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Here is John Mauldin's take on the Bear Stearns matter.
I already have a slew of emails
from people upset about what they see as a bailout of a big bank,
decrying the lack of "moral hazard." And I can understand the
sentiment, as it appears that tax-payer money may have been used to bail
out a big Wall Street bank that acted recklessly in the subprime mortgage
markets.
But that is not what has happened. This is not a bailout. The
shareholders at Bear have been essentially wiped out. Note that a third
of the shares of Bear were owned by Bear employees. Many of them have
seen a lifetime of work and savings wiped out, and their jobs may be at
risk, even if they had no connection with the actual events which caused
the crisis at Bear. Don't tell them there was no moral hazard.
For all intents and purposes, Bear would have been bankrupt this morning.
The $2 a share offer is simply to keep Bear from having to declare
bankruptcy which would mean a long, drawn out process and would have
precipitated a crisis of unimaginable proportions. Cue the
lawyers.
As I understand this morning, JP Morgan will take a $6 billion write
down, which is essentially what they are paying for Bear. The Fed is
taking $30 billion dollars in a variety of assets. They may ultimately
take a loss of a few billion dollars over time, although they may
actually make a profit. When you look at the assets, much of it is in
paper that will likely get close to par over time, and the good paper
will pay premiums mitigating the potential loss. The problem is, as the
essays below point out, no one is prepared to take that risk
today.
If it was 2005, Bear would have been allowed to collapse, as the system
back then could deal with it, as it did with REFCO. But it is not 2005.
We are in a credit crisis, a perfect storm, which is of unprecedented
proportions. If Bear had not been put into sounds hands and provided
solvency and liquidity, the credit markets would simply have frozen this
morning. As in ground to a halt. Hit the wall. The end of the world,
impossible to fathom how to get out of it type of event.
The stock market would have crashed by 20% or more, maybe a lot more. It
would have made Black Monday in 1987 look like a picnic. We would have
seen tens of trillions of dollars wiped out in equity holdings all over
the world.
As I have been writing, the Fed gets it. Their action today is actually
re-assuring. I have been writing for a long time that they would do
whatever it takes to keep the system intact. As one of the notes below
points out, this was the NY Fed stepping in, not the FOMC. The NY Fed is
responsible for market integrity, not monetary policy, and they did their
job. And you can count on other actions. They are going to change the
rules on how assets can be kept on the books of banks. Mortgage
bail-outs? Possibly. The list will grow.
Yes, tax-payers may eventually have to cover a few billion here or there
on the Bear action. But the time to worry about moral hazard was two
years ago when the various authorities allowed institutions to make
subprime loans to people with no jobs and no income and no means to repay
and then sold them to institutions all over the world as AAA assets. And
we can worry in the near future when we will need to do a complete
re-write of the rules to prevent this from happening again.
But for now, we need to bail the water out the boat and see if we can
plug the leaks. Allowing the boat to sink is not an option. And get this.
You are in the boat, whether you realize it or not. You and your friends
and neighbors and families. Whether you are in Europe or in Asia, you
would have been hurt by a failure to act by the Fed. Everything is
connected in a globalized world. Without the actions taken by the Fed,
the soft depression that many have thought would be the eventual outcome
of the huge build-up of debt would in fact become a reality. And more
quickly than you could imagine.
As I have repeatedly said, recessions are part of the business cycle.
There is nothing we can do to prevent them. But depressions are caused by
massive policy mistakes on the part of central banks and governments. And
it would have been a massive failure indeed to let Bear collapse. I
should note that this was not just a Fed action. Both President Bush and
Secretary Paulson signed off on this.
The Fed risking a few billion here and there to keep the boat afloat is
the best trade possible today. Their action saved trillions in losses for
investors all over the world. It is a relatively small price. If you want
to be outraged, think about the multiple billions in subsidies for
ethanol and the hundreds of billions of so-called earmarks over the past
few years to build bridges to nowhere. And think of the billions in lost
tax revenue that would result from the ensuing crisis. I repeat, this was
a good trade from almost any perspective, unless you are from the
hair-shirt, cut-your-nose-off-to-spite-your-face camp of economics.
The Fed is to be applauded for taking the actions they did. And they may
have to do it again, as there are rumors that another major investment
bank is on the ropes. I hope that is not the case, and will not add to
the rumors in print, but I am glad the Fed is there if we need
them.
It is precisely because the Fed is willing to take such actions that I am
modestly optimistic that we will "only" go through a rather
longish recession and slow recovery and not the soft depression that
would happen otherwise.
I got a very sad letter today from a lady whose husband is in the
construction business an hour from Atlanta. He has had no work for four
months and they are rapidly going through their savings. The jobs he can
get require them to spend more in gas to drive to than he would make. He
is sadly part of the construction industry which everyone knows is taking
a major hit.
But without the Fed action, that story would have multiplied many times
over, as the contagion of the debt crisis would have spread to sectors of
the economy that so far have seen only a relatively small impact.
Unemployment would have sky-rocketed over the next year and many more
families would have been devastated like the family above. It would have
touched every corner of the US and the globe.
Bailing out the big guys? No, the Fed does not care about the big guys,
and only mildly pays attention to the stock market, despite what
conspiracy theorists think. In the last few years, I have had the
privilege of meeting at length with a number of Fed economists and those
who have their ear. They are far more focused on the economy, their
mandates for stable inflation and keeping unemployment as possible.
No one who owned Bear stock was protected. This was to protect the small
guys who don't even realize they were at risk. To decry this deal means
you just don't get how dire a mess we were almost in. It is all well and
good to be rich or a theoretical purist and talk about how the Fed should
let the system collapse so that we can have a "cathartic"
pricing event. Or that the Fed should just leave well enough alone. But
the pain to the little guy in the streets who did nothing wrong would
simply be too much. The Fed and other regulatory authorities leaving well
enough alone is part of the reason we are where we are. First, get the
water out of the boat and fix the leaks, and then make sure we never get
here again.
And yes, I know there are lots of implications for the dollar,
commodities, markets, interest rates, etc. But we will get into that in
later letters.
For now, let's go to the essays from my friends and then a quick note
about the stock market.
John Mauldin, Editor
Outside the Box
First, from Michael Lewitt, writing last week before the Fed bailout of
Bear:
The Risks of Systemic Collapse
by Michael Lewitt
The failure of a firm of the size and stature of Bear Stearns would be as
close to an Extinction Level Event as the world's financial markets have
ever seen. Bridgewater Associates, Inc. writes that, "...the
counterparty exposures across dealers have grown so exponentially that it
is difficult to imagine any one of them failing in isolation." While
not the world's largest financial institution, Bear is a major
counterparty to virtually every important financial player in the world.
Its insolvency would effectively freeze the assets of many hedge funds
and other liquidity providers and cause the financial system to seize up.
Even an after-the-fact government bailout would do little to prevent such
a meltdown scenario since the value of all of Bear's counterparty
obligations would be thrown into question for some period of time. The
resulting cascade of hedge fund failures and financial institution
write-offs in today's mark-to-market world would be nothing less than
catastrophic.
The only way to avoid such a scenario would be for the Federal Reserve or
the Treasury to step in before the fact and engineer a merger with a
larger institution. For that to happen, the firm's management has a
responsibility to the markets to work with the authorities sufficiently
in advance to arrange a private bailout.
The risks of a systemic collapse have risen to uncomfortable levels. The
complete withdrawal of credit from the financial system has led to a
series of implosions of hedge funds and other leveraged investment
vehicles. At some point - and nobody knows when that point is - the
system is not going to be able to withstand further failures. It will not
be the sheer volume of failures that brings the system to a standstill;
the system is enormous and can sustain huge dollar losses before becoming
impaired. The problem is that the global financial system is a case study
in chaos theory. This is truly a case where a butterfly flapping its
wings in West Africa could lead to a Category Five hurricane thousands of
miles away. There are an incalculable number of derivative contracts and
counterparty relationships on which the stability of the financial system
hinges. All it would take is the collapse of the wrong firm or the wrong
derivative contract at the wrong time to throw the wrong financial
institution into crisis and force the entire system into a death spiral.
As noted above in the discussion about Bear Stearns, we may not need the
largest institution in the world to fail to cause the calamity - it may
just be a matter of something bad happening at the wrong firm at the
wrong time to trigger a systemic collapse. This is the risk implicit in a
highly leveraged financial system financed by unstable financial
structures. These scenarios may sound like the ravings of a paranoid, but
we will remind our readers that even paranoids have enemies, and the
greatest failure that investors, lenders and regulators seem to suffer
from in perpetuity is a failure of imagination. They remain incapable of
imagining that the worst can happen, and as a result they behave in a
manner that keeps that possibility alive. At some point, all of the
king's horses and all of the king's men will not be able to put Humpty
Dumpty back together again. We are not at that point yet, but we are
closer than we've ever been.
The current market collapse was the result of an abject failure to
regulate the mortgage and derivatives markets. The extent of this failure
cannot be overstated. HCM still sees great opportunities being
created in assets being sold for reasons unrelated to their underlying
value. But caution must be the byword until the system shows greater
signs of stability.
And from Bob Eisenbies of Cumberland Advisors
(www.cumber.com). Bob Eisenbeis is
Cumberland's Chief Monetary Economist. Before retirement, he was the
Executive Vice President of the Federal Reserve Bank of Atlanta. He is a
member of the U.S. Shadow Financial Regulatory Committee and a veteran of
many FOMC meetings.
The Fed Will Do What It Takes!!
By Bob Eisenbeis, Cumberland Advisors
In a stunning announcement on Sunday the Federal Reserve Board of
Governors announced three steps to address the continuation of last
week's financial turmoil.
First, the Board approved a recommendation by the Federal Reserve Bank of
NY to cut the discount rate by 25 basis points to 3.25%. Presumably it
will approve similar recommendations by the other 11 Federal Reserve
Banks today.
Secondly, the Board voted to authorize the Federal Reserve Bank of NY to
create a temporary 6 month lending facility for the 20 prime broker
dealers. This enables them to pledge a wide range of investment grade
collateral for loans at the new 25 basis point penalty rate. This takes
effect today, March 17, 2008. The first transaction has been done in
Asian markets as this commentary is being released.
Finally, the Board also ordered and also approved a $30 billion special
financing to facilitate JP Morgan's purchase of Bear Stearns Companies,
Inc. Both Morgan and Bear boards have unanimously approved the
transactions. A shareholders vote is still needed. Meanwhile, Bear
Stearns is operating under the new provisions today.
These actions demonstrate the extreme lengths, if there was ever any
doubt, that the Board of Governors are willing to go to. There singular
purpose is to prevent the collapse of a prime broker dealer and the
potential fall out to counter parties that such a collapse might entail.
The actions are important for several reasons. The new facility trumps
the recently announced Term Securities Lending Facility (TSLF) that was
to go into effect later this month on March 27th. Yesterday's
action provides direct loans to both banks and non-bank primary dealers.
It is intended to facilitate their ability to liquefy what might
otherwise be relatively illiquid assets. But it also means that the Fed
is willing to take on credit risk to broker dealers. Whether there will
still be a stigma associated with this borrowing, which would not have
accompanied the borrowing of securities through the TSLF is not known.
The new actions also demonstrate that the perceived problems in financial
markets were sufficiently critical so as to not warrant waiting for the
TSLF to go into effect later in March. Why implementation of the TSLF
wasn't accelerated is an interesting question.
The actions also demonstrate that the so-called liquidity problems (which
this author has previously suggested may be actually solvency issues) are
mainly a problem for the prime brokers who were also the main players in
proliferating securitized debt securities based on sub-prime mortgages
and other assets. It is still a major question as to what the values of
these securities are and how much of an actual liability they represent
for the intuitions in question.
Whether those risks were real or imagined may never really be known but
we now know that too-big-to fail is still alive and well, even in the US,
and despite FDICIA. Federal Deposit Insurance Corporation Improvement Act
(FIDICIA) was enacted in 1991. FIDICIA requires that management report
annually on the quality of internal controls and that the outside
auditors attest to that control evaluation.
Finally, the Fed has also taken the extraordinary step of helping to
finance the takeover of a private sector firm by one of the nation's
largest banking organizations. The implications of this will be explored
in a future Commentaries when more of the details become public.
What may be lost in the excitement of the moment, as markets attempt to
digest these latest actions, is that were taken by the Board of
Governors through the Federal Reserve Bank of NY to address issues of
financial stability. These were NOT actions taken by the Federal
Open Market Committee (FOMC). Their main responsibility is the
conduct of monetary policy for the country.
In other words, the story will not end today, Monday, March 17, 2008. We
will get a separate and important assessment of the implications of these
attempts to insulate the real economy from the potential negative
feedback effects of these financial disruptions when the FOMC releases
its decisions on whether and by how much to cut the Federal Funds rate on
Tuesday. Stay tuned, there is more to come.
And one further brief note from Bob written late last week:
It is time to stop pretending.
Since last August the assertions regarding the turmoil in financial
markets have been characterized as a temporary liquidity problem. The
problems first surfaced last year with BNP Paribas and Bear Sterns' hedge
fund collapse. More than 7 months have passed and, once again, another
Bear Sterns shoe has dropped today as it has been forced to go to the NY
Fed discount window through a JP Morgan conduit. This follows on the
heels of the collapse of the Carlyle Group sponsored hedge fund in
London. For months institutions, politicians and regulators have been in
denial. Witness, for example, the proposals currently being floated by
the SEC that would enable institutions to offer alternative
"explanations" for how they value their assets. Pundits have
been suggesting that uncertainty and loss of confidence are the roots of
the problem, but this isn't the way to think about the problem.
It is time to step back and recognize that the current situation isn't a
liquidity issue and hasn't been for some time now. Rather there is
uncertainty about the underlying quality of assets which is a solvency
issue driven by a breakdown in highly leveraged positions. Many of the
special purpose entities and vehicles are comprised of pyramids of paper
assets supported by leverage whose values are now unknown.
If it were a simple liquidity problem the actions that the Federal
Reserve has taken would have dealt with the problems by now. If one
doubts this observation, think about what the Federal Reserve has done
over the past several months in an attempt to provide liquidity to those
who need it. The Federal Funds rates have been cut by 225 basis points.
Significant liquidity has been injected into markets by major central
banks around the world. The Federal Reserve created the Term Auction
Facility and recently announced the Term Security Lending Facility. These
actions have had only temporary impacts on both market sentiment and on
credit spreads.
This is also not an "animal spirits" problem but rather is the
classic example of George Akerloff's "market for lemons."
Essentially what Akerloff tells us is that, absent better information, it
is rational for potential buyers of assets to assume that the assets
offered for sale are "lemons," hence the flight to quality.
Finance theory clearly tells us that in such circumstances, firms facing
questions about their assets, which typically are manifested by temporary
problems of access to liquidity, will quickly find ways to reveal to the
market the true condition of its assets. Smart institutions have ample
mechanisms to deal with these problems - simply open up the books and
show them to potential investors. At this time there are also several
actions that the Fed should take to ease market questions about what has
been happening.
First, there is a danger in anointing one institution to be the white
knight to deal with the Bear Sterns problem. Second, there is a pressing
need to provide more information and details about what the arrangements
are with JP Morgan and Bear Sterns. That means being more forthcoming
with its communications on what it is doing and why. Third, it is clear
that there are many potential buyers for troubled firms, if it is easy to
see what they are worth. This means that the Fed and Treasury should take
the lead in forcing increased transparency on the part of all
institutions that might be experiencing financial difficulties and those
that are not. Finally, there needs to be the recognition that the
problems at this time are confined to financial firms and have not
contaminated the market for securities of firms in the real sector.
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And a brief follow up thought from your humble analyst. I know my
position today will be somewhat controversial (a small understatement) to
many readers, but I have never let fear of being controversial deter me
from giving you my thoughts and calls as I see them.
As I write about 2 pm central time, the Dow is flat on a wild up and down
ride. I do not see this as a bottom. The Fed move keeps the system
together, but it does not do anything to stave off a fall in consumer
spending, a fall in home prices, the increased difficulty to get
consumers loans, falling construction, etc. which is what normally
happens in a recession (unlike the last time when consumers could borrow
to maintain spending).
I believe earnings are going to continue to disappoint in a broad swath
of companies, which will ultimately translate into lower stock market
prices. Be careful out there. There are good trades and deals available,
just not in traditional stock market index funds, in my opinion, which I
should point out could be quite wrong.
Your breathing sigh of relief analyst,
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