Mental Health Break

Mortgage Meltdown

The Bear Stearns meltdown and subsequent acquisition by JPMorgan (facilitated by the Federal Reserve) is in the news and hit the front pages recently. The following is a quick overview:

Who:

Bear Stearns (referred to as Bear in the rest of this write-up) is a diversified financial services holding company, and (from the company web site) “a leading global investment banking, securities trading and brokerage firm.” With approximately fourteen thousand employees, revenues of $5.95 billion (down from 2006’s $9.2 billion), net income of $233 million (down from 2006’s over $2 billion), and a profit margin of 3.2% (down from 2006’s 34.1%), the fate of Bear Stearns shows that perhaps every so often investors should pay close attention to the “Risk Factors” section of the 10-K filing, e.g. “…Our businesses could be adversely affected by market fluctuations. Our businesses are materially affected by conditions in the financial markets and economic conditions generally, both in the U.S. and elsewhere…”; “…Market fluctuations and volatility may cause us to incur significant losses in our trading and investment activities…”; “…Our businesses may be adversely affected by fluctuations in interest rates, foreign exchange rates, and equity and commodity prices. In connection with our dealer and arbitrage activities, including market-making in OTC derivative contracts, we may be adversely affected by changes in the level or volatility of interest rates, mortgage prepayment speeds or the level and shape of the yield curve…”; etc., etc. Bear has been very heavily involved in mortgage-backed securities (MBS), being a major player in the creating, underwriting, trading, and investing in these financial instruments.

What happened/timeline:

• In June 2007 two of Bear’s hedge funds that had a lot of exposure to MBS and subprime mortgages began to loose money. Bear put approximately $1.6 billion into these funds before winding them down.

• In October Bear obtained an investment in it of $1 billion by Citic Securities (owned by the Chinese government).
  

• Investors did not seem convinced (the stock gained 1.2% in value when the deal was announced, but then slipped back 2.2% the next day).
  

• In Q4 of 2007 Bear reported a quarterly loss of $859 million, the first ever quarterly loss in the firm’s storied 85-year history.
  

• Bear continued to hemorrhage… In March 2008 rumors began to circulate that some European financial institutions had stopped transacting fixed income trades with Bear, and as a result U.S. traders started pulling back, including other hedge funds, investment banks, money market funds, etc. Bear started to run out of liquid reserves.
  

• By March 13th Bear, unable to find a white knight, was in a very serious position, and was running out of liquidity. The SEC and Federal Reserve became involved. The Federal Reserve agreed to extend a short-term (28 day) discount window loan.
  

• Two days later JPMorgan (the second largest bank in the U.S. as measure by stock market capitalization; also intimately familiar with Bear’s business since they were the clearing agent for Bear’s trading activity) agreed to acquire Bear. The cost, 0.05473 of a JP share for each Bear share i.e. approximately $2 a share, thus valuing Bear at $236 million.
  

• The buyout offer was amended to 0.21753 of a JPMorgan share i.e. approximately $10 a share, now valuing Bear at approximately $1.2 billion. The Fed’s loan was also “tweaked.”
  

• The deal was approved by the boards of the two companies, the Federal Reserve, and the Office of the Comptroller of the Currency.
  

Some questions & answers:

• How unusual was the Federal Reserve’s action in extending the discount window loan? Very, the Fed usually only makes direct loans to commercial banks. However, the Fed’s rules do allow lending to non-banks if five of the total seven Fed governors give approval, although this hadn’t been done since the Great Depression in the ‘30’s and early ‘40s. In addition, the Federal Reserve also had to use a special clause allowing it to approve the loan to Bear on an emergency basis with the approval of only four Fed governors (since currently 2 seats are empty, and one governor was outside the U.S.)

• Why did JPMorgan’s offer increase from $2/share to $10/share? Well, one has to say that the initial and subsequent valuations only had a little to do with the “market.” After the initial $2 per share offer there was significant pushback by the shareholders that would have to approve the deal, so JPMorgan “sweetened” the deal slightly. As it is the shareholders are taking a massive “haircut.” To ensure approval of the deal, it is structured so that Bear will sell 95 million new shares to JPMorgan. This number was carefully chosen, a) since 95 million shares is approximately 39.5% of new total outstanding Bear shares (Bear is a Delaware firm, and Delaware law requires a shareholder vote prior to any company selling 40% or higher of its holdings), and, b) with this 39.5% of shares plus an approximately 5% of Bear shares held by its board they are “stacking the deck” to ensure that they get the required Bear shareholder approval. Stricter NYSE rules require that a company issuing new shares greater than 20% of a listed companies stock get shareholder approval. Here, Bear has exercised a clause that allows an exception if sticking with the normal process would seriously jeopardize the listed company’s viability.

• Is the Fed on the hook? Yes, in theory. The Fed is making a ten year, renewable, variable rate, $29 billion loan to JPMorgan at the discount rate (currently 2.25%). The collateral that backs this loan is $30 billion of assets, of which approximately 2/3rds are MBSs. However, these assets have been “marked to market” and the Fed will only loose if the collateral ends up being worth less than that value over the length of the loan. Also, JPMorgan has agreed to bear the first $1 billion of losses, if there are any, so the Fed has a small cushion. Conceivably the Fed could come out ahead if the collateral holds and regains value over the term of the loan. . Ditto for JPMorgan, that only has a worst case scenario total potential liability of $1 billion no matter what happens, and plenty of upside opportunity.
  

• Why did the Fed intervene? This is something that is being hotly debated. As mentioned above the Fed normally does not make loans to non-banks. However, the “pro” argument is that the Fed intervened to prevent Bear’s failure, which could have caused losses to cascade through its trading partners and through the wider market. The Fed is also trying to staunch the credit crisis and prevent it from spiraling into a full-blown banking crisis. The “con” argument is that by this action the Fed has taken credit risk onto its portfolio and increased the risk of “moral hazard” (i.e. the risk that by bailing out someone who has engaged in risky behavior you're likely to encourage similar risky behavior in the future.)
  

Some questions without answers:

Yet to be determined is if the Fed’s action actually increases “moral hazard”, and if the Fed would intervene if another “too big to fail” institution finds itself in the same position. The “moral hazard” question will undoubtedly be argued for some time…

As usual when the government intervenes there are winners and losers – the immediate losers are Bear’s stockholders and employees, while longer-term there is potential for the public to be a loser (if the Fed looses). One big loser is Bear's second-largest shareholder, British billionaire Joseph Lewis who owned 9.4% of the stock (who while amassing this stake paid an average of $107.30 per share). The clear winners are JP Morgan, and the few intrepid folk who bought Bear stock after the first offer but before the second. Citic dodged a bullet – it hadn’t yet completed its $1 billion investment in Bear and will pull out… JPMorgan gets the entirety of Bear for approximately what Bear’s Manhattan headquarters building is worth...

The Biggest Bailout in History: And Why American Taxpayers Should Get Some of the Upside
JPMorgan Agrees to Buy Bear Stearns for $240 Million (Update2)
JP Morgan Raises Offer to Buy Bear Stearns
JP Morgan Raises Its Offer For Bear Stearns

Say What?

"... this nation's first (and maybe even only) honest candidate offering himself for public service as the person to occupy the Oval Office...."

Reverend Jeremiah A. Wright, Jr., Senior Pastor (retired), Trinity United Church of Christ, describing Senator Obama - see Wright's letter to NYT about Obama

Medellin

On hearing about the Medellin v. Texas decision in the news this blogger was confused re a number of issues – for example, if Article VI of the constitution says “…and all Treaties made or which shall be made, under the Authority of the United States, shall be the supreme Law of the Land; and the Judges in every State shall be bound thereby, any Thing in the Constitution or Laws of any State to the Contrary notwithstanding” how come the Supremes voted in favor of Texas?

Began to check the ‘net to find the answer, with little luck. Most reactions & discussion seemed to fall into four main groups:

1. Good, Medellin is scum for raping and murdering two young girls, he deserves to fry…
2. The U.S. shouldn’t be subject to the jurisdiction of the International Court of Justice (highbrow version); we don’t need to listen to no stinkin’ furriners (lowbrow version),
3. Yay, states’ rights prevail over an over-reaching federal government, and,
4. Finally some smackdown, the Supreme Court puts President Bush in his place and rejects his claim of unlimited executive power.

All possible opinions, but not particularly cogent explanations of the Supremes’ legal reasoning in this case. Next stop: Docket 06-984 Medellin v. Texas at the Supreme Court web site.

The background:

Jose Ernesto Medellin is a Mexican national. In 1993 he, along with other members of a gang, raped and then murdered two girls, fourteen and sixteen, and dumped their bodies. He was arrested within a week, confessed, and subsequently convicted of murder and given the death sentence. When Medellin was arrested the police did not inform him of his right (pursuant to the Vienna Convention) to have the Mexican consulate notified of his arrest. When appealing his conviction and sentence he raised this as an issue, but the trial court rejected this on the basis that a) he had not raised this issue at his trial, and b) he had not shown that this error had a negative effect on his trial. This was then affirmed by the Texas Court of Appeals. Next Medellin filed a petition in Federal District Court, with the same results.

While all this was in progress, the Mexican government sued the U.S. government before the ICJ on behalf of 51 of its nationals, for breach of the Vienna Convention in not notifying each of these defendants of their right to contact the relevant Mexican consulate. The ICJ ruled against the U.S., holding that she had violated the Vienna Convention (article 36(1)(b)), and directed the U.S. to “provide, by means of its own choosing, review and reconsideration of the convictions and sentences of the effected Mexican nationals.” In reaction to the ICJ decision President Bush withdrew the U.S. from the Optional Protocol to the Vienna Convention on Consular Relations. (which had been proposed by the U.S. in 1963 and ratified in 1969). However, he also issued a Memorandum to the Attorney General instructing him to have “… State courts give effect to the decision in accordance with general principles of comity in cases filed by the 51 Mexican nationals addressed in that decision.”

Relying on the ICJ decision and the President’s memorandum, Medellin filed a second round of appeals in Texas. The Texas Court of Appeals rejected this on the grounds that neither the ICJ decision nor the President’s memorandum was “binding federal law” that over-ruled Texas state law limiting death penalty appeals. Medellin appealed to the Supreme Court and his case was granted certiorari (i.e. the Supreme Court agreed to hear his case).

Medellin’s position:

Medellin’s lawyer argued that the ICJ’s judgment bound the federal government and states by virtue of the constitution’s supremacy clause, and that since he was named in the case he became a party to the ICJ’s decision. He also argued that the ICJ judgment was binding on state courts by virtue of the President’s memorandum.

The position of the U.S. government:

The government filed an amicus brief in this case. It argued that The President’s constitutional role “uniquely qualifies” him to resolve foreign policy decisions related to compliance with ICJ decisions, and that the President was defending U.S. interests and protecting relations with foreign countries. Also, that relevant treaties give the President the authority to implement the judgment, and that Congress has “acquiesced” in the past.

The Supreme Court ruling:

In a 6-3 ruling the Supremes ruled against Medellin and in favor of the State of Texas - rejecting the arguments marshaled by Medellin, and those of the President.

Some details:

• The majority agreed that the ICJ judgment/decision re the Vienna Convention creates “an international law obligation” on the part of the U.S. However, the question re if this obligation constitutes binding federal law enforceable in U.S. (federal/state) courts, apparently is a separate issue.
  

• Although the word “all” in Article 6 would seem fairly clear, it seems (this was certainly unknown to this blogger as a non-lawyer, but probably is known to people that work in this field) that historically there has been a long string of precedents (going back to 1829 & 1833) that distinguish between “self-executing” and “non-self-executing” treaties. The former are those that constitute international law commitments along with automatic binding authority as domestic law, while the latter constitute international law commitments but ONLY have binding authority as domestic law IF the Congress passes enabling legislation.
  

• The Supremes held that the ICJ decision/judgment is not binding because the underlying treaties are not “self-executing.”
  

• The Supremes argued that by signing the Optional Protocol the U.S. agreed to the ICJ jurisdiction, but did not agree to be bound by the results, since the Optional Protocol only requires that signatories submit to the jurisdiction of the ICJ but says nothing re judgments and/or enforcement mechanisms. The obligation to comply with ICJ judgments comes not from the Optional Protocol or Vienna Convention, but from Article 94(1) of the United Nations Charter that says “… each Member of the U.N. undertakes to comply with the decision of the ICJ in any case to which it is a party.” The majority argued that since the language said “undertakes to comply” (e.g. as opposed to “shall comply”) the charter/treaty constituted a commitment and envisaged that members would take political actions to ensure compliance with ICJ decisions i.e. it is non self-executing. This decision was arrived at by examining the language of the appropriate documents, as well as the historical record (e.g. the Senate record of discussion when ratification took place). The majority also supplied some other reasons to support the non self-executing scenario e.g. none of the other signatories treats ICJ judgments as binding in their domestic courts, a lack of specific language in any of the treaties stating an intent to have judgments have binding effect, etc.
  

• Re the President’s memorandum the Supremes agreed that the President’s constitutional role “uniquely qualifies” him to resolve sensitive foreign policy decisions, but that this did not displace “first principles” i.e. that the President’s authority to act “must stem from an act of Congress or from the Constitution.” Given the decision that the underlying treaties are “non self-executing” the President does not have the authority to make them so, that responsibility belongs to the Congress (per the U.S. constitution).
  

• Also, there were additional arguments against Presidential authority e.g. the Supremes said that the record did not indicate Congressional acquiescence related to the issue under consideration; that while Congress has authorized the President to represent the U.S. before the U.N. and ICJ, this is in regard to international and not domestic issues, etc.
  

• Re the President’s claim that the memorandum is a valid exercise of the President’s foreign affairs authority to resolve claims disputes with foreign nations, as upheld by a series of court cases, the Supremes said that was mostly in reference to civil issues, and does not extend to criminal judgments in state courts.
  

Medellin v. Texas
Texas Wins Medellin & many otherarticles/discussion on Medellin at Opinio Juris

McCain Too

1. October 2002 this blogger observed that there seemed to be some confusion re what the President’s duty is (see the Quotes page – 3rd bullet from the bottom, reprinted below):

A Wall Street Journal article dated 11/26/2002 "Gonzales Rewrites Laws of War" discusses the role of White House Counsel Alberto Gonzales in the evolving legal strategy of the 'war on terrorism.' It argues he has "developed the underpinning for presidential orders creating military commissions, defining enemy combatants and dictating the status and rights of prisoners held from Afghanistan battles..." The WSJ has this passage: Mr. Gonzales readily admits the White House may lose some ground in court cases. While "being respectful" of constitutional rights, the administration's job ".. at the end of the day is to protect the country.", Gonzales is quoted as saying. This sentiment is often heard in our political discourse. However Gonzales, as a lawyer in a prominent role in the administration and as one whose name has been mooted as a possible Supreme Court nominee, certainly should know better.... the President of the United States does not take an oath to defend the United States, he takes an oath to defend the constitution of the United States. See the Presidential Oath of Office.


2. Another manifestation of this was noted in August 2003 (see the Quotes Page Update #1 entry on the Oped Updates page, reprinted below):

On the Quotes page (third quote from the bottom) I discuss how White House Counsel Alberto Gonzalez seems mistakenly to believe that the President of the United States takes an oath to defend the United States (when in reality he takes an oath to defend the constitution of the United States). Well, apparently the President also does not seem to realize the difference. In an August interview with the Armed Forces Radio and Television Service President Bush the following exchange took place:

AFRTS: "One final question, Mr. President. The families of America's fighting forces, they make huge sacrifices in the name of freedom, just like the service members. You touched on it earlier. You touched on it in your speech today. For months at a time, they give up their service members, they don't know where they are, they don't hear from them; they don't know if they're safe; they don't know if they're dead or alive. What message do you have for these families today?"
President Bush: "Well my messages is that what your loved one is doing is the right thing for the country. We are called upon to defend the United States of America. I take that oath, and every soldier takes that oath.  And on 9/11 our world changed and we realized the country was vulnerable and we better do something about it. And the best way to secure the homeland is to get the enemy before he gets us. At least that's my attitude. And so I — first of all, the commitment that their loved ones have made, the families of the service members have made, is in line with this business about winning and fighting war. Every person is a volunteer in our military. They've chosen to defend the United States of America. And therefore they need to get the best — if that's their attitude, and they made up their mind that's what they want to do, then my job is to get them the best equipment, the best pay, the best training possible, so if we ever have to send them in, they'll be able to do the job."



3. Then in January 2005 this blogger contrasted the fuss made over President Bush’s “sixteen words” kept in his state of the union speech, as contrasted to the three words he seemed to always leave out (see the January 20th, 2005 entry on the Brief(er) Observations page, reprinted below):

Three small words.... - "My most solemn duty is to protect this nation and its people against further attacks and emerging threats." - President George Bush at his Inaugural Address given Jan 20th, 2005. As previously observed on the Quotes page (third bullet from the bottom) and on the Oped Updates page (see Quotes page update) the President does not seem to make a distinction between an oath to 'defend the United States' and an oath to "defend the Constitution of the United States" (see the Presidential Oath of Office) This is not a small matter of words, it is a significant difference - and President Bush seems willing to do violence to the second in his efforts to achieve the first..  A lot of ink has been spilled about the "sixteen words" in the 2003 State of the Union (i.e. the yellowcake from Niger error..), but no one seems to worry about these "three words"..

4. May 2006 this blogger noted that the Cato Institute seemed finally to have come to the same realization (see the May 11th, 2006 entry on the Brief(er) Quotes page, reprinted below):

Three small words... (redux) In November 2002 this web site commented on a WSJ article that showed the White House Counsel saying that the administration's job ".. at the end of the day is to protect the country", a fundamental misunderstanding of the duty of the POTUS (see the Quotes page). Then in January 2005 this web site noted that the President seemed willing to do violence to the constitution to "preserve, protect, and defend" the country (see below). Now, sixteen months later, CATO Institute comes to a similar conclusion... May 1st, 2006 they came out with Power Surge: The Constitutional Record of George W. Bush (though they do go beyond the "war"-related issues) Quote from the Executive Summary - "President Bush's constitutional vision is, in short, sharply at odds with the text, history, and structure of our Constitution, which authorizes a government of limited powers."

And now, lo and behold, the Republican nominee seems to have the same misunderstanding. In a speech this Wednesday, March 26th, 2008, Senator McCain said "Any president who does not regard this threat as transcending all others does not deserve to sit in the White House, for he or she does not take seriously enough the first and most basic duty a president has — to protect the lives of the American people," see McCain: Collaborate more with allies.

Fighting in the South of Iraq

Re the recent break out of fighting in Basra between the "Iraqi authorities" and "militias" and "gangs", looks like we're at step 4 in this location... See slide 41 at this link

Counterinsurgency in Iraq: Theory and Practice, 2007 - David Kilcullen

As Iraq Turns...

With the war in Iraq having entered its sixth year the media have been running retrospectives – mea culpas by a very few, re-examination of the circumstances leading to the intervention, discussions re what needs to be done next, etc., and the architects of the war have been taken to task for their miscalculations. In all of this Condoleezza Rice seems to have been given a bit of a “bye.’ While her contributions to the “mushroom cloud” doomsday scenario have been remembered (specific quote: “we don't want the smoking gun to be a mushroom cloud…”), I haven’t seen any references to the Iraq Stabilization Group.

Back in October 2003 the news from Iraq was increasingly dominated by mounting casualties, and opinion polls in the United States showed that a majority of the public had begun to question President Bush's handling of the aftermath of the war. The Congress was considering the White House’s $87 billion request for Iraq. And President Bush announced the formation of the Iraq Stabilization Group, putting Rice in charge of the ISG (along with its subcommittees on counterterrorism, economic development, political affairs and media messages) with the goal of managing Iraq and Afghanistan… And that was practically the last that was heard of that group… Not an example of a shining success… However Rice seems to have a free pass on this one.


Rice will manage Iraq's 'new phase' – “President Bush is giving his national security adviser, Condoleezza Rice, the authority to manage postwar Iraq and the rebuilding of Afghanistan”

White House to Overhaul Iraq and Afghan Missions - “The creation of the stabilization group appears to give more direct control to Ms. Rice, one of the president's closest confidantes, who signed the memorandum announcing it.”