by Calculated Risk on 3/16/2008 09:25:00 PM

From the WSJ on JPMorgan and Bear Stearns: J.P. Morgan Rescues Bear Stearns

Meanwhile, worries are deepening that other securities firms and commercial banks might be on shaky ground. Lehman Brothers Holdings Inc. Chief Executive Richard Fuld, concerned about the markets and possible fallout from Bear Stearns's troubles, cut short a trip to India and returned home Sunday, ahead of schedule, according to people familiar with the matter. The decision came after a series of calls Saturday to both senior executives at the firm and Treasury Secretary Henry Paulson, these people say.

Stock Futures:

Here is a live DOW future (at the CBOT):

Here are a couple of other places to track the futures market:

Added: Live currency quotes. (hat tip central_scrutinizer)

Bloomberg Futures.

Barchart.com Indices

by Calculated Risk on 3/16/2008 07:47:00 PM

Webcast

Presentation Material (pdf)

Press Release: JPMorgan Chase To Acquire Bear Stearns

JPMorgan Chase will host a conference call today, Sunday, March 16, 2008, at 8:00 p.m. (Eastern Time) to review the acquisition of Bear Stearns. Investors can call (800) 214-0745 (domestic) / (719) 457-0700 (international), with the access code 614424, or listen via live audio webcast. The live audio webcast and presentation slides will be available on http://investor.shareholder.com/jpmorganchase/presentations.cfm under Investor Relations, Investor Presentations. A replay of the conference call will be available beginning at 11:00 p.m. (Eastern Time) on March 16, 2008, through midnight, Monday, March 31, 2008 (Eastern Time), at (888) 348-4629 (domestic) or (719) 884-8882 (international) with the access code 614424. The replay also will be available on www.jpmorganchase.com.

Details:

The transaction will be a stock-for-stock exchange. JPMorgan Chase will exchange 0.05473 shares of JPMorgan Chase common stock per one share of Bear Stearns stock. Based on the closing price of March 15, 2008, the transaction would have a value of approximately $2 per share.

Effective immediately, JPMorgan Chase is guaranteeing the trading obligations of Bear Stearns and its subsidiaries and is providing management oversight for its operations. Other than shareholder approval, the closing is not subject to any material conditions. The transaction is expected to have an expedited close by the end of the calendar second quarter 2008. The Federal Reserve, the Office of the Comptroller of the Currency (OCC) and other federal agencies have given all necessary approvals.

In addition to the financing the Federal Reserve ordinarily provides through its Discount Window, the Fed will provide special financing in connection with this transaction. The Fed has agreed to fund up to $30 billion of Bear Stearns’ less liquid assets.

by Calculated Risk on 3/16/2008 07:18:00 PM

From the Federal Reserve:

The Federal Reserve on Sunday announced two initiatives designed to bolster market liquidity and promote orderly market functioning. Liquid, well-functioning markets are essential for the promotion of economic growth.

First, the Federal Reserve Board voted unanimously to authorize the Federal Reserve Bank of New York to create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets. This facility will be available for business on Monday, March 17. It will be in place for at least six months and may be extended as conditions warrant. Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities. The interest rate charged on such credit will be the same as the primary credit rate, or discount rate, at the Federal Reserve Bank of New York.

Second, the Federal Reserve Board unanimously approved a request by the Federal Reserve Bank of New York to decrease the primary credit rate from 3-1/2 percent to 3-1/4 percent, effective immediately. This step lowers the spread of the primary credit rate over the Federal Open Market Committee’s target federal funds rate to 1/4 percentage point. The Board also approved an increase in the maximum maturity of primary credit loans to 90 days from 30 days.

The Board also approved the financing arrangement announced by JPMorgan Chase & Co. and The Bear Stearns Companies Inc.

by Calculated Risk on 3/16/2008 07:08:00 PM

Here is the story: J.P. Morgan to Buy Bear Stearns

by Calculated Risk on 3/16/2008 04:06:00 PM

UPDATE: WSJ: Bear Stearns Closes in on Deal To Sell Itself to J.P. Morgan

People familiar with the discussions said all sides were pushing hard to complete an agreement before financial markets in Asia open for Monday trading.

... the company is likely to fetch considerably less on a per-share basis than its stock price of $30 in New York Stock Exchange composite trading Friday at 4 p.m.

The Financial Times reports: Bear races to forge deal with JPMorgan

Bear Stearns ... was this weekend fighting against the clock on a deal to sell itself to JPMorgan Chase ... “We’re definitely in the mix,” a senior person at JPMorgan said.
...
JPMorgan has been contacting clients to inform them of the coming consolidation.

... people close to the situation said ... it was ... likely the firm would be acquired as a whole and split later.

My guess is a deal will be reached before the market opens tomorrow.

by Calculated Risk on 3/16/2008 01:37:00 PM

Click on image for full cartoon at the WaPo site.

Here is a simplistic cartoon from the WaPo showing how leverage can boost returns - and can also lead to disaster. How Debt Bites Back (hat tip David).

This cartoon shows leverage of 30 to 1; I think 14 to 1 is more typical.

Using the other numbers in the cartoon, 14 to 1 leverage would result in 36% return from the hedge fund when all is going well (before the hedge fund manager's cut).

And of course a 36% return will attract more investors, and allow the hedge fund to borrow more money (with the same leverage) - and pay the hedge fund manager larger fees. As the cartoon points out, because of the credit issues, this ends up being a losing strategy for investors - but the cartoon misses the final point - this is still a winning strategy for the hedge fund manager!

Back in 2005, Professor Hamilton wrote: Hedge fund risk

Psst-- want to earn a 41% annual return over a decade? Then read on.

... let me tell you about [a] fund ... called CDP, which was described by MIT Professor Andrew Lo in an article published in Financial Analysts Journal in 2001.

1992-1999 was a good time to be in stocks-- a strategy of buying and holding the S&P 500 would have earned you a 16% annual return, with $100 million invested in 1992 growing to $367 million by 1999. As nice as this was, it pales in comparison to CDP's strategy, which would have turned $100 million into $2.7 billion, a 41% annual compounded return, with a positive return in every single year.

Want to learn more? CDP stands for "Capital Decimation Partners", a hypothetical fund created by Professor Lo in order to illustrate the potential difficulty in evaluating a fund's risk if all you had to go on was a decade of stellar returns. The strategy whereby CDP would have amassed a hypothetical fortune was amazingly simple-- it simply sold put options on the S&P 500 stock index (SPX).

Buying put options is a way that an investor can buy insurance against the possibility of a big loss. For example, the S&P 500 index is currently valued around 1250. You can buy an option (the 1150 March 2006 put) that will pay you $100 for every point that the S&P is below 1150 on a specified date in March. Such an insurance policy would today cost you about $750. If you've bought enough puts to balance the equity you have invested long, you have nothing to fear if the market goes below 1150, because every dollar you lose on your main holdings you can gain back from your put option.

But what about the person who sold you that put? They have now assumed all of your downside risk. Lo's Capital Decimation Partners would use its capital to meet the margin requirements (which guarantee to the exchange that CDP could in fact make the payments to the buyer of the put), and roll over the proceeds to make even bigger bets. Essentially it was thus using leverage to turn the relatively small proceeds from selling these puts into a huge return on the capital invested.

Of course, if you play that game long enough, eventually the market will make a big enough move against you that your capital used to meet margin requirements gets completely wiped out, giving you a long-run guaranteed return on your investment of -100%. But over the 1992-99 period, Lo's hypothetical fund dodged that bullet and ended up turning in a whopping performance.

Lo gives a variety of other examples of funds that could go for a long period with very high returns and yet entail enormous risks. They all have this feature of pursuing investments that have a high probability of a modest return and a very small probability of a huge loss. By leveraging such investments, one can achieve a very impressive record as long as that low probability disastrous event does not occur.

And when the hedge fund does go under (the low probability event occurs), no one asks the hedge fund manager to return their fees. A short term winning strategy, with "a long-run guaranteed return on investment of -100%", is still a potential winning strategy for a hedge fund manager.

by Anonymous on 3/16/2008 11:00:00 AM

Dr. Krugman has inspired me to get back to the Muddled Metaphor Index. Longtime readers will know that the MMI emerged last summer as one of our blog's tools for measuring distress in the credit markets. The MMI is calculated by plotting the disintegration of metaphoricity in reports of credit market events against the general unwillingness to recognize reality until it bites you on the shoulderblade, and then chortling over the results. Some people question the science here, but we tell them to go jump in a desert.

Today's text is the reliable New York Times on Thornburg Mortgage's problems. Personally, the thing I like best about this article is that it makes no sense whatsoever to anyone who doesn't already know what Thornburg's business plan is. You imagine the average reader asking: so if Thornburg doesn't make these "Ninja" loans, how come they own all these securities full of them? The term "leverage" haunts the article like an elusive ghost that hints at a sinister presence but never quite fully materializes. That's because the whole thing just begs for another awkward metaphor to be piled on.

There are in fact several gems here:

Thornburg already had one near-death experience last summer, when the mortgage crisis first hit and its shares plunged. Racing from interview to interview, and huddling with investors and analysts, Mr. Goldstone managed to convince the market that his company could survive. He even managed to raise more than $500 million in fresh capital from investors.

This time, though, the outlook is more dire.

Specifically, the problem concerns Alt-A securities, an obscure part of the mortgage debt market that may soon become as familiar as the now-infamous subprime category. Thornburg holds billions in securities backed by Alt-A mortgages, which were considered safer than subprime but not rock solid.

Alt-A (short for Alternative-A) borrowers typically had good credit scores but lacked the documentation to lift them into the prime category.

“Alt-A has been the precipitating event; it’s just been feeding on itself,” Mr. Goldstone says. “You have AAA-rated mortgage securities trading with junk bond yields. That makes no sense.”

Yeah, it was all so precipitous. Unless you're some blogger who has been harping on the looming Alt-A problem for a year or so. Then it's more like a--oh, no, not a--AAACK!---

The story of Alt-A and Thornburg also illustrates why the current credit crisis is different from past panics, like the market crash of 1987 or the crisis a decade ago when Long-Term Capital imploded. Those were rapid-paced events, which erupted and then faded from view. This is more akin to a slow-motion, chain-reaction car crash.

Whew. I was just sure it was gonna be a train wreck, and I don't think I can handle any more of those. But of course it's like a car crash in the ocean:

IN other words, this isn’t the tip of the iceberg; it’s another iceberg entirely.

So it's a precipitous event that is also slow-motion, a chain-reaction like hitting one iceberg and almost going to the bottom but not quite and then sailing on for a while until you hit a different iceberg because after having hit the first iceberg you are still convinced that those little bitty chunks of ice floating on the waves don't have great big honkin' bergs under the surface because, like, how often does that happen?

And as Mr. Goldstone can tell you, few can predict who will be the next to feel the impact.

Um. Few complete uninformed idiots could predict this. I'd guess that an entire troop of moderately alert cub scouts could go take a look at some financial statements to see who else is overleveraged in the Alt-A sector and make a couple of pretty solid predictions, myself.

Whocoodanode? is alive and well.

by Calculated Risk on 3/15/2008 09:13:00 PM

Charlie Gasparino at CNBC reports: Bear Stearns Weekend Talks Reveal 2 Key Contenders (hat tip risk capital)

... potential bidders for Bear have been narrowed to ... J.C. Flowers and JPMorgan Chase

... bankers have now come to the conclusion that a deal must be done by Monday ...

If there's no deal Bear Stearns will have to file for bankruptcy, executives said.

by Calculated Risk on 3/15/2008 05:07:00 PM

The following graph shows an interesting relationship (Caution: correlation doesn't imply causation!). As Mortgage Equity Withdrawal (MEW) rose, so did the trade deficit. Note: both are shown as a percent of GDP.

Now that MEW is falling, the trade deficit is also falling - especially if we exclude petroleum imports.

Click on graph for larger image.

The dashed green line is the Kennedy-Greenspan MEW estimates as a percent of GDP.

Clearly the housing bust led to less MEW, and less MEW might have contributed to the declining trade deficit. (Something I predicted in 2005).

Looking forward, it appears MEW will decline sharply in 2008, as housing prices decline further, lending standards are tightened, especially for HELOCs, and since homeowner percent equity is already at record lows. In other words, the Home ATM is closing.

This suggests that the trade deficit (especially ex-petroleum) might decline sharply too. Part of the decline in the trade deficit is related to the falling dollar and higher U.S. exports (See Krugman's Good news on the dollar)

However, to complete the global rebalancing, two things must happen: both petroleum imports (in dollars) and the deficit with China must decline. The good news is the January trade deficit with China - although still huge at $20.3 billion - was actually less than the $21.3 billion in January 2007. The bad news is oil imports (in dollars) were at record levels.

Unless we see these key components of the trade deficit start to decline (oil and China), other exporters to the U.S. will have to bear the burden of the possibly sharp rebalancing of global trade.


Added: On oil, here is a KAL's cartoon from the Economist:

Click on image to see cartoon at The Economist.

by Anonymous on 3/15/2008 09:30:00 AM

Yves at naked capitalism has a great post up this morning on Character and Capitalism. I strongly recommend Yves' post and the Steve Waldman post as well.

Two anecdotes to add to the mix: back in the 90s I found myself at some manager compliance training session at my stuffy regional midwestern bank. The compliance officer was talking about the corporate policy of running credit reports on job applicants. The rationale was that, well, you don't hire people to handle other people's money all day if you have reason to believe they are personally desperate for money.

The human resources manager was there, and at that point she let out a loud uncontrollable guffaw. Challenged, she responded that yes, the HR department does order the credit reports as policy requires. They put them in the file, as policy requires, and get on with hiring people anyway. "Are you aware," she asked the compliance officer, "what we pay tellers and accounting clerks? If we didn't hire people who really needed the money, we wouldn't have anyone to hire."

A few years later I was in some meeting of the CRA Committee (Community Reinvestment Act), wherein we were examining the proposed guidelines for a low-income lending initiative. There was some resistance to the loan program based on the fact that borrowers with incomes as low as 50% of the area median could qualify. Grumbling about having to make loans to "poor people" ensued. My boss pointed out that over half the rank and file in his department who would be actually handling these loans--reviewing the loan files, preparing them for the servicing system, delivering them to custodians and investors--were paid 50% of the area median or less. Henry Ford might have figured out many decades ago that you need to pay your workers enough that they can buy your product, but that lesson was lost on the banks.