Today's TIDBITS

March 18, 2008   

Why is Bear Stearn’s Stock Trading at Over $2 a Share?

From Bloomberg:  “Bear Stearns Cos. rose 45 percent in New York trading to triple the current $275 million value of JPMorgan Chase & Co.'s buyout plan as traders increased bets that investor resistance would force a higher offer.  JPMorgan, with backing from the Federal Reserve, agreed on March 16 take over the 85-year-old New York-based securities firm for about $2 a share in stock to prevent a collapse.  Shareholders must approve the transaction.  Yesterday, billionaire Joseph Lewis, Bear Stearns's second-biggest shareholder, called the price ``derisory,'' according to a phone interview cited by CNBC. Other investors may share that opinion.  ``It's perfectly possible that the deal you see right now is not the deal you're going to get…There's every incentive for shareholders to vote `no' the first time.''

From Fortune:  “Why is Bear Stearns (BSC) up nearly 70% Tuesday, to a price about $6 a share above its $2-a-share buyout agreement with JPMorgan Chase (JPM)? Two groups are piling into the company’s stock so they can vote in favor of the deal…The first group is the hedge funds that were selling so-called credit default swaps that protect the purchaser against a possible bankruptcy at Bear Stearns. Spreads on Bear Stearns CDS soared to 1,000 basis points Friday - meaning it cost $1 million to insure against a default of $10 million face value of bonds. Those spreads have since narrowed to around 350 basis points, or $350,000 per $10 million in insurance, in light of the prospect that JPMorgan Chase will take over Bear’s obligations. So a seller of a Bear Stearns credit default swap on Friday, having taken in $1 million in premium, can now turn around and protect himself against a default in Bear Stearns for $350,000.  That translates into a $650,000 gain -and the potential profit stands to get bigger as the close of the transaction approaches and Bear spreads move more in line with JPMorgan’s, which are around 115. Those dynamics give hedge funds a big incentive to make sure the deal goes through.  Beyond the credit default swap trade, there’s another group interested in making sure JPMorgan winds up owning Bear Stearns. Holders of Bear Stearns debt want the deal to go through so they won’t end up fighting with other creditors in bankruptcy court over the remains of the firm - the likely outcome if Bear shareholders turn the deal down. And Bear Stearns bonds that recently traded as low as 80 cents on the dollar could soon be worth 100 cents if JPMorgan goes through with its purchase.  So while taking a loss on the stock makes little sense on the face of it, buying at $7 to get cashed out at $2 can pay off if you’ve bet enough money elsewhere.”

Fed Decided Systemic Risk Greater than Moral Hazard Risk - Puts Fed’s Resources and Reputation at Risk

From The International Herald Tribune:  “Far more than at any time before, the Federal Reserve is putting its vast resources and its reputation on the line to rescue Wall Street's biggest institutions from their far-reaching mistakes.  Over the next few months, the central bank will lend hundreds of billions of dollars to banks and investment firms that financed a mountain of mortgages now headed toward default.  No one knows how many financial institutions will be looking for money, or how much they will seek. No one knows how much in hard-to-value securities the central bank, in return, will have to hold as collateral.  And no one knows how much the Fed could lose if the borrowers fail to repay their loans or whether hundreds of billions of dollars will ultimately have to come from taxpayers to shield the nation's financial system from ruin.  In recent weeks, the central bank announced a series of emergency short-term loan programs that totaled about $400 billion. But on Sunday, Fed officials raised the stakes by offering investment banks a new loan program without any explicit size limit.  These moves, along with a $30 billion credit line to help JPMorgan Chase take over the failing Bear Stearns, is fraught with more than financial risk.  The biggest danger is damage to the Federal Reserve's credibility if it is seen as unwilling to let financial institutions face the consequences of their decisions. Central banks have long been acutely sensitive to "moral hazard," the danger that rescuing investors from their mistakes will simply encourage others to be more reckless in the future.  Fed officials for years have cringed at the mention of a "Greenspan put," an allusion to the belief of some investors that Alan Greenspan, the former Fed chairman, would use the Fed's powers to protect them against a plunge in financial markets and provide them with a metaphorical "put" — an option to unwind their positions at an acceptable price.  But the moves undertaken by the current chairman, Ben Bernanke, amount to a much bigger insurance policy than anything Greenspan provided.  Bernanke had made clear for months that he wanted to avoid a bailout of Wall Street. But as an economic scholar who spent years studying the Depression of the 1930s, he had also drawn the lesson that panics in financial markets can transform a modest downturn into a cataclysm.  Fed policy makers now contend that the consequences of not coming to the rescue would have been a cascade of bankruptcies and defaults on Wall Street that could have undermined the financial system and risked severe damage to the economy.  Few analysts were ready on Monday to question the Fed's uncomfortable effort in balancing risks. But it could be months or years before the full consequences become apparent.  Alan Blinder, a professor of economics at Princeton and a former Fed vice chairman, commented: "These kinds of crisis-prevention measures always have to balance potential moral hazard costs down the line against the clear and present danger that something is going to happen right now.  "You're taking on substantial risks when you do something virtually unprecedented or you put money at risk. The Fed has now done both."  Another big risk is that the central bank, in providing a cushion of emergency loans, could jeopardize its reputation as an inflation fighter… There were hints on Monday that the central bank's rescue operation might have bolstered confidence in the battered credit markets.  Several measures of risk aversion receded slightly. Spreads between the higher yields that investors demand for debt securities compared with those for safer Treasury bonds declined slightly. So did prices for credit default swaps, which amount to insurance premiums paid to protect bondholders in the case of a default… Analysts caution that for all its might, the Federal Reserve and its loan program face limits unless officials decide to start printing more money to pay for the rescue.

At the moment, the central bank has committed cash and Treasury bonds that are in its own reserves, totaling about $800 billion. But having agreed to provide at least $400 billion in short-term loans, and probably more, it is pledging a big share of its resources to the rescue.  "The Fed is now running on less than a half tank of gas," Laurence Meyer, a forecaster at Macroeconomic Advisers and a former Fed governor, wrote in a note to clients. "The Fed seems to be running out of room for these types of measures."  Officials at the central bank brushed aside such concerns, noting that many of the loans would be limited to 28 days and that the longest-term loans have to be repaid within 90 days. Fed officials also say that the combined rescue effort is not as big as the sum of the individual loan programs implies, because some institutions will simply shift from an earlier program that is less convenient to the newest one announced on Sunday.  If the rescue effort fails, taxpayers could indirectly wind up having to assume part of the cost. Tax revenue does not pay for the Federal Reserve's operations, including the rescue effort, because the Fed earns income from its trading operations.  But the Fed does pay the Treasury a regular stream of money every year out of its trading profits, lowering the amount it needs to borrow from outsiders. If the new borrowers on Wall Street are unable to repay, and if the market value of the securities they pledge as collateral continues to drop, the losses will come out of the Fed's payments to the Treasury.”

How Bond Ratings Became So Important to the Financial System

From Time:  “The practice of giving letter grades to bonds to reflect their riskiness was pioneered by John Moody in 1909. But the industry took its current form only in the early 1970s. That's when Moody's and its competitors switched from selling research to investors to charging bond issuers to rate their goods. This approach wasn't unheard of: you have to advertise in Good Housekeeping to get the Good Housekeeping Seal of Approval. What made it problematic was that at about the same time, the Securities and Exchange Commission (SEC) exalted the status of the ratings by writing them into the rules governing securities firms' capital holdings. Since then, the use of bond ratings in regulation has only grown. Many institutional investors are banned from owning non-investment-grade bonds. Bank-capital requirements--the cash and equivalents banks need to keep on hand--give more weight to highly graded securities. And this is increasingly the case not just in the U.S. but around the world.  What all this amounts to, argues Frank Partnoy, a derivatives salesman turned University of San Diego law professor, who is one of the sharpest critics of the ratings status quo, is a "regulatory license" for the ratings agencies. It's certainly a license to print money. Moody's, the lone ratings firm for which data are available, made $702 million in after-tax profit last year, up from $289 million just five years before. Its operating profit margin was a stunning 50% of revenue. By comparison, Google's was 30%.  To keep that profit machine going, Moody's and S&P have to keep finding new things to rate. And they're under intense pressure from issuers and investors alike to get as many securities as possible into the top ratings categories. The result is grade inflation, especially in new products like CDOs. That's how banks and investors around the world ended up owning billions of dollars in triple-A mortgage junk. It also helps explain the growth of bond insurers, companies that used their own triple-A ratings to bump ever more bond issues into the top categories--even as their businesses ceased to be triple-A safe.  One way to combat these tendencies would be to subject the raters to tight regulation by the sec. But that understaffed agency is unlikely to be up to the task, especially since it's not clear what exactly the task would be.  Which leaves the alternative suggested by Partnoy and several economists: cleansing the federal code of its reliance on bond ratings. Among the simplest fixes would be removing the ban on pension funds' holding debt securities rated lower than BBB. The funds can make far riskier investments in stocks and hedge funds, after all. Bank-capital requirements do have to take into account the quality of securities, but there are market-based measures that could at least partly replace ratings.”

Bank Credit Remains Tight As More Back-Up Lines Are Used

From Bloomberg:  “Citigroup Inc., JPMorgan Chase & Co. and the rest of the banking industry face a new drain on their capital.  Borrowers from Sprint Nextel Corp. to Porsche Automobile Holding SE to MGIC Investment Corp. are drawing on credit lines.

JPMorgan analysts say it's the start of a trend that may force banks to raise as much as $40 billion to keep an adequate cushion against potential losses.  Companies are scrambling for cash at one of the worst times for the financial services industry. The world's biggest firms have taken $195 billion in writedowns and losses on securities tied to subprime mortgages, and the 10 biggest U.S. banks have the lowest capital levels in at least 17 years, according to Credit Suisse Group… ``The capital of the financial system has imploded,'' Goldman, a former head of debt research at Bank of America Corp., said in an interview on Bloomberg Radio in New York last week. ``They have commitments to make loans, which they are being called out on, and their capital is bleeding to death.''   Bear Stearns Cos. was forced to sell itself to JPMorgan for $240 million, 90 percent less than its value last week, after the firm was crippled by clients pulling money and lenders reining in credit.  Banks had more than $1.4 trillion in untapped loan commitments as of September, the most since data became available in 1989, according to the Shared National Credit survey by four U.S. regulators including the Federal Reserve and Office of the Comptroller of the Currency.  New York-based Citigroup had $471 billion at yearend, more than any other U.S. bank, according to regulatory filings.  Charlotte, North Carolina-based Bank of America disclosed $406 billion of undrawn loan agreements and New York-based JPMorgan had $251 billion. Merrill Lynch & Co. had $59.3 billion.  The banks' Tier 1 capital, which includes common stock, retained earnings and perpetual stock, shows why any further drain may ``severely'' limit new lending, said Credit Suisse …The median Tier 1 level at the 10 biggest U.S. banks fell to 7.3 percent of risk-weighted assets at the end of 2007, from 8.7 percent a year earlier, according to the analysts. The ratio hasn't been as low since the Zurich-based bank began tracking in 1990. The minimum for a ``well-capitalized'' rating from regulators is 6 percent. The assets are calculated by weighing each type relative to its chance of default.  To compensate for the declines, banks have raised at least $50 billion in new capital from investors such as the Government of Singapore Investment Corp. and Abu Dhabi Investment Authority to bolster their balance sheets… The added demand from borrowers comes as banks rein in lending to everyone from hedge funds to homeowners in an attempt to preserve capital… Borrowers will be more inclined to tap credit lines as banks tighten their lending standards… ``It's a vicious cycle,'' he said. ``The more that they tighten the lending standards, the more there will be certain stresses in the financial market. Any sort of unfunded commitments they've put out are likely to be called on.''… ``If they are short of capital at some point, banks may stop offering credit to borrowers that would normally qualify for a loan,'' said Anil Kashyap, a professor at the University of Chicago Graduate School of Business, and a former economist for the Federal Reserve. ``That's the definition of a credit crunch.''”

European Central Bank (ECB) Monetary Policy On Hold for Now

From MNI:  “Acute and ongoing concerns about inflation will keep the European Central Bank's monetary policy on hold for the foreseeable future despite slowing economic growth and a sharply rising euro, well-placed eurozone central bankers have told Market News International.   With inflation above 3%, oil over $100 a barrel, and wage talks threatening to yield potentially inflationary pay rises, the ECB would probably be considering an interest rate hike under more normal circumstances.  But severe market turbulence, economic headwinds from across the Atlantic, and the euro's unrelenting ascent have left the bank with its hands tied for now…”

Dealer Comments on FOMC Decision

From Goldman:  “The decision of the Federal Open Market Committee to cut its federal funds rate target by 75 basis points is a clear disappointment to the markets, which had priced in 100bp up until right before the announcement, when they backed off only slightly from this view.  From the nature of the statement, it seems clear that any thought of easing by 100bp would have met with considerable resistance. As it was, two members -- Fisher of Dallas and Plosser of Philadelphia -- dissented from the 75bp move; both "preferred less aggressive action at this meeting."  Moreover, only three district banks -- Boston, New York, and San Francisco -- applied for the parallel cut in the discount rate to 2-1/2%.  Of those, only the New York President -- Timothy Geithner -- is a voting member at this time (he is permanently Vice Chair of the FOMC).  Although one cannot be absolutely sure what the other banks had applied for, it appears that even the 75bp rate cut had soft support outside the Northeast corridor.  If so, then 100bp could have invited a couple more dissents.  The statement is factually faithful to recent developments, noting a further weakening in growth, both overall and in consumer spending in particular, and a softening in the labor markets.  It also comments on the stress in financial markets, noting the likely dampening effect on growth in coming quarters.  On the inflation side, the statement notes an increase in "some" measures of expectations but reiterates the Committee's expectation that inflation will moderate as pressures ease in commodity markets and on resource utilization.  Although the final pargraph focuses mainly on "downside risks to growth," the final statement has shifted a bit to resurrect this concern about inflation. Whereas in January it promised that the Committee "will act in a timely manner as needed to address those risks" -- implying risks to growth -- today the parallel statement amends the final clause to say "to promote sustainable economic growth and price stability."”

From FTN:  “…they are concerned about inflation, too, enough that they say more about inflation than growth… It is entirely possible that Bernanke pressed for a full point cut and was forced to settle for 75bp, but more likely he got exactly what he asked for. Fisher and Plosser apparently were unable to push Mishkin, who has expressed a similar concern over inflation in recent weeks, or anyone else to stand with them. Still, Bernanke will have his hands full if inflation continues to push higher. There is internal division within the Fed now.”

From Morgan Stanley:  “…for the first time in memory, the statement indicated that “inflation expectations have risen.”  We are surprised at the outcome of the meeting from a number of different standpoints. In the wake of the unprecedented action announced on Sunday night, we had been looking for a 100 bp cut in the funds rate target. We also believed that the wording of the statement would be at least as dovish as the January version. Finally, even though Plosser and Fisher are well known hawks, we are very surprised that more than one policymaker would issue a formal dissent in such a fragile environment.  Indeed, the dissents might be a signal that the 75 bp outcome represented a compromise between some who pushed for a larger move and those that would go along with only a 50bp cut.”

From Deutsche Bank:  “Some of the internal debate was probably reflected in the votes for the discount rate cut.  Only three banks supported a 75bps cut, whereas the January move had the support of nine banks.  After today's action, we believe any further rate cuts are likely to be in smaller increments.  At present, we are looking for a 50 bp cut at the April meeting and a 25 bp cut at the June meeting.” 

From Citi:  “In the context of recent days' near seizing up of the financial markets, this is a surprising  posture. If this action fails to support renewed financial stability, inflation

will not be among the key worries and policy would be more likely pressed eventually to use unconventional policy and let go of controlling the funds rate. Credit and equities will be key over the next few days in assessing how much closer to zero policy may need to go.”

From Merrill Lynch:  “It is a sign of these turbulent times that the Fed can be accused of doing the minimum expected while lowering the funds rate …in what was the largest proportional easing on record.  This would have been like Volcker cutting rates 450 bps in one fell swoop.”

From Merrill Lynch:  “…in nominal terms, the FFR [Fed funds rate] is now 150.0 to 175.0 bps below its 'neutral" level, which is highly accommodative, and in 'real" terms, the FFR is negative, and highly stimuluative.”

From Bank of America:  “The Federal funds rate is now below both headline and core inflation, and is also below select measures of inflationary expectations. :

[ Note- Post FOMC, most dealers are looking for another 50bp of easing in April]

MISC

From Deutsche:  “The repo mkt has broken its mooring and seems to be headed for zero.  There is so much cash out there looking for a short-term place to rest that it has overwhelmed the mkt.  The Treasury just auctioned 31bln 1mo Bills at 0.52[%].”

From Morgan Stanley:  “The GSEs could grow roughly 30-40 bln for each 1 bln in capital that is released from the ofheo surcharge …That is if they earmark each 1bln of capital release to straight purchases of mortgages.”

From USA Today:  “More than three in four Americans think the country is in a recession, a USA TODAY/Gallup Poll over the weekend shows, reflecting a crisis of confidence that economists say could make the economy worse… Not since September 1992, two months before President George H.W. Bush lost re-election, have so many Americans said the economy was in such bad shape… Asked if the nation could slip into a depression lasting several years, 59% said it was likely, and 79% said they were worried about it. A recession is an economic downturn that usually lasts at least six months; a depression is longer, deeper and more broadly dispersed.”

From Bloomberg:  “The cost of crude oil exceeded the value of gasoline for the first time in more than two years as oil surged to a record, undermining the profitability of refining. U.S. gasoline futures on the New York Mercantile Exchange, representing wholesale prices, normally cost more than the raw material, crude oil, to reflect the cost of refinery processing.”

End-of-Day Market Update

From Bloomberg:  “U.S. stocks rallied the most in five years as earnings from Lehman Brothers Holdings Inc. and Goldman Sachs Group Inc. allayed concern investment banks are collapsing and the Federal Reserve cut its benchmark rate.  Lehman, the fourth-biggest securities firm, had its steepest advance ever and helped lead financial stocks to their biggest gain since 2000. Goldman, the largest securities firm, rallied the most in nine years. All 10 industry groups in the Standard & Poor's 500 Index added at least 1 percent after the Fed cut the target rate for overnight lending by 0.75 percentage point, helping the market erase a two-day tumble that wiped out $767 billion following Bear Stearns Cos.'s collapse. ``The run on the investment banks would appear to be over,… It seems certain we are going to finish the week with the four investment banks we started with, and we couldn't be sure of that Monday morning. The Fed decision is actually a bit of a sideshow.''      The S&P 500 rose 54.14 points, or 4.2 percent, to 1,330.74. The Dow Jones Industrial Average climbed 420.41, or 3.5 percent, to 12,392.66, its fourth-biggest point gain ever. The Nasdaq Composite Index increased 91.25, or 4.2 percent, to 2,268.26. Sixteen stocks rose for every one that fell on the New York Stock Exchange. Treasuries dropped and the dollar surged the most in almost four years against the yen.  Financial shares in the S&P 500 gained 8.5 percent as a group, the top advance among 10 industries, after the better- than-forecast earnings at Lehman and Goldman assuaged concern that Wall Street firms were overvalued. The Fed reduced its benchmark rate to the lowest level in more than three years. The central bank has cut the rate six times and slashed the discount rate for direct loans to banks eight times since the middle of August, when the collapse of subprime mortgages started to infect markets around the world. Goldman surged $24.57, or 16 percent, to $175.59. Net income fell to $1.51 billion, or $3.23 a share, in the three months ended Feb. 29 from $3.2 billion, or $6.67, a year earlier, Goldman said in a statement. The average estimate of 17 analysts surveyed by  Bloomberg was for $2.59 a share, with forecasts ranging from $1.95 to $3.40. Lehman, which lost 19 percent yesterday, climbed 46 percent today to $46.49. First-quarter net income declined to $489 million, or 81 cents a share, from $1.15 billion, or $1.96, a year earlier, the New York-based firm said. That beat the 72- cent average estimate of 16 analysts surveyed by Bloomberg. Earnings were depressed by a $1.8 billion writedown caused by the slump in the mortgage market. Assuming Lehman will fail because Bear Stearns did is ``a bad bet to make,'' …While both are involved in mortgage securities, Lehman has more diversity from overseas operations, money-management businesses and high-profile deals…Citigroup Inc., the biggest U.S. bank, advanced $2.09 to $20.71. JPMorgan Chase & Co., the third-largest U.S. bank, gained 6 percent. Merrill Lynch & Co., the third-biggest securities firm, added 13 percent.  U.S. financial stocks are getting closer to ``bottoming out,'' analysts at Morgan Stanley said.  ``We view the banks as vulnerable to the credit cycle, with Fed rate cuts only a partial offset,'' the analysts, led by Nigel Dally, wrote in a report to clients. ``But some of these risks are now in the stocks.''      Financial shares tumbled to their lowest level in almost five years yesterday on concern Wall Street's biggest firms may be overvalued following the $2-a-share takeover of Bear Stearns by JPMorgan.”

From Bloomberg:  “The dollar surged the most in nine years against the yen and gained against the euro after the Federal Reserve cut interest rates by 0.75 percentage point in a bid to boost the economy and confidence in financial markets… The ``interest-rate differential is less negative for the dollar,'' … ``The currency market had completely discounted'' a full-point cut.… The U.S. currency has lost 15 percent against the yen and euro in the past year…”

From UBS:  “Treasuries sold off most of the day as better-than-expected earnings from Goldman and Lehman eased the market's worries. The news that OFHEO was planning to reduce the GSEs' excess capital requirements also breathed life into Agency spread product. When the Fed rate cut proved smaller than many expected, yields shot up even more in the front end, and the 2s30s curve flattened nearly 22bps by 3pm… TIPS recovered some of their losses from the last few days, with January 2009 breakevens out by 18bps and the breakeven curve flattening 15bps. Crude was up more than $3/barrel on the day, and stocks finished with large gains notwithstanding a slight hiccup after the Fed. Treasury volume was 97% of the 30-day average… Swaps saw light flows, and front end spreads narrowed significantly on the feeling that the Fed will continue to swoop in to save the credit markets and the banks, if needed. Swap spreads across the board did bounce off their tights of the day after the Fed only eased 75bps, however. Agencies shot up as speculation abounded about the easing of capital constraints on the GSEs', with Fannie stock up 30%. At one point, 10-year agencies were 30bps tighter to Treasuries and 25 tighter to swaps, but have come in about 5bps from their tights. Even so, today's spread tightening in 10yr Agencies versus swaps is one of the biggest moves ever. Mortgages opened a lot tighter on short covering, but prices got pushed so high it brought about billions in origination. MBS went from 12 ticks tighter to Treasuries pre-Fed to 5 wider post-Fed. After some new buyers showed up, they are now 3 tighter to Treasuries.”

Three month T-Bill yield fell 20 bp to 0.87% 

Two year T-Note yield rose 26 bp to 1.60% 

Ten year T-Note yield rose 15 bp to 3.46% 

Dow rose 420 to 12,393  

S&P 500 rose 54 to 1331  

Dollar index rose 0.38 to 71.83

Yen at 99.8 per dollar 

Euro at 1.564

Gold fell $25 to $977.5

Oil rose $3.09 to $108.80 

*All prices as of 4:15 PM