Counterparty Risk
It would be instructive to know what “counterparty risk” means since it’s the reason the Federal Reserve decided on the unprecedented act to lend $29 Billion dollars to JPMorgan Chase so that it could buy Bear Stearns. Counterparty Risk is the answer to the question, “Why did the Federal Reserve do this?”. I danced around this topic in a previous post.
OK, so what exactly is counterparty risk?
Let’s set the stage: Two large, competent and experienced organizations enter into an agreement (contract). Let’s say, as an example, Bear Stearns and a major national bank. The bank has no reason to believe that Bear Stearns won’t be able to fulfill its duties under the contract. And Bear Stearns has no reason to believe the bank won’t be able to fulfill its duties under the contract. In this example, so far, both parties are fairly confident in each other’s abilities to “perform” their contractual duties. Now let’s imagine for a moment that Bear Stearns had thousands of such agreements. All based, in part, that Bear Stearns was a financially able organization valued in the marketplace at about $19 Billion dollars. Until one day, it wasn’t.
Very simply, counterparty risk is the risk one party in a contract has that the “other” party in the contract will not be able to fulfill its obligations as outlined in the contract. I have mentioned previously that there is a crisis of confidence present in the markets today. At the core, the problem is that we can’t trust the numbers. A corollary to that is that we can’t trust the companies providing those numbers because it seems that *they* don’t even know the value (or lack of value) of the holdings on their books.
The Federal Reserve had to be concerned that a Bear Stearns failure might intensify the confidence crisis further. I am not alone in thinking this. Meredith Whitney, a bank analyst at Oppenheimer, as reported in the NY Times, had this to say: “The rescue was absolutely all about counterparty risk. If Bear went under, everyone’s solvency was going to be thrown into question. There could have been a systematic run on counterparties in general”. The emphasis is mine.
Remember the stories of the 1920’s depression “runs” on banks? Things are a lot more complex today. Back then we only had to worry about banks. How about a “run” on every financial institution: banks, credit unions, savings and loans, mutual fund firms? Only history will tell if the Federal Reserve made the “right call”, because right now, I’m not so sure.
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UPDATE April 2, 2008: Well, we just heard from the Federal Reserve Chairman himself on the previously unprecedented Bear Stearns bailout plan: “With financial conditions fragile, the sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions ….and could have severely shaken confidence.” Doesn’t that sound familiar?