Accordign to Plender in the Financial Times, the role of the Fed is to play market maker of last resort if there are no efficient markets. The argument can be made that the markets are efficient and the MBS and derivative securities written on top of the asset bubble are, when the bubble pops, the trash that the market is pricing them to be. Nonetheless, it truly appears that Bernanke's Fed is using a for profit LLC ran by Blackstone to sell off assets from Bear Stearns under financing from the Fed. They are orderly and sytematically dismantling the illiquid Bear Stearns portfolio, and consequently trying to make a market. I am very curious to see who buys these and for how much. I wouldn't hold my breath waiting for the tax payers to get their $29 billion dollars used to finance these securities back, that's for sure.

On a related noted, I don't think many banks are holding their breath either...

Hoarding by banks stokes fears on credit crisis

Central banks’ efforts to ease strains in the money markets are failing to stop financial institutions from hoarding cash, stoking fears that the recent respite in equity markets may not signal the end of the credit crisis.

Banks’ borrowing costs – a sign of their willingness to lend to each other – in the US, eurozone and the UK rose again even after the Federal Reserve’s unprecedented activity in lending to retail and investment banks against weaker than usual collateral and similar action in Europe.

This was referred to me by a reader whose email I misplaced, so I cannot give him a hat tip, but thank you anyway. Here is an excerpt from Institutional Risk Analytics :

Here's our question: Why did the Fed of New York facilitate the rape of BSC by JPMorgan Chase (NYSE:JPM)?

The
announcement by the Fed of a new lending facility for broker-dealers to
borrow from the discount window, made just hours after BSC's board of
directors apparently was forced by the Fed to sell for $2 per share to
JPM, strikes us as clear evidence of an anti-BSC bias by the US central
bank. Why not just lend directly to BSC under the new Fed loan
facility?

One prominent New York lawyer who is very well acquainted with the Federal Reserve Act tells The IRA
that the Fed of New York did two things last week: 1) approved a loan
to JPM, which was then passed through to BSC; and 2), created a new
facility to lend directly to broker dealers under Section 13 of the FRA.

"There
is nothing new here," adds the lawyer, who notes that the Federal
Reserve Banks made loans to individuals in the 1930s under the
emergency provisions of Section 13 of the FRA and could have easily
lent directly to BSC without involving JPM at all.

Thus
again the question to Fed of New York President Tim Geithner: Why was
JPM involved in this transaction? Why not simply extend liquidity
support to BSC as you now offer to every other primary dealer? As and
when BSC shareholders litigate over this mess, Geithner et al may be
forced to answer those questions in public.

To
us, even at $10 per share, the JPM buyout stinks to high heaven because
of the conflicted role played by the Fed of New York. Does anyone
believe that the Fed would force Lehman Brothers (NYSE:LEH) or Goldman
Sachs (NYSE:GS) into such a fire sale? Indeed, it looks to us like the
Fed of New York and BSC both got rolled by JPM CEO Jamie Dimon and his
merry banksters. But the JPM crowd won't be laughing much longer.

The
same forces that pushed BSC into insolvency are working on JPM and the
other money centers as you read these lines, but JPM first and
foremost. Just look at the range of valuations included in JPM's
disclosure to Canadian officials regarding price estimates for illiquid
structured assets and you can see why JPM's Dimon has been so upbeat in
recent months.

Readers can now see the popular media and ratings agencies chime in
to what I have been alleging since late last year. The investment
banking industry, as a whole, is entering steep cyclical decline. From
the Wall Street Journal :

S&P Flags Goldman, Lehman

Standard & Poor's, in a continuing sign of loss of confidence in investment banks' profitability, Friday put Goldman Sachs Group Inc. and Lehman Brothers Holdings Inc. on negative outlook, lowering them from stable.

Although
S&P didn't change the senior-debt ratings from AA-minus for Goldman
and A-plus for Lehman Brothers, it brought its view of the likelihood
of a precipitous decline in profits at the Wall Street firms during the
next two years to the same negative levels it previously assigned to Merrill Lynch & Co. and Morgan Stanley.

The
changes in the ratings outlooks are appropriate despite the fact that
recent actions by the Federal Reserve have instilled confidence in the
capital markets, S&P added.

"We believe that
negative rating outlooks are broadly appropriate for the independent
securities firms, reflecting the potential for a more substantial
decline in profitability from capital-market activities," S&P said
in a report whose principal authors are managing director Scott
Sprinzen and analyst Diane Hinton. "Our current expectation is that net
revenues could decline 20%-30% year-on-year" after write-downs. The
banks are relying heavily on proprietary trading and asset management to prop up losses in capital markets and M&A. As the bear market really kicks in, there is generally an outflow from money management firms and operations. In addition the amount of leverage, market risk (Ex. the GS Global Alpha quant debacle), and particularly credit risk assumed by these firms (Morgan Stanly in particular) portends a blow up coming to a town near you!

S&P previously said rating
downgrades would be likely if it believed companies' balance sheets
were being overloaded with assets that were deteriorating in value.
Investment banks have written down more than $100 billion of securities
and loans since the middle of last year and are still finding it hard
to sell the assets to large investors. Investors will become more risk averse as the value of theses securities and loans drop even further. Reference the research in leveraged and high yield loans from my pdf Assured Guaranty consolidated analysis , media reports on CMBS, RMBS, residential real estate and the financing backing its construction, foreclosures, and my very extensive opinions and analysis on the commercial real estate sector .

The ratings
firm said that, even with the likely 20% to 30% decline in
profitability that would erode banks' "margin of safety," it expects to
sustain current debt ratings because the Fed last week said investment
banks can now borrow at lower rates against some of their battered
securities. Yes, the Fed has altered the playing field and caused me to modify my investment thesis. Keep in mind that it is modified, not revamped. The core thesis remains the same. Insolvency. What the Fed has done was injected massive amounts of liquidity to forestall cash flow insolvency, but balance sheet insolvency is beyond the Fed's control even if they were to open up it's wallet to the fullest extent possible .

"Nonetheless, we see some possibility,
were there to be persisting capital-markets turmoil and sharply
weakening economic conditions, that financial performance could
deteriorate significantly more than we now assume, which would call the
current ratings into question," S&P said.

The
company downgraded Merrill Lynch's senior debt to A-plus on Oct. 24 and
put Morgan Stanley on CreditWatch with negative implications on Dec.
19. Morgan Stanley's senior debt is rated AA-minus.

The "virtual collapse" of Bear Stearns
Cos. last week "highlights the extent to which securities firms are
exposed to capital-market sentiments and explains the Federal Reserve's
actions to support the U.S. securities industry directly," S&P
said. The Fed arranged for J.P. Morgan Chase
& Co. to buy Bear, which S&P rates BBB (Whaaattt!!!!?? I just can't resist taking a poke at this. So, exactly what does it take to get a junk rating out of S&P? Let's see here... Ambac is AAA, Bear Stearns is investment grade. Okay, I get it. You have to lose a lot of your shareholder's money to stay in this in this club. I have no shareholders, but I am sure I made somebody some money somewhere, somehow. How do you rate BoomBustBlog.com? Super Duper Senior AAAA? Come on, please... I know I haven't paid you yet, but the check is in the mail), at $2 a share and
guaranteed the bank against $30 billion of losses on Bear Stearns's
problem assets.

Think about this. S&P rates BSC at BBB (above junk), while the market rated BSC at the lowest junk possible which precipitated the run on the bank, bankruptcy and corporate death are knocking at their door, and shareholders were gifted with 95% drop in thier share price!!! Wouldn't it be real cool if you had a service that actually proactively rated these companies and events, and called for a negative rating BEFORE you lost all of your money? I really wonder how much such a service would cost if it actually existed?

Come on S&P! If I can do it, you can do it. First, perpetually increasing housing price appreciation, then extremely optimistic MBS default rates coming off the top of the mother of all bubbles, then AAA subprime (isn't that an oxymoron?) CDO tranches, followed by these AAA monolines (losing 90% of their share price value in a few months paying 14%, super junk rates on their AAA paper) and now the investment grade insolvent investment bank !!! I bet you charge a whole lot more than I do for this blog. Really, I betcha...

JP Morgan's trying to up the ante to $10 per share. The $5 strike
calls were selling for pennies the Monday after the deal was announced when nobody wanted them.
That would have been at least $5.50 per call profit, with very, very
little upfront investment. An astute investor could have ridden Bear
Stearns down from $105 to $3.50, and back up to $10 rather easily by
not following the crowd, doing a little math and applying common sense.
The $2 could never have flown without a value destorying fight. A basic
premise in negotiations, "always leave something on the table for the
other side". Let's look back to last week or two, after BSC fell from
the $90's down to $3 in the previous following the Breaking of the Bear
blog post:

March 13: It looks as if the prudent should start debating the ability of Bear Stearns to remain a going concern
March 17: BSC calls are almost free and the JP Morgan Deal is not signed in stone

I think I'm going to start doubling the price of this blog. Now it's free x 2! Blogger's have to eat, too.

Comments from a blog member - I would like to hear my constituency's opinion on this:

One of the banks that I have been following in the recent months is ICICI bank. The stock peaked around $71 on Jan 10th and is down to around $36 of late. From what I can observe, Indian market took off just around the time MER was making margin calls on BSC (last July-August) mostly due to foreign money flows. (Smart money got in early and setup rising expectations). Of late ICICI has revealed derivative losses and may be there is more to come. And this has shown up in the near 50% drop in the stock over a 10 week period. (By the time CNBC started touting "Emerging market safe havens" smart money was already getting out). Lot of common people in India are getting hurt in the process and are learning a hard lesson. On the ground in Indian real estate is beyond bubble territory, people buying multiple homes as investment at the height of the bubble, but there are signs of sentiment turning negative. For the service industry the Rupee appreciation along with US downturn is becoming a serious problem. Although service export industry is a net positive, it can only employ a very small slice of the population. Despite all this India may not be as dependent on exports as China and has a reasonably mature/strong domestic market.

Recent news bytes:

• Bloomberg: Treasuries rose and three-month bill rates plunged to to 0.56%,
  the lowest level in almost 50 years on speculation credit market losses
  will widen (e.g. ex-LTCM Meriwether's fund facing losses, Thornburg
  Mortgage Inc. may go bankrupt, Merrill suing monoliner over recalled
  $3.1bn CDO guarantee)
• RGE Montitor: Flight to quality trades:
  -
  The rate on the three-month Treasury bill, viewed by investors as a
  haven in times of trouble, dropped 32 basis points to 0.56% on Feb 19;
  - Capital preservation trade: buy Treasuries sell stocks;
  - TED spreads (= LIBOR- T-Bill) spiking upwards in all markets
  - 2-year swap spreads widening
• BNP:
  Signs of interbank lending stress and liquidity hoarding eased after
  Fed actions on March 16/17; spreads on the rise again in US, UK and
  Euro market. Interbank spread decomposition shows that crunch is driven
  by upward trending credit premium since 2008 instead of liquidity
  premium as was the case in H2 2007. Fed interventions ultimately can
  address liquidity, not credit concerns.
• Fed, BoE, ECB intervening in their respective markets
• Krugman:
  Flight to quality and cash hoarding lead to Treasury yields close to
  zero--> if there is no compensation for holding Treasury paper,
  investors prefer to hold cash--> normal monetary policy channel via
  buying and selling of Treasuries breaks down (i.e. liquidity trap). He also points out that TED spreads - between 3-month Libor and 3-month treasuries - are now
  back to where it was, saying that the results of the rate cut and the
  new liquidity measures must be disappointing to the Fed.
• Yves Smith
  at Naked Capitalism backs up my assertion that all attention has focused so far on US banks, but European banks are in at least as much trouble, citing research that some European banks have written off senior and
  mezzanine tranches of CDOs to a large extent, while others have not at
  all, quoting CreditSights, whose model indicates a shortfall in
  write-downs of over $3bn for Barclays, RBS and SocGen, and of over $6bn
  for UBS .

Lehman
has been in my bearish sites, but until now I have not put the
microscope on them. That will change very soon. I am also intensifying my
research on Morgan Stanley since I feel they carry the most credit
risk, leverage and level 3 asset concentrations (bullsh1t risk) on the
street. I will also start covering the borrow short buy long funds that have been going bust lately like TMA and Carlyle Capital which are still over $10 per share. I had a short position on KFN, which I unfortunately closed out a while back. I am looking into to going back in, although to do so would be a bet that they will be wiped out of existence since their share price has fallen so much thus far. They have the exact same problem Carlyle Capital has (had?).

I am very close to spreading out to the European and Asian banks. I know they are in serious trouble, it is just that I have but so much to dedicate in analytical resources and time. I hate running in blind. Anyone who has experise in any of these areas (or any other areas of interest), feel free to start a post, thread or user group - or contact me to share info and thoughts.

The Naked Capitalism Blog
alleges the collateral pledged by prime brokers to the Fed via commercial
banks will be valued by the commercial banks. Since they often hold the
same collateral, this facility may induce them not to write down their
own assets and put on excessive valuations. One way to counter this is to try to identify the classes of assets and put our own gross marks on them. This is what I did with GGP and the monolines. It may not be the most accurate in some cases. GGP is quite accurate in my opinion due to ample supporting data and proven robust modeling, the monolines were educated guesses just like everyone else's opinion on valuation. What makes the monoline situation believable is that you can be off by a whopping 25% and still see how they are in trouble because the losses x leverage x macro trend is not very ambiguous.

...and for those who haven't read the popular Money Trap article, click here,

Not only did they add that much liqudity, they expanded the eligible collateral to include CMBS. It appears that the I banking system was in more trouble than we were led to believe. Now, those companies with high levels of ineligible collateral will still have many of the same problems as last week. In addition, the Fed can swap for treasuries all it wants, no one will want to buy these structured and MBS securities. Too many people know what's behind them and what level in the boom-bust cycle they were written on.

From Bloomberg :

The Federal Reserve, in its first extension of credit to non-banks since the Great Depression, lent $28.8 billion as of yesterday to the biggest securities firms to try to stabilize capital markets.

In a separate announcement, the Fed expanded collateral eligible for its first auction of Treasuries March 27 to include bundled mortgage debt and securities linked to commercial real- estate loans. The value of the sale was set at $75 billion, part of a $200 billion facility unveiled last week... The recipients of the Fed's credit are getting cash and Treasury notes in exchange for securities tied to mortgages and other distressed debt...

The central bank's Primary Dealer Credit Facility, announced March 16, allows Wall Street banks to borrow money overnight at a 2.5 percent interest rate, the same charged to commercial banks. The Fed bypassed its own emergency-lending policies and used broader authority in the Federal Reserve Act to give both kinds of companies the same borrowing costs.

Six Months

The central bank said the loans will be available for at least six months. The Fed's decision to be lender of last resort to the 20 primary dealers of government debt came two days after the Fed provided emergency financing to Bear Stearns through JPMorgan.

The Fed's weekly balance sheet released today showed other credit extensions, including loans to facilitate JPMorgan's purchase of Bear Stearns, averaged $5.5 billion a day for the week ended yesterday. The balance ended at zero, according to the Fed's weekly balance sheet.

The zero balance on the Bear Stearns loans signals that the Fed has yet to extend the $30 billion in financing to JPMorgan in exchange for collateral that includes ``less liquid'' Bear assets. The $5.5 billion daily average of the JPMorgan-Bear Stearns loan indicates that a March 14 bridge loan, assuming it was paid off three days later, totaled about $13 billion.

`Show Some Leadership'

Morgan Stanley and Goldman Sachs Group Inc. said yesterday that they borrowed to ``test'' the new lending facility. Lehman Brothers Holdings Inc. Chief Financial Officer Erin Callan said in a Bloomberg Television interview that the firm was using the lending window to ``show some leadership.'' The Fed report today showed that the lending averaged $13.4 billion in the week ended yesterday...

In the Term Securities Lending Facility, the New York Fed bank today altered its plans so it will accept the expanded collateral list, which includes residential mortgage-backed securities, in the first weekly auction instead of the second.

The new eligible collateral for the TSLF includes agency collateralized-mortgage obligations and AAA/Aaa-rated commercial mortgage-backed securities, in addition to similarly rated private-label residential mortgage-backed securities and any collateral normally eligible for Fed open-market operations...

The Fed scheduled the second auction for April 3 and said the central bank's Open Markets Desk will announce the size and the eligible collateral the prior day.

This is a refresher to the
The Riskiest Bank on the Street piece that I posted a few months ago on Morgan Stanley. Let me get straight to the salient points.

High exposure to level 3 assets to cause
significant write-down
- Morgan Stanley’s exposure to level 2 and level 3 assets (this is about more than subprime) stood at $226 bn and
$74 bn as of November 30, 2007. Morgan Stanley has the highest ‘Level 3
assets-to-equity’ of 236% after Bear Stearns. In 4Q2007, Morgan Stanley
reported a $9.4 bn write-off primarily relating subprime related mortgages.
With nearly 50% decline in ABX-HE-BBB 06-2 index since November 2007, more
losses are likely to be reported in the coming quarters.

Drying liquidity in the repo market to impact
Morgan Stanley’s funding - The $4.5 trillion repo market, accounting for 20-25% of
assets of five top brokerage firms, enables short-term financing by selling
securities and agreeing to repurchase them. During good times these loans were
inexpensive and could be easily rolled over. However with declining value of
securities used as collateral, lenders in repo market have become increasingly
worried about losing money on securities used as collateral. In addition to
being selective and cautious while lending, lenders are also demanding higher
amount of collateral. For instance, for every $100 to be lent, lenders are
requiring $105 for bonds backed by Fannie Mae and Freddie Mac (up from $102 few
weeks ago) and $130 for bonds backed by 'Alt-A' loans. This is leading to
tightening credit conditions and severe liquidity crunch in the repo market.

The liquidly crisis took its toll on Bear Stearns
(see The Breaking of the Bear)
which sought an emergency funding from the Federal Reserve on March 14,
2008,
as its clients withdrew assets while their creditors stopped renewing
short-term loans. Bear Stearns' financing crisis has created wide
spread
concerns on the brokerage firms relying heavily on repo markets for
day-to-day
cash requirements. Morgan Stanley relies heavily on short term
financing with
$162.8 bn or 16% of total assets in form of repo financing as of
November 30,
2007. Although we believe that Morgan Stanley along with other
brokerage firms
could face short-term cash problems owing to declining confidence in
the
capital markets, the Fed’s recent initiative by allowing brokers to
borrow
directly from the central bank (and lowering the Fed rate to 2.25%)
would ease
the liquidity concerns to a considerable extent. This is something that
I will explore in depth in the very near future, since much of the
level three assets may or may not qualify for "Fed Funding". This may
portend less liquidity than the popular media may have you believe. See
the overview of recent events for more on the Fed's move .

Decline in investment banking revenues
- In view of
declining activity in the capital markets, Morgan Stanley in line with
other
brokerage firms, is expected to show a decline in investment-banking
revenues.
In 1Q08, Lehman brothers and Goldman Sachs reported a 20% and 16.4%
y-o-y
decline in net revenues. As per Bloomberg, Morgan Stanley’s sale of
stock and
equity-linked offerings declined to $7.77 bn in 1Q08 compared to $14 bn
1Q07
while Morgan Stanley’s sales of high-yield bonds plunged to $101.5 mn
from
$2.46 bn in 1Q207. Morgan
Stanley’s reported earnings dropped 47% in 1Q08. This has been hailed
as a near "blowout" quarter by the sell side and the media, even though
it clearly shows a rapidly deteriorating business and is a very
disappointing result. The street's game of lowering expectations to
create the aura of "better than expected" results should not pass
muster with the quality of readers that I have visit my blog.

Challenges ahead - Brokerage firms are
facing several challenges owing to a slow down in economy, increased regulation,
lightening credit conditions and reduced capital market activity particularly
relating to mergers & acquisitions and corporate-finance. Traditionally
brokerage firms have borrowed money to growth their business. Now with credit
being harder to come by despite falling interest rates, brokerage firms going
forward will operate at reduced leverage levels impacting their future
profitability.

Valuation – Owing to continuing write-downs due to
widening credit spreads and persistent weakness in the credit markets, we
expect financial services firms’ valuation to remain under pressure until the
credit market situation eases off significantly. Decline in fixed-income
securities has negatively impacted the book value of securities. Based on a 15%
haircut of illiquid assets, Morgan Stanley’s adjusted book value stands at
$18.4 per share. Based on price-to-book value multiple of 1.23, Morgan
Stanley’s valuation comes approximately $22.7 per share implying a downward
potential of 47.0% from current share price of $42.9.

Next up will be a complete and verbose forensic analysis of Assured Guaranty.

Source: As per latest filings

Here is a quip from an email that I recieved earlier that prompted me to explain how I fell about the I banking industry now:

Longer term, politically the Fed may be forced to cut them off --- but we are obviously quite a ways away from that happening just yet. (referring to the I banks that just got access to the Fed window)

Great call on Bear. If these guys can now submit almost anything to the fed window --- munis, mortgages, etc. and fund at FF+25, doesn't that take funding off the table and then really it becomes an issue of the credit quality of the collateral. In past banking cycles --- low Fed funding almost always reliquified the banks, and I assume it will work again this cycle.

Is it time to move on to the next stage --- companies that are going to experience credit issues on assets but can not fall into the arms of the central bank?

Well, to begin with the I banks are holding a lot of stuff they can’t submit to the Fed. They were also starving for liquidity despite what they said (ex. Bear Stearn’s Schwartz on CNBC, who is bound to get sued for those statements). This is why they all hit the window the day after it was opened. The industry in general is heading for a downturn. Many can’t be patient, but a macro bet against the investment banking business is not a bad bet at all, particularly if you catch it after a euphoric rally like we just had. Look at GS and LEH stock already, less than 24 hours after “beating the Street”. MS is moving lower too.

I am having my analysts look into exactly where the Fed assistance will or will not help the banks and I will probably post my findings some time late next week. The fed has mitigated the Bear Stearns style run on the bank, but all is still not well. There is a lot of counterparty credit risk abound, and the I banks shoulder most of it. They are the ones exposed to the parties that cannot run to the Fed!

If I were a Bear Stearns employee or shareholder I would opt to force the firm into bankruptcy protection over selling for 1.25% of last year’s share price. At $2, the sales price is analogous to an under priced put option for the shareholders to hold the threat of bankruptcy over the Fed’s head. Once in bankruptcy protection, the prime brokerage clients and CDS counterparties will try to run for cover and all hell will break loose with the other banks. I think you realize there are a lot of under capitalized CDS counterparties abound that in no way could pay off on these things. These are the guys that use one CDS to hedge against another. Once the domino effect gets going…

With all of that being said, you are right about looking for the other weak credit companies. I need to find the TMAs and Carlyle Capitals. Theoretically, the I banks should extend their new found credit to these companies, but I doubt it would happen.

In addition, I listen to the talking heads on CNBC who say that we need to stabilize housing prices in order to move forward, blah, blah, blah.... I consider this to be total nonsense and indicative of extreme ignorance in regards to what the problems are in the macro sector and how we got here in the first place.

These many issues that we see around us will not go away until housing prices go back to historical norms. If you stabilize prices before prices go back down to where they should be, you will simply have another bust - on top of the one that we just had.

It is as simple as this. People are not going to buy houses until they can afford to buy houses. Housing prices have outstripped real incomes by multiples. This relationship is what must be stabilized and reversed.

From RGE Monitor:

• FT: Financial Stability Forum urges prompt writedowns and warned that the full impact of the credit squeeze had yet to be felt. Banks wrote down $140bn by Q4 ($84bn in U.S., about $40bn in Europe) subprime securities so far, finance ministers expect $400bn. Half of it expected in U.S., other half rest of world.
• Fitch: Basel II rules allow easier clean break with off-balance sheet vehicles.
• SIFMA: Outstanding volume for the European securitization market stood at €1.32 trillion, as of 30 September 2007. Euro-denominated CDO market volume 2004-2007= €285.4bn (around $410bn)
• WSJ: EU banks reported to be exposed to monoliners via popular 'negative basis trades' in past few years (arbitrage opportunity technically due to oversupply when CDS spread (i.e. cost to buy protection) on a single name is smaller than the bond yield--> buy both bond and protection from monoliner and cash in the risk-free spread difference.)
  --> 6 banks out of 8 planning monoline rescue were European; expected losses in $20-140bn range
• European banks also reported to be exposed to commercial real estate loans/CMBS and leveraged loans stemming from buy-out boom. These markets are turning now and additional writedowns are expected ($100-200bn)
• UK, Spain, Ireland financial sector additionally exposed to domestic housing bust--> Spanish banks e.g. less exposed to U.S. subprime fallout and off-balance sheet SIVs but draws heavily on ECB lending facility which delays actual writedowns on unviable collateral. I have warned members of this blog about this several times.