The Derivatives Chernobyl

The Derivatives Chernobyl - Collapse of Bear Stearns on March 16, 2008
Incident:
The latest jolt to the massive derivatives edifice came with the collapse of Bear Stearns on March 16, 2008. Bear Stearns helped fuel the explosive growth in the credit derivative market, where banks, hedge funds and other investors have engaged in $45 trillion worth of bets on the credit-worthiness of companies and countries. Before it collapsed, Bear was the counterparty to $13 trillion in derivative trades. On March 14, 2008, Bear's ratings were downgraded by Moody's, a major rating agency; and on March 16, the brokerage was bought by JPMorgan for pennies on the dollar, a token buyout designed to avoid the legal complications of bankruptcy. The deal was backed by a $29 billion “non-recourse” loan from the Federal Reserve. “Non-recourse” meant that the Fed got only Bear's shaky paper assets as collateral. If those proved to be worthless, JPM was off the hook. It was an unprecedented move, of questionable legality; but it was said to be justified because, as one headline put it, “Fed's Rescue of Bear Halted Derivatives Chernobyl.” The notion either that Bear was “rescued” or that the Chernobyl was halted, however, was grossly misleading. The CEOs managed to salvage their enormous bonuses, but it was a “bailout” only for JPM and Bear's creditors. For the shareholders, it was a wipeout. Their stock initially dropped from $156 to $2, and 30 percent of it was held by the employees. Another big chunk was held by the pension funds of teachers and other public servants. The share price was later raised to $10 a share in response to shareholder outrage, but the shareholders were still essentially wiped out; and the fact that one Wall Street bank had to be fed to the lions to rescue the others hardly inspires a feeling of confidence. Neutron bombs are not so easily contained.
The Bear Stearns hit from the derivatives iceberg followed an earlier one in January, when global markets took their worst tumble since September 11, 2001. Commentators were asking if this was “the big one” - a 1929-style crash; and it probably would have been if deft market manipulations had not swiftly covered over the approaching catastrophe. The precipitous drop was blamed on the threat of downgrades in the ratings of two major monoline insurers, Ambac and MBIA, followed by a $7.2 billion loss in derivative trades by Societe Generale, France's second-largest bank.

Analysis:
The Monolines serve as counterparties in a web of credit default swaps, and a downgrade in their ratings would jeopardize the whole shaky derivatives edifice. Without the Monoline insurers' AAA seal, billions of dollars worth of AAA investments would revert to junk bonds. Many institutional have a fiduciary duty to invest in only the “safest” triple-A bonds. Downgraded bonds therefore get dumped on the market, jeopardizing the banks that are still holding billions of dollars worth of these bonds. In this case, AMBAC was being used as a "cover" by the banks which originated these bundles of mortgages to get their mispriced ratings. Ambac Financial Group, Inc. is a holding company whose affiliates provide financial guarantees and financial services to clients in both the public and private sectors around the world. Ambac's principal operating subsidiary, Ambac Assurance Corporation, is a guarantor of public finance and structured finance obligations. The downgrade of AMBAC in January signaled a simultaneous downgrade of bonds from over 100,000 municipalities and institutions, totaling more than $500 billion.
Now that the mortgages were failing and the banks were stuck with them, AMBAC couldn’t possibly pay; they could not cover the debt. And the banks don't wish to mark these CDOs to market [downgrade them to their real market value] because they are probably at best worth 60 cents on the dollar, but are being held by the banks on balance at roughly par. The banks would therefore no doubt need one bailout after another from the only pocket deeper than their own, the U.S. government's. But the federal government's AAA rating is already in jeopardy, due to its gargantuan $9 trillion debt.