IN the week or so since the Federal
Reserve Bank of New York pushed Bear
Stearns into the arms of JPMorgan
Chase, there has been much buzz about why the deal went down precisely as it
did.
Its primary purpose, according to regulators, was to forestall a toppling
of financial dominoes on Wall Street, in the event that Bear Stearns skidded
into bankruptcy and other firms began falling apart as well.
But a closer look at the terms of this shotgun marriage, and its
implications for a wide array of market participants, presents another
intriguing dimension to the deal. The JPMorgan-Bear arrangement, and the Bank
of America-Countrywide match before it, may offer templates that allow the
Federal Reserve to achieve something beyond basic search-and-rescue efforts:
taking some air out of the enormous bubble in the credit insurance market and
zapping some of the speculators who have caused it to inflate so wildly.
Of course, it could be simple coincidence that the rescues caused billions
of dollars (or more) in credit insurance on the debt of Countrywide and Bear
Stearns to become worthless. Regulators haven?t pointed at concerns about credit
default swaps, as these insurance contracts are called, as reasons for the two
takeovers. (And Bank of America?s chief executive, Kenneth
D. Lewis, has flatly denied that his deal with Countrywide was at the behest
of regulators.)
Yet an effect of both deals, should they go through, is the elimination of
all outstanding credit default swaps on both Bear Stearns and Countrywide bonds.
Entities who wrote the insurance ? and would have been required to pay out if
the companies defaulted ? are the big winners. They can breathe a sigh of
relief, pocket the premiums they earned on the insurance and live to play
another day.
Investors who bought credit insurance to hedge their Bear Stearns and
Countrywide bonds will be happy to receive new debt obligations from the
acquirers in exchange for their stakes. They are simply out the premiums they
paid to buy the insurance.
On the other hand, the big losers here are those who bought the insurance
to speculate against the fortunes of two troubled companies. That?s because the
value of their insurance, which increased as the Bear and Countrywide bonds
fell, has now collapsed as those bonds have risen to reflect their takeover by
stronger banks.
We do not yet know who these speculators are, but hedge fund and
proprietary trading desks on Wall Street are undoubtedly among them.
The derivatives market is huge, unregulated and opaque because participants
undertake the transactions privately and don?t record them in a central market.
The growth in the market and the potential for disruption, as a result of its
size, has surely caused regulators to lose plenty of sleep.
Credit default swaps were created as innovative insurance contracts that
bondholders could buy to hedge their exposure to the securities. Like a
homeowner?s policy that insures against a flood or fire, the swaps are intended
to cover losses to banks and bondholders when companies fail to pay their debts.
The contracts typically last five years.
Recently, however, speculators have swamped the market, using the
derivatives to bet on companies they view as troubled. That has helped the swaps
become some of the fastest-growing contracts in the derivatives world. The value
of the insurance outstanding stood at $43 trillion last June, according to the
Bank for International Settlements. Two years earlier, that amount was $10.2
trillion.
But before a contract can pay out to a buyer of the insurance, a company
must default on its bonds. In both the Countrywide and Bear Stearns takeovers,
the companies were saved before they could default. Both deals also specify that
the acquiring banks assume the debt of the target.
As a result, the insurance policies that once covered Bear Stearns and
Countrywide bonds will become the obligations of much stronger issuers: JPMorgan
and Bank of America. No payouts are coming, guys.
So consider all those swaggering hedge fund managers and Wall Street
proprietary traders who recorded paper gains on their credit insurance bets as
the prices of Bear and Countrywide bonds fell. Now they must reverse those gains
as a result of the rescues. If they still hold the insurance contracts, they are
up a creek ? and the Fed just took away their paddles.
An interesting side note: It?s likely that JPMorgan, the biggest bank in
the credit default swap market, had a good deal of this kind of exposure to Bear
Stearns on its books. Absorbing Bear Stearns for a mere $250 million allows
JPMorgan to eliminate that risk at a bargain-basement price. JPMorgan declined
to comment on the size of its portfolio of credit default swaps.
We?ve yet to hear a peep about losses stemming from the Countrywide and
Bear Stearns debacles. That doesn?t mean they aren?t there. Remember all those
months that the subprime problem was supposed to have been ?contained??
IF we?ve learned anything from this year-long walk down the credit-crisis
trail, it is that speculators on the losing end of such deals don?t typically
volunteer that they have suffered enormous hits in their portfolios until they
are forced to ? often when they?re on the brink of collapse.
Do the Bear Stearns and Countrywide deals represent a regulatory template?
Both had the same types of winners and losers. Bondholders won, while
stockholders and credit insurance owners lost. Although there aren?t that many
big banks left that are financially sound enough to buy out the next failure,
it?s a pretty good bet that future rescues will look a lot like these.
Maybe it?s just a coincidence that both these deals involve wiping out
billions of dollars worth of outstanding credit default swaps linked to Bear
Stearns and Countrywide bonds.
Still, helping to trim the risk just a tad in the $43 trillion credit
default swap market certainly qualifies as a side benefit. Had either Bear
Stearns or Countrywide defaulted, the possibility that some of the parties
couldn?t afford to pay what they owed to insurance holders posed a real risk to
the entire financial system.
It?s pretty clear that some major losses are floating around out there on
busted credit default swap positions. Investors in hedge funds whose managers
have boasted recently about their astute swap bets would be wise to ask whether
those gains are on paper or in hand. Hedge fund managers are paid on paper
gains, after all, so the question is more than just rhetorical.
Losses, losses, who?s got the losses?