Curious Trading by Federal Reserve Advisor May Result in JPMorgan Chase $1.264 Billion Windfall

Reprinted with permission from EconomicPolicyJournal

Since the Federal Reserve Bank of New York finished purchasing $1.25 trillion in mortgage backed securities in March 2010, it has continued to support those markets with billions in so-called dollar rolls. Even as this is not well known, what is less well known is that the advisor to the Fed's other MBS portfolio also continues to actively trade the account. The annual turnover appears to be 12%. One has to ask what the purpose of this turnover is, given it was sold to the public as a portfolio simply being wound down. Just what has BlackRock been selling off and who is buying the discards? (Could it be the Fed itself?) Is this a case of getting stronger paper into the portfolio for the benefit of JPMorgan Chase, run by President Obama’s "Favorite Banker", Jamie Dimon? Will an easily overlooked disclosure in the portfolio’s audit allow a $1.264 billion windfall payment to JP Morgan in the coming weeks? Nothing can be known for sure unless the Federal Reserve provides further data. But the trading in the portfolio and its valuation is very suspicious. Below is some background followed by a forensic analysis of what is known to date, with a discussion of what further data needs to be provided by the Fed to gain a full understanding of what BlackRock is attempting to accomplish with the unusually heavy trading in Maiden Lane.


Background
On the wings of the US housing boom, Bear Stearns had become the second-largest underwriter of US mortgage bonds, but from the summer of 2007 through March 2008, it quickly devolved into fire sale fodder as the subprime market imploded. It was eventually sold for $10 a share (down from $159 per share) to JP Morgan Chase (JPMC). In testimony before the Senate Banking Committee, bank president Jamie Dimon said his firm was “acquiring some $360 billion of Bear Stearns assets and liabilities.”However, they “could not and would not have assumed the substantial risks of acquiring Bear Stearns without the $30 billion facility provided by the Fed.” Maiden Lane LLC was to be this facility, financed on June 26, 2008 with a $28.8 billion senior loan from the New York Fed and a $1.15 billion subordinate loan from JPMC. The loans would purchase part of the Bear Stearns portfolio and be managed by BlackRock Financial Management, Inc. as Investment Manager. JPMC’s losses would be limited to its $1.15 billion contribution. The loans would each have a ten year term, with the Fed scheduled to be paid back starting as soon as June 26, 2010. The NY Fed was also granted certain discretionary options with respect to the timing of the payback which will be explored later.

 

This unprecedented intervention by the Federal Reserve was fiercely contested, and Chairman Bernanke was brought before the Senate Committee on Banking, to explain post facto that:

 

The sudden failure of Bear Stearns likely would have led to achaotic unwinding of positions in those markets and could have severely shaken confidence…The purpose of our action, as with our other recent actions--including our provision of liquidity to financial firms and our reductions in the federal funds rate target--was, as best as possible, to improve the functioning of financial markets and to limit any adverse effects of financial turmoil on the broader economy.

 

Despite that what the Fed attempted to avert became a new chapter in history and economic text books, it would be reasonable to infer that the new facility would be purposed with the orderly wind down of certain Bear Stearns assets after liquidity later improved. Indeed, on March 24, 2008 the NY Fed published a summary of terms, which referenced BlackRock only to the extent that it had “been retained by the New York Fed to manage and liquidate the assets.” The accompanying press release said that “BlackRock Financial Management, Inc. will manage the portfolio under guidelines established by the New York Fed designed to minimize disruption to financial markets and maximize recovery value.” As will be demonstrated, rather than merely referring to opportunistic liquidation, “maximize recovery value” would come to mean aggressive opportunistic purchasing of new assets as well.

 

In addition, the summary provided the repayment order as follows:

 

Repayment of the loans will begin on the second anniversary of the loan, unless the Reserve Bank determines to begin payments earlier. Payments from the liquidation of the assets in the LLC will be made in the following order (each category must be fully paid before proceeding to the next lower category):

 

to pay the necessary operating expenses of the LLC incurred in managing and liquidating the assets as of the repayment date;

 

to repay the entire $29 billion principal due to the New York Fed;

 

to pay all interest due to the New York Fed on its loan;

 

to repay the entire $1 billion subordinated note due toJPMorgan Chase;

 

to pay all interest due to JPMorgan Chase on its subordinated note;

 

to pay any other non-operating expenses of the LLC, if any.

 

Any remaining funds resulting from the liquidation of the assets will be paid to the New York Fed.

 

The two important points thus far are: (1) the portfolio would be used to wind down certain Bear Stearns assets and (2), JPMC is lower on the repayment ladder than the American taxpayer, inasmuch as the NY Fed can be said to represent such.

 

In the meantime, things did not go well for the Maiden Lane portfolio.Though Dimon denied before the Senate that the riskiest assets had been placed in the facility, as Janet Tavakoli wrote on February 18, 2010:

 

The assets included financing in the process of being restructured for Hilton Hotels and financing for Extended Stay, a hotel operator that is in bankruptcy. Since June 2008, the Maiden Lane I portfolio deteriorated further, and the Fed's reported value had fallen from the original $30 billion (including JPMorgan's $1 billion "cushion") to $27.1 billion at the end of 2009. If Jamie Dimon didn't give the Fed his riskiest assets, then he must have taken on some interesting risk in that original $360 billion from Bear Stearns.

 

Approximately ten months after Maiden Lane’s June 26, 2008 inception, in April 2009, the NY Fed published for the first time detailed disclosure of its portfolio composition in the form of the 2008 Maiden Lane audit and asummary web page. Long after BlackRock had commenced management of the portfolio, the public became privy to the fact that its investment directive was not only to liquidate, but to remain fully invested—specifically, to re-invest any wound down securities for a period of at least two years.From the web page:

 

During the period from June 26, 2008 (the Closing Date) to the second anniversary of the Closing Date (Accumulation Period), any proceeds realized on the Asset Portfolio (including interest proceeds and proceeds from maturity or liquidation of the Asset Portfolio) after payment of certain fees and expenses and any payments made pursuant to the derivative contracts will be deposited into a reserve account (Reserve Account) and reinvested in certain eligible investments.

 

 

BlackRock Financial Management Inc. (Investment Manager) has been retained by the New York Fed to manage the assets held in the ML LLC portfolio.

 

The Investment Manager’s primary objective in managing the ML LLC portfolio is to pay off the Senior Loan, including principal and interest, while refraining from investment actions that would disturb general financial market conditions.

 

The Investment Manager may purchase new assets in pursuit of the objective noted above. Eligible assets for reinvestment must be dollar-denominated and must fall within one of the following two categories:

 

All U.S. Treasury securities

 

Agency securities (MBS and debentures)

 

New York Fed, at its sole discretion, may add permissible categories for reinvestment.

 

Additionally, the Investment Manager may enter into OTC and exchange-traded derivatives solely for the purpose of hedging interest rate risk. Derivative contracts that would create new exposures to equities, commodities, foreign currency-denominated assets or sub-investment grade assets are expressly prohibited.

 

Agency securities are the mortgage backed securities and debt of the various housing related enterprises that enjoy a direct or indirect guarantee by the US Treasury, such as Fannie Mae, Freddie Mac and Ginnie Mae.While certainly not immune from toxicity, there is a well established, relatively liquid (during normal times) market for their instruments. They are also sold under a prospectus and therefore registered with the Securities and Exchange Commission. Contrasted with the extremely illiquid loan portfolio and non-Agency (private label) MBS, it makes sense that if there were to be trading allowed, it would be in Agency MBS and, of course, US Treasurys.

 

Maiden Lane Holdings Analysis

 

In April and May, 2010, the NY Fed released detailed reports of Maiden Lane holdings as of January 31, 2010 and March 31, 2010, respectively. As the Current Principal Balance (CPB) and CUSIP were provided for each security held, an algorithm was applied to match the unique CUSIP for each Agency MBS for both report dates to reveal changes in the holdings over the two month period, specifically looking for: (1) changes in CPB, (2) acquisition of new securities, and (3) elimination of securities from the portfolio. With most MBS, as prepayments and defaults occur over time, CPB will decline into the final payout. However, depending on the structure of the MBS and market conditions, it can stay the same or rise. It is important to note that CPB does not give information about a security’s fair value.

 

Composition of Maiden Lane LLC Holdings
 
January 31, 20101
March 31, 2010
Difference
Total Assets in Maiden Lane2
$74,894,458,000
$73,740,103,587
$(1,154,354,413)
Federal Agency & GSE MBS Assets3
$31,938,562,000
$31,447,314,996
$(491,247,004)
Agency MBS ($) as % of Total Assets ($)
42.64%
42.65%
0.01%
Number of Agency MBS Securities
1,430
1,472
42
1 Rounded to thousands for this reporting date
2 Current Principal Balance or Notional Amount (e.g., swaps and hedges)
3 Current Principal Balance
Source: Detailed ML holdings Federal Reserve Bank of New York

 

While total assets and Agency MBS decreased over the period, the number of issues of Agency MBS increased sufficiently to keep the percentage of the Agency MBS portion of the portfolio nearly constant with respect to total assets over the period.

 

Changes in Current Principal Balance of Maiden Lane LLC Holdings of Federal Agency & GSE MBSfrom January 31, 2010 to March 31, 2010

 

Beginning Agency MBS Assets
$31,938,562,000
Agency MBS with CPB Lower1
$26,364,322,408
Agency MBS with CPB Unchanged2
$2,886,046,328
Agency MBS with CPB Higher
$727,401,888
Newly Acquired Agency MBS
$1,469,544,372
Agency MBS that was Liquidated or Received Final Payment
$(278,136,000)
Ending Agency MBS Assets
$31,447,314,996
1 Current Principal Balance (CPB)
2 Differences of less than $1,000 are considered unchanged because January 31, 2010 figures are rounded to the nearest thousand
Source: Detailed ML holdings Federal Reserve Bank of New York

 

Additions of new Agency MBS total 1.96% of Agency MBS assets as of the beginning of the period, which suggests that the total turnover for this part of the portfolio in the first two years ended June 26, 2010 could be 23.52%, or $7.512 billion. Some of the newly acquired securities were for forward delivery, such as FNMA 10-45 (CUSIP 31398PMD8) for $100 million, so the portfolio composition could conceivably change even after the two year accumulation period as forward contracts are settled.

 

Six months after Maiden Lane’s inception, the NY Fed began its $1.25 trillion Agency MBS purchasing program in January, 2010, and continued through March 31, 2010. Detailed holdings of these assets, which are managed by the NY Fed in its System Open Market Account (SOMA) are similarly disclosed weekly at par, or face value. An analysis was performed of the SOMA’s assets over the same two month period. Though little crossover between the SOMA and Maiden Lane disclosed assets was found, it would be necessary to obtain detailed holdings since inception to determine whether or not BlackRock possibly sold Maiden Lane assets to the NY Fed, especially since the January 31 to March 31 period was one in which the Fed was winding down Agency MBS purchases.

A similar analysis was also performed of the Maiden Lane residential mortgage backed securities (RMBS) portfolio. According to the NY Fed’s website, BlackRock was constrained to investing proceeds only in US Treasury securities and Agency MBS and debentures, and was expressly prohibited from creating any new exposure to sub-investment grade securities. Though the NY Fed retained sole discretion to add permissible categories for reinvestment, no disclosure has been made indicating that it did so.

 

It was curious then to find that four new RMBS appeared in Maiden Lane over the two month period, totaling $9.430 million. One in particular stands out as it is was underwritten by JP Morgan Securities Inc. and Countrywide Securities. Namely, $5.000 million of one Class M-8 (CUSIP 46626LBA7) of J. P. Morgan Acquisition Corp. 2005-FLD1, originally issued via aprospectus supplement dated July 29, 2005 in gross amount of $15.247 million, which was downgraded to CCC (junk status) by Standard & Poors on July 23, 2008. The other tree non-Agency MBS were ATRIUM V 2006-5 (CUSIP 04963WAJ5), CARRINGTON MTG LN 2006-NC5 (144539AN3), and CARRINGTON MTG LN 2006-NC5 (CUSIP 144539AM5).

 

Because JPMC is not only a subordinate debt holder of Maiden Lane, but also involved in its hedging transactions, there was a potential violation of section 23A of the Federal Reserve Act and the Board’s Regulation W. As such, it was granted an exemption by letter dated June 26, 2008 from the Board of Governors. The exemption was qualified as follows:

 

This determination is specifically conditioned on compliance by JPMC and JPMC Bank with all the commitments and representations made in connection with the request. These commitments and representations are deemed to be conditions imposed in writing by the Board in connection with granting the request and, as such, may be enforced in proceedings under applicable law. This determination is based on the specific facts and circumstances of the existing and proposed relationships among JPMC, JPMC Bank, and Maiden Lane. Any material change in those facts and circumstances or any failure by JPMC or JPMC Bank to observe any of its commitments or representations may result in a revocation of the exemption.

 

While the $5 million RMBS purchase constitutes an immaterial portion of the Maiden Lane portfolio, it is material that, in the limited public disclosures released to date, there is not only an apparent violation of the original terms of the facility, but a glaring potential conflict of interest. In light of this, a review of the June 26, 2008 exemption letter may be in order.

 

Motive

 

The question remains: why all this trading by BlackRock for a relatively insignificant taxpayer asset, and why all these recent data releases by the NY Fed?

 

To answer, one must return to the updated terms page for Maiden Lane published in April, 2009, where for the first time there is disclosed an interesting statement about the repayment of the loans:

 

At the sole discretion of the New York Fed, repayment of the Senior Loan could commence during the Accumulation Period [sic prior to June 26, 2010], but only so long as the ML LLC pays in full the outstanding principal amount of the Subordinate Loan plus any accrued and unpaid interest.

 

It appears to be a backhanded escape clause that would allow JPMC to be repaid ahead of the NY Fed. No mention is made of any qualifications to ensure that the NY Fed would have a chance at future recovery. Additionally, the use of the term “commence” means it was not contemplated for bothparties to be repaid in full ahead of time. Delving into the 2008 Maiden Lane audit for clarification, there are a few more details:

 

Repayment on the Senior Loan may only begin prior to the second anniversary of the closing date of the Loans if the Subordinated Loan has been paid in full. Repayment of the Loans will only occur after payment in full of closing costs for the LLC, operating expenses, and maintenance of a reserve account for loan commitments.

 

 

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