Fed Intervention Cause Woes to Speculators

Wall St. and investors have been abuzz over the shotgun marriage between Bear Stearns and J.P. Morgan Chase. Regulators claim that the move was to prevent a Bear Stearns bankruptcy that would ignite a tumbling of financial dominoes on Wall St.

Gretchen Morgenson of the New York Times thinks there is more to the story though. Morgenson explains that the J.P. Morgan - Bear Stearns arrangement, and the
Bank of America - Countrywide match before it, are tactics by the Federal Reserve to deflate the credit insurance market and humble some of the speculators who have caused it to inflate so enormously.

The Feds haven’t voiced concerns over the credit default swaps, aka credit insurance contracts, and the banks haven’t commented either, but the Feds intervention has caused at least billions of dollars in credit insurance on the debt of Countrywide and Bear Stearns to become worthless. Their marriages with Bank of America and J.P. Morgan respectively will wipe out all outstanding credit default swaps because the two stronger banks will assume the debt of the target. For J.P. Morgan, taking in Bear Stearns debt for a mere $250 million allows J.P. Morgan to eliminate a huge risk at bargain price.

Credit default swaps are typically 5-year insurance contracts that bondholders could buy to hedge their exposure to the securities. The swaps are supposed to cover losses to banks and bondholders when companies fail to pay their debts. In recent times though, the credit insurance market have been swamped by speculators who use derivatives to bet on troubled companies, making the swaps the fastest growing contracts. The value of the insurance outstanding rose from $10.2 trillion to $43 trillion in two years.

However, the rule of the game requires the company to default on its bonds before an insurance contract will pay out to the buyer.

Entities that wrote the insurance no longer have to pay since these companies will not default. Investors who bought credit insurance to hedge their Bear Stearns and Countrywide bonds will receive new debt obligations from the acquiring banks so they’ll be safe too. However, the biggest losers are the speculators who bought insurance and betted on the failure of the two troubled companies. They lost their entire bet as their insurance value collapsed after the takeover caused the bonds to rise.

The speculators are mostly participants who do their transactions privately and the derivatives market is huge and unregulated so it is unknown who those speculators are right now. Speculators aren’t likely to voluntarily reveal their losses until they’re forced to. But hedge fund and proprietary trading desks on Wall Street are most likely among them.

Bear Stearns and Countrywide’s deals may be a template for future rescues even though there aren’t many big banks left that are financially sound enough undertake such a rescue.