March 16th, 2008

Sunday before the Crash: Paulson says nothing

Posted in Money, These United States by ed


Treasury Secretary and former Goldman Sachs chairman Henry Paulson went on TV (Fox) this (Sunday) morning to say nothing of substance in the wake of the failure and Fed bailout of Bear Stearns on Friday.

And like Bush on Friday, speaking as markets melted on the Bear news, Paulson rejected the various ideas in Congress for aggressive extra-market action to staunch the flowing blood.

And Paulson’s only comment on the housing business — the heart of the matter — was that “the markets have to correct.”

Words to remember.

Paulson never fails to inspire despair when he speaks. He is something of a Dubya in this respect. Both men seem to lack the imagination and ideas their jobs require.

The coming week in the markets looms. Four of the five major brokers report their latest results. The Fed meets Tuesday on interest rates. The biggest IPO (Visa, the credit card system) in many years tries to float on Tuesday. And triple witching expiration (all futures and options contracts) occurs on Thursday. The markets are then closed for Black Friday.

The week, then, is jam packed with explosive material. The potential for the panic that sank Bear Stearns spreading to the other big brokers is real, and the fear of such was already palpable on Friday, when Lehman (the second biggest player in mortgage bonds) sank 15% while Bear fell 47%.

The only bit of substance in Paulson’s appearance came when he hinted obliquely that a bona fide buy-under of Bear (which would take its liabilities off the Fed’s balance sheet) is in the works. JPMorgan Chase was Bear’s prime creditor and as such served as broker between Bear and the Fed in the bailout on Friday. It and HSBC, a brit bank, are the names that circulated Friday as Bear’s best suitors.

But the world is running out of megabanks. If the other major brokers suffer anything like the crisis of confidence that crushed Bear, who will buy them? Citigroup is already on the ropes — a candidate for failure or fire sale. UBS (of Switzerland) and Deutsche Bank like Citigroup have been deeply gouged by the collapse and or freezing of markets in structured finance bonds. Bank of America has already bought the largest mortgagor, crippled Countrywide, and is suffering for the move …

Paulson was asked directly three times today if the Fed would (indeed, could) buy the obligations of the other four brokers if they too went belly up. He (of course) refused each time to answer the question.

Thus, if the panic spreads to the other four this week, it’s very hard to imagine an orderly reaction. Rather, it seems we’ll see an unprecedented and almost immeasurable panicked unwind of trillions in securities that will completely freeze the global system.

At that point the Free Market game ends, once again. Anyone too young or too shallow to know of the world before Reagan will have his mind blown. Historyless, they haven’t a clue. And reading the commentary the creepy impression intrudes that the world of finance, and the financial press, are universally populated with such people.


The five big brokers — Merrill Lynch, Morgan Stanley, Goldman Sachs, Lehman Brothers and Bear Stearns — are the counterparties in trillions of dollars worth of derivatve securities, most of which are swap agreements in which one party pays the other a small regular fee in exchange for the right to receive compensation in the future upon the occurrence of specified trigger events. In essence these swaps are like insurance policies.

After the Fed bailout was announced Friday morning, Bear had its basic credit rating downgraded by S&P in the afternoon. This downgrade triggers termination provisions in a zillion swap agreements in which Bear is counterparty. What happens now?

Three or four years ago, while working as a principal drafter of CDOs for a Wall Street law firm, I chatted with my boss about this very scenario: specifically, what would happen if Lehman Brothers — also counterparty to a zillion swap agreements — failed to hold up its end. There was no imaginable answer then, and none now, aside from “the game ends.”

(The Lehman entity that does most of its swap agreements is Lehman Brothers Special Financing, Inc. In my experience, whenever LBSF entered a swap agreement (which are, inter alia, often embedded in CDOs to help control interest rate and similar environmental risks), its obligations thereunder were guaranteed by the holding company atop the Lehman empire, Lehman Brothers Holdings Inc.)

So what happens if what happened to Bear on Friday happens to Lehman (the second largest player, again, in mortgage bonds) this week as confidence corrodes and rating agencies downgrade?

The parties on the other end of the swap agreements, at bottom, are mostly structured-finance bond investors. “At bottom” means: once one works thru the shell-company issuers of the bonds. These issuers are technically the prime party to the swap agreements, and as such they stand up for the investors of the bonds they issue.

(But also note that these issuers are indeed shell companies created and controlled by the “counterparty” — whether it be Bear, Lehman, Goldman, Morgan Stanley or Merrill. So in fact both the prime party and the counterparty are the same: the Wall Street broker. And thus the potential for conflicts of interest, when something like Bear fails, are there. But let’s assume that the shell issuers act as they should: to defend the interests of the investors in their bonds.)

When a rating agency downgrade of the counterparty (which happened Friday to Bear) occurs, it triggers termination provisions in the swap agreement, under which the prime party (the issuer) has the right to terminate the swap.

When talking about a swap embedded in a CDO, the termination of the swap in turn triggers termination provisions of CDO itself. This makes sense: the protection afforded to the CDO by the swap no longer exists, so the deal closes down to protect the CDO investor.

But when the spector of a major broker failing shadows the Street …

A zillion swaps terminating simultaenously … Triggering same of a half zillion CDOs — which may otherwise be healthy, paying their investors regular interest and preserving principal for return at wind up …?

If a CDO abruptly closes down, the broker has to sell the assets underlying the CDO to recover principal for the CDO investor. These assets, as the name “Collateralized Debt Obligations” implies, are all kinds of debt instruments: corporate bonds, mortgage and credit card and auto loan bonds (common types of “asset-backed securities”), packaged LBO loans …

One CDO abruptly closing down would produce an unpleasant blip in the credit markets. A dozen closing down the same week would mean a bad weekend in Southhampton and Greenwich. But what happens when, say, ten percent of the CDOs that contain swap agreements where Bear Stearns is the counterparty suddenly are compelled to sell their assets in an already devastated and dry market?

The spectre haunting Wall Street, then, this Sunday, is that of huge fire sales sweeping the global credit markets.

Especially if it becomes clear early in the week that a bona fide buy out of Bear by a big bank is not shortly forthcoming. As many suspect. For to buy Bear one would have to understand its vast portfolio of derivative securities, and it’s going to take longer than a weekend to come to that understanding.

Yet Paulson today said nothing and clearly indicated that Bush-Cheney will continue to do almost nothing.

Thus it’s not much of a stretch to worry that the coming week may be one of the great debacles in the history of the markets. The 1987 crash was roughly 22% of the Dow. A comparable crash today would be over 2,500 points.

Then again — the potential for a remarkable upswing is also out there, — simply because things have been so bad since August, and particularly since January.

– If Monday morning presents the world with a definitive Bear buy-under plan …

– If the four major brokers reporting results this week manage to show numbers that persuade people that the fate of Bear does not await all, perhaps even that the trashing of Bear was irrational …

– If the Visa IPO avoids the fate of the space shuttle Challenger …

– If the Fed on Tuesday with its words and acts manages to persuade people that SOMEBODY in Washington is not a shallow boneheaded Free Market ideologue …

– If despite Paulson’s non-performance today on the tube, the Fed or Treasury announced a program to buy Fannie Mae and Freddie Mac mortgage bonds (Joltin’ Jersey Jim Cramer says a $50 billion purchase would stabilize this sector of the credit markets, the dark heart of the matter) …

The latter move would be pound wise. But Paulson nixed it today.

Something broader and even more effective would be to revise the accounting regulations (passed in 1993) that require institutions to mark these complex structured finance bonds to market value, despite the fact that for many classes of such no secondary market exists (or was ever intended to exist, in the case of the CDOs I worked on).

Or: institute price controls on the wounded bond classes that will allow institutions to carry them on their books and stop announcing huge paper losses, allowing the bonds to live out their lives and return most of the interest and principal they were intended to return — well above what the current (non-existent) Market Values imply.

(Price Controls of course would blow the mind of the Reagan-born Free Marketeers that dominate the industry; we haven’t seen them since Nixon.)

There is no doubt that the Western (increasingly a global) finance system is facing its worse crisis since the one triggered by the crash of 1929. So far the reaction of Washington today echoes the blase Laissez Faire reaction of Hoover and Wall Street in 1929. A huge and protracted decline in credit caused the Great Depression. Doctrines of the day dictated austerity for the people. So far we are tracking the same path.

At some point somebody will realize there is no market cure for what ails the markets. But how long, Adonai, how long?


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