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Old 03-25-2008, 07:27 AM   #21
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Their equity should have been used before the the customers get $29B of garbage debt on their account.
So you think that the people who paid $100+ for the stock and are now being offered $10 didn't get punished? Remember, like most of the big firms, Bear paid out much/most of those big bonuses in company stock.

I would also suggest that you are deluded if you think the Fed got lumbered with low quality securities. What they got are illiquid securities, not necessarily lousy ones.
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Old 03-25-2008, 09:32 AM   #22
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How about the millions of uninformed (but panicky) investors who all start fearing for the health of their brokerage houses and start selling so they can get their money out?
Maybe I'm being dense here, but don't the brokerage houses just sell the stock and give the proceeds to the investors?

I understand that if 10 million of us all call our brokers on the same day, that overwhelms the mechanical capacity of the system. But I really have trouble believing that was going to happen last Monday. Assuming there were "a lot" of sell orders, trades pile up waiting to be executed, people see prices dropping, some rethink their decisions and cancel the sell order before the broker gets to it. Others bring cash in looking for bargains.

Stocks have their worst single day since 1929. People who panicked lose money. Cooler heads prevail as the week goes on. People who didn't panic do fine.

What am I missing?
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Old 03-25-2008, 09:38 AM   #23
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What am I missing?
What you are mising is that many of these investors are leveraged, so a relatively small drop in asset prices causes nsolvency, which impacts everyone in the lender-borrower conga line. Equity market drops have been notthing comparred to falls in the prices of credit derivatives, asset baced securities, etc.
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Old 03-25-2008, 10:05 AM   #24
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Suppose, for a moment, that your $65 billion estimate is true. So Bear blows up and takes that much out of the hides of its counterparties. Now knowing that all the parties trading such derivatives have just suffered a large loss, what do you think the remaining derivatives dealers will do, especially in a very stressed market? Simple: raise margin requirements. So you now have a massive margin call going out to every participant in the capital markets. Those receiving margin calls have to raise cash to meet such calls, so they sell securities into a no-bid market. The ensuing plunge in prices begets yet another margin call. Rinse and repeat until there is no functioning capital market system, banking system, economy, etc.
I think I'm learning stuff here. You seem to assume that the dealers have a unilateral right to raise margin requirements. I would have guessed that they were fixed by contract (maybe the initial margin plus accumulated losses). So in my world, the total real value of derivatives isn't impacted by all this (any losses are offset by some gains elsewhere) and so no additional margin is needed.

I can see that in yours, dealers can just panic and call for more total cash than we have.

We should be looking for system-wide changes coming out of this. We shouldn't be in the position where one, not terribly big player, can set off a chain reaction that brings down the whole economy. Is there some change in the margin rules that you can see?

(Note, I'm assuming here that "margn account" means some cash held by the dealer that assures the dealer that you will make good on anything you owe if the derivative value goes against you. I'm not thinking of a "margin account" that indicates you borrowed money from the dealer to buy the derivative.)

Now I'm on to your next step, where people have to sell "securities" into a no-bid market. What type of securities are they selling? At first, I thought you meant bonds and stocks. But then you go on to say "the ensuing plunge begets yet another margin call". Why? If the sellers owned the securities, why do dropping prices create another margin call? Even if the "securities" were derivatives, that doesn't change the type of margin account above.
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Old 03-25-2008, 10:09 AM   #25
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Brewer,

To head off some confusion, I finished my post #24 before I read your #23.

I think I may have mis-interpreted "margin account". Maybe you can clarify.
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Old 03-25-2008, 10:18 AM   #26
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I think I may have mis-interpreted "margin account".
Let's say you have $100,000 in equity in a margin account with a 50% margin requirement. This $100K is invested in, say, CMOs.

That means you can "borrow" up to an additional $100,000 to purchase more CMOs, using the original securities as collateral. You retain 50% "equity" in the margin account, the minimum allowable.

Let's say they raise the margin requirements to 66 2/3% -- that is, your equity needs to be at least 2/3 as much as the security value in the account. That means that your $100K equity can only control a total of $150K in securities. Thus, you will be hit with a "margin call" to sell $50,000 of these CMOs in order to make the call. (The other alternative would be to inject another $100,000 in cash.)

But if you did this, a LOT of investors and institutions would be hit with the same margin calls. You'd have an obscene number of sellers and almost no buyers. The market value of the underlying securities would plummet as a result. Let's say that when you mark to market these securities lose 20% of value because of all the sellers, no buyers and little liquidity. Now even after you sold that $50K to meet the margin call, you now have $50,000 borrowed on a portfolio that is now worth $120,000 (20% less than the $150,000 these used to be worth). But with $120K of securities, suddenly you have only $70,000 in equity...and that means you can control only $105,000 in securities to meet the 66 2/3% margin requirements. Now you have to sell ANOTHER $15,000 of these securities into an already stressed market, as do many others -- which makes the buyer/seller imbalance even worse and causes the security value to fall more.

Rinse, lather, repeat. You have a potential death spiral. This is exactly the scenario the Fed is trying to avoid by accepting these securities as collateral in exchange for Treasury securities. The Fed doesn't have to sell into margin calls.
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Old 03-25-2008, 10:20 AM   #27
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Now I'm on to your next step, where people have to sell "securities" into a no-bid market. What type of securities are they selling? At first, I thought you meant bonds and stocks. But then you go on to say "the ensuing plunge begets yet another margin call". Why? If the sellers owned the securities, why do dropping prices create another margin call? Even if the "securities" were derivatives, that doesn't change the type of margin account above.

What kind of securities are they selling? Anything they can find a bid on. Stocks, bonds, MBS, ABS, life insurance settlements, derivatives of any flavor you'd like, commodities, etc.

Why might successive waves of forced selling beget more margin calls? A simple example: Suppose you write 1 million put options on stock XYZ. You accept a payment up front, say $5 a share, and agree that any time in the next year the owner of the put can sell you the stock at $100 a share regardless of what the market price is. Suppose the market price is $125 when you write the put option, and you also own 10 million shares (of 100 million outstanding). You left some cash on deposit with your broker to secure the put obligation (say, $1 a share). The stock gets hit and goes down to $75, and your broker issues a margin call demanding $10 million in cash. Your only other asset is shares of XYZ, so you start selling to meet the margin call. You meet the mmargin call, but in doing so you knocked the stock down to $65, so the next day the broker wants another $5 million cash. So you start selling more XYZ... etc.

The above is one of the things that happened in the credit and credit derivative markets in the last 6 months that helped them crash.
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Old 03-25-2008, 10:51 AM   #28
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I don't get the "exposure to the tune of the notional value". For example, I've got an interest rate swap with a notional of $100 million, and Bear owes me, they only owe the difference in interest rates, maybe 1-2%, times the $100 million. That means I'm out $1-2 million. I'm not short the whole notional amount.
Actually, if your counter-party fails you are exposed on the whole notional amount. That's not to say you have lost the whole notional amount - just that it is exposed to loss.

Also, you have picked an example where the loss is relatively small. As you know, these derivative contracts exist on almost everything, including assets where there is much more volatility than 1-2% of the notional amount. Suppose you had entered into a swap to hedge a $100 million portfolio of financial stocks last year. Your portfolio might be down 50%, the loss of which is offset by the swap. If your counter-party fails and the swap agreement didn't include interim marks to the market (and many don't), you would have lost the full $50 million. Even with interim marks, your loss could be substantially more than 1-2%. Credit default swaps, commodity swaps, swaps on individual stocks, etc. can be extremely volatile, and you can experience great losses should you become unhedged through counter-party failure.
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Old 03-25-2008, 02:22 PM   #29
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Let's say you have $100,000 in equity in a margin account with a 50% margin requirement. This $100K is invested in, say, CMOs.

That means you can "borrow" up to an additional $100,000 to purchase more CMOs, using the original securities as collateral. You retain 50% "equity" in the margin account, the minimum allowable.

Let's say they raise the margin requirements to 66 2/3% -- that is, your equity needs to be at least 2/3 as much as the security value in the account. That means that your $100K equity can only control a total of $150K in securities. Thus, you will be hit with a "margin call" to sell $50,000 of these CMOs in order to make the call. (The other alternative would be to inject another $100,000 in cash.)

But if you did this, a LOT of investors and institutions would be hit with the same margin calls. You'd have an obscene number of sellers and almost no buyers. The market value of the underlying securities would plummet as a result. Let's say that when you mark to market these securities lose 20% of value because of all the sellers, no buyers and little liquidity. Now even after you sold that $50K to meet the margin call, you now have $50,000 borrowed on a portfolio that is now worth $120,000 (20% less than the $150,000 these used to be worth). But with $120K of securities, suddenly you have only $70,000 in equity...and that means you can control only $105,000 in securities to meet the 66 2/3% margin requirements. Now you have to sell ANOTHER $15,000 of these securities into an already stressed market, as do many others -- which makes the buyer/seller imbalance even worse and causes the security value to fall more.

Rinse, lather, repeat. You have a potential death spiral. This is exactly the scenario the Fed is trying to avoid by accepting these securities as collateral in exchange for Treasury securities. The Fed doesn't have to sell into margin calls.
Yes, I understand this scenario. The first time I heard the phrase "buying stocks on the margin" it had to do with the 1929 crash. My understanding was that margin requirements were very low then (maybe 10%) and the gov't increased them to 50% to prevent exactly this type of spiral.

If even the 50% leads to so much leverage that the whole economy can collapse, then I have to wonder if any margin buying should be allowed. Do we (all of us, not just the buyers) get enough economic efficiency out of this practice to make it worth our while to allow it?
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Old 03-25-2008, 02:44 PM   #30
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Do we (all of us, not just the buyers) get enough economic efficiency out of this practice to make it worth our while to allow it?
I doubt it for the small investor...........
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Old 03-25-2008, 02:56 PM   #31
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What kind of securities are they selling? Anything they can find a bid on. Stocks, bonds, MBS, ABS, life insurance settlements, derivatives of any flavor you'd like, commodities, etc.

Why might successive waves of forced selling beget more margin calls? A simple example: Suppose you write 1 million put options on stock XYZ. You accept a payment up front, say $5 a share, and agree that any time in the next year the owner of the put can sell you the stock at $100 a share regardless of what the market price is. Suppose the market price is $125 when you write the put option, and you also own 10 million shares (of 100 million outstanding). You left some cash on deposit with your broker to secure the put obligation (say, $1 a share). The stock gets hit and goes down to $75, and your broker issues a margin call demanding $10 million in cash. Your only other asset is shares of XYZ, so you start selling to meet the margin call. You meet the mmargin call, but in doing so you knocked the stock down to $65, so the next day the broker wants another $5 million cash. So you start selling more XYZ... etc.

The above is one of the things that happened in the credit and credit derivative markets in the last 6 months that helped them crash.
Brewer, I think I can understand this next step. A margin call leads to a distress sale of a real asset, but that asset is the underlying on another derivative, so somebody else is calling for cash because of that drop.

I want to be sure that the type of "margin account" you're talking about here isn't the type that Ziggy is talking about. Correct?

It looks to me like the drop to $75 puts the put (bad choice of words) into the money by $25 a share. Since the option is on 1 million shares, would the dealer be looking for $10 milliion or $25 million additional money? Again, I'm not sure how brokers determine margin requirement.

That said, if there is a call option someplace else in the system, it seems that the margin needs on that option have gone down. I can see why it wouldn't be symetric in your example, because the price has fallen so far.

My impression was that the big run up in derivative volumes comes from intermediaries (I'm not sure of the names, "dealers", "brokers", "banks"?) who are managing large blocks of derivatives and work hard to make the block risk-neutral. For example, if UBS is doing derivatives driven by Euro vs. Dollar exhange rates, then UBS wants to be in the position where an upward shift in the rate produces exactly offsetting gains and losses on its block, so there is no net impact on UBS's bottom line. They seem to brag that they use sophisticated mathematical techniques to keep themselves in that position. It seems that any margin increases they would expect from their customers would be offset by margin decreases with other customers.

So is that true? If so, I can see that there would still be other derivatives out there that aren't part of managed blocks and could have an overall bias in one direction or the other. Is this what's going on? Or does all the sophisticated management fail when the movements get too big?
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Old 03-25-2008, 03:00 PM   #32
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I want to be sure that the type of "margin account" you're talking about here isn't the type that Ziggy is talking about. Correct?
An institutional portfolio subject to "margin requirements" isn't strictly the same as a "margin account" for an individual investor, but margin requirements work the same way in either case, and similar dynamics can trigger a death spiral -- falling prices beget margin calls which beget selling which begets lower prices which begets another margin call which begets more selling which begets....
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Old 03-25-2008, 03:13 PM   #33
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My impression was that the big run up in derivative volumes comes from intermediaries (I'm not sure of the names, "dealers", "brokers", "banks"?) who are managing large blocks of derivatives and work hard to make the block risk-neutral. For example, if UBS is doing derivatives driven by Euro vs. Dollar exhange rates, then UBS wants to be in the position where an upward shift in the rate produces exactly offsetting gains and losses on its block, so there is no net impact on UBS's bottom line. They seem to brag that they use sophisticated mathematical techniques to keep themselves in that position. It seems that any margin increases they would expect from their customers would be offset by margin decreases with other customers.

So is that true? If so, I can see that there would still be other derivatives out there that aren't part of managed blocks and could have an overall bias in one direction or the other. Is this what's going on? Or does all the sophisticated management fail when the movements get too big?
We all hope (as do the regulators) that the dealerrs do indeed run matched books. Given the dynamic nature of these portfolios, it is anyone's guess as to whether this is really true.

The real problem is in the counterparties to the dealer. When a trade goes awry in normal times, you suck it up and get on with life. In bad times, it can be catastrophic. To give you a plain vanilla idea, there are publicly traded REITs that do nothing but invest in a leveraged portfolio of agency MBS. This paper is very safe - backed by conforming mortgages and guarateed by Fannie, Freddie or Ginnie. It is usually among the most liquid and safest paper in the world. These trusts got whacked recently. Why? Spreads over treasuries for agency MBS gapped out real wide (and the dollar price of the bonds dropped). At the same time, the swaps that these trusts put on to hedge some of their interest rate exposure (effectively shorting 3 year treasuries) went against them, triggering margin calls. Combine this mess with 8 to 1 leverage and you have lots of forced selling of some of the safest, most liquid paper in existence, begetting more margin calls.
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Old 03-25-2008, 06:50 PM   #34
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An institutional portfolio subject to "margin requirements" isn't strictly the same as a "margin account" for an individual investor, but margin requirements work the same way in either case, and similar dynamics can trigger a death spiral -- falling prices beget margin calls which beget selling which begets lower prices which begets another margin call which begets more selling which begets....
I think I've got the idea. I still have the same question. Economists tell us that if a certain private transactions create large enough "negative externalities", then it's reasonable for the gov't to ban, regulate, or tax those transactions. If institutional investors can cause a general economic meltdown (hurting innocent bystanders like us) due to their activities, should the gov't step in and change the rules?
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Old 03-25-2008, 07:16 PM   #35
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Economists tell us that if a certain private transactions create large enough "negative externalities", then it's reasonable for the gov't to ban, regulate, or tax those transactions. If institutional investors can cause a general economic meltdown (hurting innocent bystanders like us) due to their activities, should the gov't step in and change the rules?
We don't even need a study to determine if the regs should be changed. Since the government deems it worthwhile to jump in and help these firms (using our money) when things might go wrong in a broader way, we've already got the answer on whether the negative externalities are sufficient to warrant more regulations.

I would normally have absolutely no reason to demand that motorcyclists wear a helmet. It's their brain, and whether it stays in their cranium is none of my concern. However, when I am forced to pay for post-accident health care, ongoing therapy, welfare when he/she can't support their family anymore, then I have a right to say something about helmet use. Or whether motorcycles should be legal. Same with the financial markets--they benefit from the regulated playing field and the investor confidence it inspires, but obviously since taxpayers are presently footing the bill (or, more precisely, assuming unexpected levels of risk, which is the same thing in the long run), then we have two alternatives to reduce the costs to taxpayers:
1) Allow the markets to be entirely on their own without any taxpayer-funded bailouts ("Nope, you don't need to wear a helmet--please sign this waiver of govt funded support in case of accident")
2) More govt regulation and oversight commensurate with the now-fully-demonstrated level of risk the government is assuming (explicitly or implicitly)
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Old 03-25-2008, 07:19 PM   #36
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We all hope (as do the regulators) that the dealerrs do indeed run matched books. Given the dynamic nature of these portfolios, it is anyone's guess as to whether this is really true.

The real problem is in the counterparties to the dealer. When a trade goes awry in normal times, you suck it up and get on with life. In bad times, it can be catastrophic. To give you a plain vanilla idea, there are publicly traded REITs that do nothing but invest in a leveraged portfolio of agency MBS. This paper is very safe - backed by conforming mortgages and guarateed by Fannie, Freddie or Ginnie. It is usually among the most liquid and safest paper in the world. These trusts got whacked recently. Why? Spreads over treasuries for agency MBS gapped out real wide (and the dollar price of the bonds dropped). At the same time, the swaps that these trusts put on to hedge some of their interest rate exposure (effectively shorting 3 year treasuries) went against them, triggering margin calls. Combine this mess with 8 to 1 leverage and you have lots of forced selling of some of the safest, most liquid paper in existence, begetting more margin calls.
I'll reword this to see if I understand it. These REITS used leverage to increase the volatility of normally boring Agency MBS. That magnifies the upside when things are going well, and magnifies the down when things go badly. We may have a bad enough down that some of the REITS will be legally bankrupt (although their assets will probably cover their liabilities eventually). That causes problems for their creditors, who may include derivative dealers. Correct?

It seems to me that this puts us right back to my post #6, except that I replace "Bear Stearns" with "Bear Stearns and MBS concentrated REITS".

The problem is still the same, why can't we let them fail the old-fashioned way? My understanding of "prudent management" is that you spread your risks. If a few players didn't, they fail. Their creditors should be diversified. No single creditor should be so exposed to BSC or these REITS that the creditor goes down just because they have to wait for the bankruptcy process to play out before they get their money. The system is supposed to be spreading risk so that a big hit in one sector is a big deal only to a few players who got over-concentrated in that sector.

I think you're saying that at least some of BSC's creditors are so leveraged that even if BSC represents only a normally prudent percent of their book, the leverage magnifies that percent into a solvency issue. Instead of the system dissipating the impact by spreading it across a lot of players, there's enough leverage out there that it gets re-concentrated over and over. Is that right?
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Old 03-25-2008, 08:03 PM   #37
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We don't even need a study to determine if the regs should be changed. Since the government deems it worthwhile to jump in and help these firms (using our money) when things might go wrong in a broader way, we've already got the answer on whether the negative externalities are sufficient to warrant more regulations.

I would normally have absolutely no reason to demand that motorcyclists wear a helmet. It's their brain, and whether it stays in their cranium is none of my concern. However, when I am forced to pay for post-accident health care, ongoing therapy, welfare when he/she can't support their family anymore, then I have a right to say something about helmet use. Or whether motorcycles should be legal. Same with the financial markets--they benefit from the regulated playing field and the investor confidence it inspires, but obviously since taxpayers are presently footing the bill (or, more precisely, assuming unexpected levels of risk, which is the same thing in the long run), then we have two alternatives to reduce the costs to taxpayers:
1) Allow the markets to be entirely on their own without any taxpayer-funded bailouts ("Nope, you don't need to wear a helmet--please sign this waiver of govt funded support in case of accident")
2) More govt regulation and oversight commensurate with the now-fully-demonstrated level of risk the government is assuming (explicitly or implicitly)

What Sam said. (My we do agree a lot.)
Assuming #2 is the eventual answer, (it seems very unlikely that we will have less regulation), how do ensure that the folks who create the risky investment suffer appropriately when the risk fail?

By this I mean, smart guys like Brewer figure out these neat ways of using leverage, securitizing pools of mortgages, and developing credit swaps etc. When everything is going decently they get million dollar bonus, when things are going really well they get 2 million, when things go bad some get fired but the rest keep most of their million dollar bonus.

The people who lose out are the folks (including anybody with an S&P 500 fund) who buy Bear @50 and then get $10 from JPM.

It seems to me that equal smart guys in Silicon Valley invent; iPhones, Google search, Facebook, and Intel microprocessors, and they make millions from stock options. However, the guys who invent pets.com, napster etc, get paid a decent salary but if investors get hurt they get hurt worse cause they never collect the million dollar bonus.
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Old 03-25-2008, 08:33 PM   #38
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So you think that the people who paid $100+ for the stock and are now being offered $10 didn't get punished? Remember, like most of the big firms, Bear paid out much/most of those big bonuses in company stock.

I would also suggest that you are deluded if you think the Fed got lumbered with low quality securities. What they got are illiquid securities, not necessarily lousy ones.
First point, sure the stockholders did pay paid a price as they should have, but how much did the Bear bond holders lose? Isn't bankrupcy the obvious risk in owning a bond? I think the $29B backing should have come from their equity, not the taxpayers.

Second point, I heard today that the FED has a deal in the works w/Blackstone to sell off the FED/Bear assets. Another commission for the Wall Street MBS gang . If the assets are not that bad, why not let Bear go into liquidation and leave the FED guarantee out of it. Someone would purchased them at some price, the FED could have helped delay the bankrupcy with short term liquidity to allow an orderly sale. Now that the assets are going to be put on the market through a Blackstone "orderly sale", where was the crisis?
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Old 03-25-2008, 08:54 PM   #39
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Originally Posted by RockOn View Post

Second point, I heard today that the FED has a deal in the works w/Blackstone to sell off the FED/Bear assets. Another commission for the Wall Street MBS gang . If the assets are not that bad, why not let Bear go into liquidation and leave the FED guarantee out of it. Someone would purchased them at some price, the FED could have helped delay the bankrupcy with short term liquidity to allow an orderly sale. Now that the assets are going to be put on the market through a Blackstone "orderly sale", where was the crisis?
I think you're looking for a story that isn't there. The Fed hired Blackrock, not Blackstone. Blackrock is the largest manager of fixed income investments in the US (might be tied with PIMCO) and are more than qualified to do the job. The profits from the sale will go to the NY Fed.
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Old 03-25-2008, 09:00 PM   #40
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I think you're looking for a story that isn't there. The Fed hired Blackrock, not Blackstone. Blackrock is the largest manager of fixed income investments in the US (might be tied with PIMCO) and are more than qualified to do the job. The profits from the sale will go to the NY Fed.
Sorry, I thought I heard Blackstone, the hearing is the first to go. I still argue the point that they are going to put the securities on the market. Why couldn't that have been done without the taxpayers being on the hook? If they are putting them on the market anyway, where was the crisis?

Also, profits from the sale? you must be kidding
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