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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