to my irresponsibility and stop accepting my 'certificates'? What if they actually ask me to pay up on some of the ones outstanding? Furthermore, what happens to all the people who have used my 'certificates' as assets upon which to write IOU's of their own? In theory of course, there should be a catastrophe of the 'Plagues of Egypt' proportion, but what we have is a miracle instead. This is because, if you are American, even if you make a $ 10,000,000 hole in the assets of the world with your $200, there are no severe ramifications. Instead, someone actually pays you $100 and then takes over the business of writing your 'certificates'. The fact that this someone has also been given a $30B 'loan' from public money makes for the Mother of all Financial Miracles.

Welcome to the even newer economy, where a private $10Trillion loss can be papered over with $30Billion of taxpayer money. This is the New World, where a crack that would bring down the World economy is papered over by empty promises. May God protect us from the crushing blow of Inevitability. But don't panic just yet, this is all probably just my imagination.



Finance News:

1. Bear Stearns was bought out by JP Morgan for less than 20% of the value (Price?) of its Head Office Building ... this is an intelligent discussion of why ... read more here

2. A beautiful and succinct explanation of why Hedge Fund collapses are always spectacular ... (hat-tip to Michael Gassner) ... read more here

3. What a juicy piece of news for those following the Bear Stearns buyout! ... It seems that JP Morgan will have to raise its bid to $10/share from $2/share because the CEO did not read the 'merger' agreement carefully before it was signed ... read more here

4. This came out just as I wrote #3 above ... Its official at $10 / share. The mechanics of the transaction are quite funny though ... It seems JP Morgan does not need the approval of a majority of today's shareholders for the deal to go through ... read more here


Economic News:

1. Prospects for the US$ ... The info on the amount of leverage used by Goldman Sachs and Merrill Lynch is astounding ... read more here

2. The US Treasury congratulates the Fed for putting $30Billion of public money on the line during the Bear Stearns buyout ... (if anyone needed more confirmation that the game is rigged) ... this is the 'Too Big to Fail' philosophy on steroids. Friends bailing out other friends using public money ... read more here

3. Excellent Column on the 'End of Capitalism on Wall Street' ... too funny ... read more here

4. The Economist suggests (a mere hint of a suggestion) that JP Morgan Chase has swallowed a whale / bitten off more than it can chew with the buyout of Bear Stearns ... read more here

Islamic & Middle East Finance:

1. 'Islamic' Bond listed on the London Stock Exchange ... read more here


Miscellaneous:

1. And you thought that we were a developed economy that was beyond worrying about food prices ... read more here

2. Does this mean the end is near? ... The US Defence Department may not know where all its Nukes are ... No less an authority than CNN folks ... read more here