March 18, 2008

Perception is reality

Take a balance sheet weakened by the non-marketability of assets on it. Add in doubts from counterparties and an unwillingness to take the other side of a trade to, for example, assume interest rate risks. Combine with client uncertainty and top it all off with the loss of access to the critical commercial paper market (the financial lifeblood of all the large non-depository banks) and you have the perfect financial storm that destroys an investment bank.

That, in short, is what happened to Bear Stearns. Was Bear in trouble? Sure. The fact that the company made some horrendous bets on some very toxic MBS, mostly filled with Alt A and Sub-Prime credits. Then they dumped them into CDO's, in which interests were sold to investors. Just to add another layer of risk, they then borrowed heavily against the shit credits in the CDO to, wait for it, buy still more shitty credits to juice the return. The CDO could borrow cheaply so the spread income was very good and helped Bear come in with extremely good profits. As long as no one doubted the value of the credits in the CDO. When those became unsaleable, creditors called loans and there was a run on the bank.

And that last bit is what killed Bear. You can't pay off $100 Billion in loans with $20 Billion in equity, for example. If you can't float that $100 Billion with constant funding, you're effectively bankrupt. Well, that's actually putting it mildly. You're a cautionary tale. The fact that the assets you've acquired with that debt are worth less than 1/10 what you paid just seals the deal on the tragedy.

Though the underlying event was different, something very similar happened to Salomon Bros. in 1991. Then, a white knight was able to step in, restore confidence and, by extension, the funding. No such luck this time with JPMorgan Chase. The only question that remains is were their actions deliberate. Consider this...

The swiftness of Mr. Dimon’s decision to buy Bear is remarkable given that he has not been an aggressive acquirer since he joined the firm after selling it BankOne, where he was chief executive. He has cautioned patience about making acquisitions, though he had suggested in recent months that the firm might be ready to make a major deal.

Earlier this month, the co-chief executive of JPMorgan’s investment bank, William T. Winters, said on a conference call with investors: “If a special opportunity came up to acquire a prime broker at a decent return, we wouldn’t hesitate. We’ve always said, ‘Boy, if there was one for sale, we’d love to look at it.’ ”

A deal needed to be reached quickly to protect the business from collapsing entirely. With most if not all of its clients stopping trading with the firm, its days were numbered.

One has to wonder if maybe the crisis of confidence was, if only in part, exacerbated by JPMC. Of course, we'll probably find out. That's what lawsuits are all about.

Posted by mcblogger at March 18, 2008 11:59 AM

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