Saturday, October 27, 2007

How the Brokerage Firms Dealt the Hedge Funds a Mortgage-Backed Ace in the Hole

The Associated Press reported on Friday, October 26, 2007, that broker-dealer subsidiaries of some of the largest bank holding companies gave price guarantees to hedge funds that bought mortgage-backed securities from them. See Reportedly, Bank of America, Citigroup and JPMorgan Chase are the bank holding companies involved. While not all the details of these guarantees are known, it seems that if the hedge fund tried to sell the mortgage-backed security and couldn't get a minimum guaranteed price, the broker would provide liquidity to the hedge fund in some manner. The broker might buy back the security, find another buyer for it, or pay a penalty to the hedge fund. One way or another, it would seem that if the mortgage-backed security's price fell below a specified level, the security pretty much belonged to the broker, not the hedge fund.

Could you get a brokerage firm to guarantee that if you bought a stock from them, they'd protect you if the price of the stock fell below a specified level? We didn't think so. They might try to sell you a product like a put option if you wanted protection, and that would allow them to earn another commission from you. But they wouldn't take the risk themselves that the stock price might fall below the level you wanted to protect. So this guarantee of mortgage-backed securities is unusual, to say the least.

The guarantee, which hasn't been exactly highly publicized amidst the subprime mess and credit market blowup, explains a lot. This is one reason why brokers were able to sell so many mortgage-backed securities to hedge funds. What they were really selling was Lake Wobegon, that wonderful place where, among other things, all investments do above average.

The guarantee is likely to be one reason by so many bank holding companies have recently been announcing so many losses. With hedge funds facing numerous withdrawal requests but unable to sell their mortgage-backed securities in the open market, they've no doubt turned to the brokers that guaranteed a minimum price for those hot tamales.

The guarantee is also likely to be one reason why the Federal Reserve has been so concerned about the subprime mess and credit crunch. It could cause major blowback on the bank holding companies that are the parent corporations of the brokerage firms that issued the guarantees. The Fed has relaxed regulatory requirements to allow the commercial bank subsidiaries of these bank holding companies to lend badly needed liquidity to their broker-dealer affiliates. This was part of a quiet bailout of the banks we discussed this past August.

The existence of the guarantee raises a few questions. First, did the bank holding companies adequately account for the mortgage-backed securities that were protected? One might wonder whether the bank holding companies could truly treat these securities as sold to the hedge funds, when the bank holding companies bore the risk of loss on them below a certain price level. Ordinarily, a company can't account for an asset as sold if it still holds some aspects of ownership, and bearing risk of loss is a strong indication of ownership. Should the mortgage-backed securities that were guaranteed have been carried on the bank holding companies' balance sheets? And even if the bank holding companies could validly keep these guaranteed mortgage-backed securities off their balance sheets, did they maintain appropriate reserves for the possibility that they might have to honor the guarantees?

Another question is whether the bank holding companies adequately disclosed the risks associated with the guarantees. These guarantees meant that if the market for mortgage-backed securities fell far enough, big time blowback would happen. SEC regulations say that public companies should make disclosures about their market risks (that's in 17 C.F.R. 229.305, for those of the lawyerly persuasion). Should the bank holding companies have made market risk disclosure about the guaranteed mortgage-backed securities, and, if so, did they?

A third question is when did the Fed find out about these guarantees? It's obvious such guarantees have implications for the safety and soundness of the nation's banking system. It's also obvious that these guarantees would explain why so many mortgage-backed securities of questionable liquidity could be sold. And it's additionally obvious that selling a whopping shipload of these mortgage-backed securities could create a lot of stress for the financial system. It would be one thing if a brokerage firm that has no commercial bank affiliate and therefore isn't regulated by the Fed issued guarantees such as these. Such a firm would not put federally insured deposits at risk. But a bank holding company that has an investment banking subsidiary can do just that through risky investment banking activities (and aren't just about all of them pretty risky?). It's the Fed's job to know about things like these guarantees while they are being made, not after the fact when they've apparently caused large losses.

One final thought. The guarantees may be part of the reason why there are few sales of mortgage-backed securities. The hedge funds know that they don't have to sell if the bona fide third party bids get below a certain level. So sales don't occur if the market really nosedives. Why is that bad? Because normal market mechanisms are disrupted. There are vulture funds and other junkyard investors out there, looking for mortgage-backed bargains. But they can't do a trade if the hedge funds are putting the guaranteed securities back to the brokerage firms. Thus, no price floor is established and the market price is indeterminate, which is another way of saying zero. Many important accounting, lending and investment decisions can't be made without a positive market price. But the guarantees may be impeding the establishment of market prices. But the hedge funds aren't about to forgo their guarantees and trade in the open market, so there's no easy way out of this gridlock.

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