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L7. Notes on the key learning areas from the case, JPM Bear S Tip of Iceberg

Off balance sheet (OBS) financing means a company does not include a liability on its
balance sheet. But should identify the liability somewhere in the financial
statements/accounts (this is not always the case).

What is leverage?

Leverage allows a financial institution to increase the potential gains or losses on a position
or investment beyond what would be possible through a direct investment of its own funds.

There are three types of leverage:

1. Balance sheet leverage (based on balance sheet concepts)

2. Economic leverage (based on market dependent future cash flows)
3. Embedded leverage (based on market risk)

No single measure can capture all three dimensions simultaneously.

Balance sheet leverage is the most visible and widely recognised type. Whenever an
entitys assets exceed its equity base, its balance sheet is said to be leveraged. Banks
typically engage in leverage by borrowing to acquire more assets with the goal of
increasing their return on equity.

Economic leverage exists when a bank is exposed to a change in the value of a position by
more than the amount they paid for it. E.g. a loan guarantee that does not show up on the
banks balance sheet even though it involves a contingent commitment that may
materialise in the future.

Embedded leverage refers to a position with an exposure larger than the underlying market
factor, e.g. when an institution holds a security or exposure that is itself leveraged.
Embedded leverage is very difficult to measure, be it in an individual institution or in the
broader financial system. Most structured credit products have high levels of embedded
leverage, resulting in an overall exposure to loss that is a multiple of a direct investment in
the underlying portfolio. Two layer securitisations, e.g. in the case of a CDO that invests in
asset backed securities, can boost embedded leverage to even higher levels.

Source: 2009. World Bank the Leverage Ratio: A New Binding Limit on Banks.

Security Repurchase Agreements aka Repos

A repo transaction is a combination of an agreement to sell a security at a given price and

an agreement to repurchase the security at a later date, typically at a higher price. For
example, a broker-dealer could sell a security to a money-market mutual fund and agree
to repurchase the security the next day. Thus, repo agreements are essentially short-term
collateralised loans--with cash, in this example, initially being transferred from the money
market fund to the broker-dealer, then with "principle and interest" being paid upon
repurchase of the security the next day--and are a common source of short-term funding
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for financial institutions such as broker-dealers, banks, and mortgage real estate investment
trusts.

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Moral Hazard

It is clear that neither the Bear Stearns management nor the regulators of the financial
sector in the US wanted Bear Stearns to fail. The Federal Reserve pumped liquidity into the
economy and expanded its lending beyond the commercial banking sector.

In March it helped JP Morgan Chases buyout of Bear Stearns. Why, because the firm was
so severely strapped for cash and the Fed was terrified of the consequences to the
broader financial system if the firm failed. 6 months after helping JPMC buy Bear, the Fed
provided an $85 billion bridge loan to prevent the disorderly failure of AIG (American
International Group) a giant global company that was one of the biggest writers of Credit
Default Swaps.

Question: why was Fed so concerned about AIG? As the crisis unfurled, credit risk
increase, and the people who had bought CDSs to insure themselves against such an
event, were making hay. AIG had to pay them.

The Fed felt compelled to protect the financial system from severe shocks and the overall
economy from spill overs from the financial sector crisis that might produce serious
downturns resulting in: .? Company closures, downsizing, job losses, unemployment
increasing etc.

These actions raise the issue of Moral Hazard.

Moral hazard is a term first used by the insurance industry. It captures the unfortunate
paradox of efforts to mitigate the adverse consequences of risk these efforts may
encourage the very behaviour they are intended to prevent.

E.g. people insured against having their mobiles stolen, may be less vigilant about keeping
the device safe because the losses due to carelessness are partly borne by the insurance
company.

Moral hazard occurs whenever an institution like the Fed, the Central Bank of Ireland and
so forth, cushions the adverse impact of events.

In fact, reducing the consequences of risky financial behaviour encourages greater

carelessness about risk down the road as investors begin to assume that so-called benign
intervention will protect them.

In the case of Bear Stearns, would the greater good have been served had the Fed done
nothing and allowed the firms to fail immediately taking all management, shareholders
and creditors down with them? This course would have avoided moral hazard entirely
AND SATISFIED THE GENERAL PUBLICS DESIRE TO SEE WALL STREET HIGH FLIERS BROUGHT
DOWN. And the markets would have self-corrected eventually. But, at what cost to the
broader economy?