Bear Stearns’s supply of repo funding – the lifeblood of any financial institution – was curtailed and the broker ran out of cash because of liquidity being withdrawn by institutions concerned about its exposure to both mortgages and hedge funds.
Brokers have illiquid balance sheets and depend on the markets’ perception of their creditworthiness in order to operate. So when margin calls led to the forced liquidation of credit fund Carlyle Capital, and forced sales at other credit hedge funds, market rumours of liquidity problems at Bear became widespread. They became a self-fulfilling prophecy.
The Federal Reserve stepped in with an unprecedented (at least since the Great Crash in 1929) emergency line of funding via JPMorgan. The latter then agreed initially to pick up Bear at a cut-price $2 a share, a fraction of book value and with the additional benefit of a $30 billion back-up line to fund Bear’s illiquid assets.
Meltdown
It was news that the fundamental state of the US housing market was worsening that triggered the latest downturn in the credit crisis, with falls in house prices now forecast in the 20% to 30% range. Unsurprisingly, the sub-prime index fell further. The 07-02 ABX is now in housing market meltdown territory and, as of March 20, the price on triple As was 52.38, down by more than 11 points on the month. As for the triple Bs, these fell a further three points to 12.89, which means that further write-downs of ABS CDO positions are highly likely.
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Money markets stressed, again |
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Eonia v Euribor spread |
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Source: Dresdner Kleinwort |
A New York banker who covers the high-grade frequent issuer sector explains how illiquid the agency market has become. "There were hours where you couldn’t get a bid. Two or three minutes was the previous definition of a dangerous market. Spreads were moving one to 15 basis points on a whim," says Alex Corley-Smith at BNP Paribas. "Agencies were moving double-digits basis points versus swaps. It was hard to have a view on [agency] spreads based on the fundamentals. The market was moving in relation to CDS, Freddie and Fannie equity," she says.
The various actions that the Fed and other authorities have taken finally seemed to take effect (See Regulation: Desperate measures... Euromoney, March 2008). First, the agency market rallied. Bonds tightened by a little under 20 basis points on a Libor basis in the five-year maturities.
Of the non-monetary measures, two in particular were cited by market participants as particularly helpful in underpinning the mortgage sector. The first was the Fed’s decision to relieve brokers by offering them treasuries in return for illiquid mortgage-backed and other securities collateral. The other was the Office of Federal Housing Enterprise Oversight’s decision to relax the government sponsored enterprises’ (GSE’s) capital restraints.
The relaxation of the capital constraints that Freddie and Fannie were operating under from 30% to 20% is highly significant. These measures reintroduced a bid for mortgages and the prospect of the bears being caught short.
Although the economic outlook remains uncertain, a sustained period of value-based trading is the best that can be hoped for because, despite the cessation of market free fall, there are still significant signs of stress. The main corporate credit indices narrowed in response to the authorities’ actions but the money markets remain locked up. The hoarding of liquidity has not eased, as illustrated by the spread between Euro Overnight Index Average and Euribor not falling from wides. Similarly, swap spreads are still at recent highs.
For all these efforts by the authorities to introduce some liquidity into the mortgage markets, it is a somewhat vain hope that the capital markets will return as a source of funding in the near future. That is why it is worth remembering the role of the Federal Home Loan Banks system of funding US mortgages.
The vast majority of US banks, either large or small financial institutions, have used the FHLB during the credit crunch. During the second half of 2007, FHLB assets rose by more than $200 billion. According to the agency, combined total assets were $1.274 trillion at December 31 2007, an increase of 25.4% from $1.016 trillion at year-end 2006.
Given the latest downward leg in the credit crisis, it is highly likely that this trend has continued. The FHLB regulator, the Federal Housing Finance Board, temporarily approved an increase in the amount of Freddie and Fannie MBS the agency can purchase by more than $100 billion.