On April 23, the Fed released audited financial statements which included financial statements from a few of the super “structured investment vehicles” that it created in 2008. The Fed called them “Special Purpose Vehicles”. Yeah, right, we know what “Special Purpose” means. Here’s a hint: giveaway. JP Morgan Chase got a sweet heart deal with the help of Maiden Lane. With the stroke of a pen $30 billion in assets were moved from Bear Stearns balance sheet to the Feds.

Background

The Fed (Federal Reserve Bank of New York) wanted to help out JP Morgan Chase purchase The Bear Stearns Company. Does Jamie Dimon, CEO of JP Morgan Chase serve on the Board of Directors of FRBNY? No conflict of interest there! But Bearn Stearns had a “toxic asset” problem.

FRBNY (at the time Tim Geithner was President of FRBNY) and JP Morgan Chase agreed to form Maiden Lane, LLC (limited liability company) for the sole purpose of acquiring about $30 billion of Bear Stearns toxic assets. FRBNY was the sole and managing member of Maiden Lane.

Maiden Lane was capitalized by a $28.8 billion senior loan from FRBNY and $1.15 billion subordinate loan from JP Morgan Chase. No cash here – just debt. At some point between March 14, 2008 and December 31, 2008, JP Morgan Chase’s subordinate loan was paid off or just disappeared with interest - $1.18 billion. FRBNY senior loan was secured by Bear Stearns former “toxic assets” that were purchased by Maiden Lane. There has to be a better word than “secured” for this specific instance.

Toxic Assets and Liabilities

Below is the balance sheet of Maiden Lane, LLC. Looks innocent enough?

Click to enlarge.

Notice the “Senior loan payable, at fair value” – this is where it starts getting interesting. Remember, FRBNY original senior loan was $28.8 billion but some now the “fair value” of the senior loan is $25.6 billion. What happened? Now, I am not an accountant and there may be a very good explanation for this but check this out:

For accounting purposes, the FRBNY’s senior loan is a “Level 3” liability. I thought loan terms were fairly straight forward. Based on this “Level 3” valuation the senior loan is worth $3.4 billion less than the original principal amount. The financial statements don’t indicate a pay down on principal. It is just called an “Unrealized Gain”.

Level 3 of the fair value hierarchy is described as:

Level 3 – Valuation is based on inputs from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect the LLC’s own estimates of assumptions that market participants would use in pricing the asset and liability. Valuation techniques include the use of option pricing models, discounted cash flow models, and similar techniques.

Is the “Unrealized Gain” on the senior loan tied to the investment losses on the asset side?

The asset side of the balance sheet is also very interesting. Of course the assets were worth less on December 31, 2008 than they were when Maiden Lane purchased them. How about $5.5 billion less! That is $5.5 billion investment loss in just 9 months (actually less considering June was the closing date).

So, FRBNY makes a $28.8 billion loan (revalued to $25.6 billion) and loses $5.5 – so much for a return on investment. The majority of the losses were from commercial mortgage loans ($2.1 billion). Can you imagine what these losses are like now considering the continued deterioration of credit quality?

How about those rating agencies? Maiden Lane lost $1.5 billion on Non-agency CMOs. Most the Non-agency CMOs were AAA-rated. Now, it is possible that most of the losses were centered on lower rated CMOs.

Maiden Lane’s asset side looks very bad – the toxicity is obvious. The loan portfolio is heavily weighed in favor of commercial mortgage loans (65% of unpaid principal balances on mortgage loans). Many of those commercial mortgages loans are to hotels or the hospitality industry (83% of unpaid principal balances on commercial mortgage loans). Actually, it is worse one borrower owes 48% of unpaid principal balances of the commercial mortgage loan portfolio. That is risky!

What’s deal today without credit default swaps?

The LLC portfolio consists of various derivative financial instruments, primarily consisting of a total return swap agreement (“TRS”) with JPMC. The LLC may enter into additional derivative contracts during the normal course of business to economically hedge its exposure to interest rates. Losses may arise if the value of the derivative contracts acquired decrease because of an unfavorable change in the market price of the underlying security, or if the counterparty’ does not perform under the contract.
……

At closing, the LLC and JPMC entered into the TRS with reference obligations representing a basket of credit default swaps (“CDS”) and interest rate swaps (“IRS”). The TRS is structured such that the LLC’s economic position for each CDS and IRS replicates Bear Stearns’ economic position. JPMC is the calculation agent for the TRS and the underlying values are also monitored by the Investment Manager on behalf of the LLC. The LLC made an initial payment to JPMC of $3.3 billion, which was included in the purchase price of the assets. At December 31, 2008, the cash collateral liability associated with the TRS is reflected in cash and cash equivalents and investments in the amounts of $2.1 billion and $0.5 billion, respectively. In addition, the LLC has pledged $3.0 billion of agency CMOs to JPMC.

Maiden Lane was the protection seller or guarantor and it sounds like JP Morgan will make some money off this arrangement. The notional amounts of CDS were $3.6 billion but had a fair value of -$2.7 billion as December 31, 2008. I would like to know why this is necessary.

At this rate of loss and considering that credit quality is not getting better, particularly in commercial real estate, it is hard to see how Maiden Lane/FRBNY recoups this $29 billion loan. This was definitely a sweet heart deal for JP Morgan Chase. The Fed would say it was necessary to prevent system-wide collapse of global financial system. I am not to sure about that because after all Lehman Brothers was allowed to fail just a few months later.