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Hussman has interesting opinion on the BSC matter:
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March 24, 2008
Why is Bear Stearns Trading at $6 Instead of $2?
John P. Hussman, Ph.D.
All rights reserved and actively enforced.
Reprint Policy
Well, the ECRI (one of the more reliable private economic analysis
groups) has finally thrown in the towel ? "With the Weekly Leading
Index having dropped more than 13 points in the last nine months, it
is exhibiting a pronounced, pervasive, and persistent decline that is
unambiguously recessionary."
The possibility of a "bear market rally" aside, if the S&P 500 has
already set its low, it will have been the first time that the market
has responded to a similar economic downturn with less than a 20%
loss on a closing basis. If we define the recent downturn as a bear
market anyway, the recent low will represent the highest level of
valuation that has ever prevailed at the bottom of a bear market. I
expect neither of these to be true for long, but as usual, we'll
respond to the evidence as it unfolds ? without the need to forecast
any particular scenario.
Though our investment horizon of interest is a complete market cycle,
we don't generally think in terms of bull and bear markets, because
they can only be determined in hindsight. We prefer observable
measures that allow us to identify the prevailing state or "Market
Climate" at every point in time. We don't expect various Market
Climates to overlap tightly with actual bull or bear markets.
Instead, we expect that, on average, the return/risk profile
in "favorable" Market Climates will significantly exceed the
return/risk profile in "unfavorable" Market Climates. Accordingly, if
we accept a greater amount of risk during favorable conditions, and
less during unfavorable conditions, we expect to perform strongly ?
at controlled risk ? over the complete market cycle.
For now, we remain defensive, but we recognize the potential for
a "bear market rally" despite conditions that, as yet, do not provide
enough evidence to warrant removing a significant portion of our
hedges.
Why is Bear Stearns trading at $6 instead of $2?
As I emphasized last week, the large "term financing" and "term
securities lending" programs initiated by the Fed do not expose the
Fed to default risk in mortgage collateral it accepts from the banks
that act as primary dealers. Even if the underlying securities
default, those facilities involve repurchase agreements, so the bank
putting up the collateral has to repurchase the collateral at the
original price plus interest after a term of 28 or 90 days. The Fed
only stands to lose if the bank itself fails, and so spectacularly
that the bank's liquidation value goes negative even after zeroing
out bondholder claims and stockholder equity. Even in the present
environment, this is unlikely.
Alarmingly, immediately after the pixels dried on last week's comment
(noting "the Fed is emphatically not taking the default risk of the
mortgage market onto itself" with these term facilities), details
emerged that the Fed had agreed to a very different deal in its
attempt to rescue Bear Stearns. This is a major and ominous departure
from historical Fed policy, and from legality.
I'll cut straight to the chase.
Bear Stearns is trading at $6 instead of $2 because unelected
bureaucrats went beyond their legal mandates, delivered a windfall to
a single private company at public expense, entered agreements that
violate the the public trust, and created a situation where even if
the bureaucratic malfeasance stands, the shareholders of Bear Stearns
will either reject the deal or be deprived of their right to
determine the fate of the company they own. Very simply, Bear Stearns
is still in play. Still, when all is said and done, my own impression
is that the ultimate value of the stock will not be $2, but exactly
zero.
In effect, the Federal Reserve decided last week to overstep its
legal boundaries ? going beyond providing liquidity to the banking
system and attempting to ensure the solvency of a non-bank entity.
Specifically, the Fed agreed to provide a $30 billion "non-recourse
loan" to J.P. Morgan, secured only by the worst tranche of Bear
Stearns' mortgage debt. But the bank ? J.P. Morgan ? was in no
financial trouble. Instead, it was effectively offered a subsidy by
the Fed at public expense. Rick Santelli of CNBC is exactly right. If
this is how the U.S. government is going to operate in a democratic,
free-market society, "we might as well put a hammer and sickle on the
flag."
What is a "non-recourse loan"? Put simply, if the homeowners
underlying that weak tranche of debt go into foreclosure, they will
lose their homes, and the public will lose as well. But J.P. Morgan
will not lose, nor will Bear Stearns' bondholders. This will be an
outrageous outcome if it is allowed to stand.
In my view, the deal would be palatable if J.P. Morgan was to remain
fully responsible for any losses on the "collateral" provided to the
Federal Reserve, assuming shareholders were to consent to the buyout.
As it stands, Congress should quickly step in to bust the existing
deal and demand an alternate resolution, by clearly insisting that
the Fed's action was not legal.
The Fed did not act to save a bank, but to enrich one. Congress has
the power to appropriate resources for such a deal by the
representative will of the people ? the Fed does not, even under
Depression era banking laws. The "loan" falls outside of Section 13-3
of the Federal Reserve Act, because it is not in fact a loan to
either Bear Stearns or J.P. Morgan. Bear Stearns is no longer a
business entity under this agreement. And if the fiction that this is
a "loan" to J.P. Morgan was true, then the only point at which
the "collateral" would become an issue would be in the event that
J.P. Morgan itself was to fail. No, this is not a loan. It is a put
option granted by the Fed to J.P. Morgan on a basket of toxic
securities. And it is not legal.
The deal was made under duress, to the benefit of a private company,
on the basis of financial assurances that the bureaucrats involved
had no business making. The Federal Reserve is going to put up public
assets and accept default risk so that Bear Stearns' own bondholders
are effectively immunized?! That's not sound monetary policy ? it's a
picnic for insiders, bought and paid for through the abuse of public
funds by government officials too unprincipled even to recognize the
abuse. The only good thing about this deal is that it buys time while
principled ways of busting and restructuring it can be settled.
This is not an issue of letting Bear Stearns "fail" on the claims of
its customers and counterparties. Nobody wants that. The issue is the
method by which it was rescued ? who was protected, and who was not;
why a consortium was not used instead of a single firm; why the
claims of Bear's bondholders should be secure while the public bears
the risk of the toxic waste foisted upon us. This deal should, and I
believe will, be restructured. J.P. Morgan will cry foul, but that
will be like a child who found the Easter basket and is now forced to
share the chocolate. Bear Stearns is worth more than zero in
acquisition, provided that the bondholders take an appropriate loss.
As of November's 10K report, Bear Stearns had $9 billion in unsecured
short-term debt, and $66 billion in long-term debt. The $12 billion
in shareholder equity, of course, is gone. Any portion of the debt
that is unsecured should be the first to fall. If Bear Stearns is
worth $2 a share to somebody (provided $30 billion of "non-recourse
loans" from the Fed), and yet Bear's bondholders and even the
unsecured lenders can still expect to be paid off on over $75 billion
of debt (J.P. Morgan assumes that obligation as part of the buyout),
then the public guarantees aren't required in the first place. What
is required is that Bear's bondholders take a loss, as they should,
rather than the public doing so.
In the unlikely event the value of Bear Stearns is negative after
entirely zeroing out both shareholder equity and bondholder claims ?
then and only then is there a problem for Bear's customers and
counterparties. But in fact, J.P. Morgan is already willing to take
on all of Bear's assets and liabilities, including over $75 billion
in debt to Bear's bondholders, for $2 a share. This is an indication
that bondholder's claims would not even be wiped out in a full
liquidation. Surely, whatever loss is required to transfer the
ownership of the company should be taken by the bondholders, not by
the public.
Again, this is not water under the bridge, and the deal struck last
week should not be allowed to stand if we care at all about the
integrity of the capital markets. The Long-Term Capital crisis was
resolved by a consortium of financial institutions providing capital
in return for ownership. The panic of 1907 was resolved the same way.
This deal should be busted, and fast. If there's not a single buyer
that will take on both the assets and liabilities without the
government assuming private default risk, Bear's assets should be put
out for bid, Bear's bonds should go into default, and by the
unfortunate reality of how equities work, Bear's shareholders
shouldn't get $2 ? they should get nothing.
Bear's stock is selling at more than $2 for two reasons ? one is that
the market evidently believes there is some chance for the deal to be
busted, either by Congress or by shareholder rejection. And second,
because Bear's bondholders are frantic to own the stock so they can
vote for this lousy deal to go through. After all, buying up a few
hundred million in stock to secure $75 billion of debt doesn't seem
like a bad trade. Whatever happens, this is not over, for the simple
reason that it is wrong.
The U.S. economy will get through this without the requirement of
massive public bailouts. What is required, however, is that the stock
and bondholders of financial companies take due losses. Customers and
counterparties need not, and I expect will not, be harmed. The value
of the shareholder equity and debt issued by most financial
institutions is ample buffer. In general, writedowns against
shareholder equity alone will be enough, provided that regulations
are revised to allow institutions to continue servicing existing
financial commitments on the basis of more flexible capital
requirements.
If the market was "certain to crash" in the event that Bear Stearns
failed, then the market is certain to crash anyway, because Bear
Stearns wasn't the last shoe to drop ? it was one of the first.
Unfortunately, we're standing in a shoe store. Wasn't the
market "certain to crash" without the Fed's surprise rate cut in
January too? At what point will investors figure out that the
liquidity problems are nothing but the precursors of insolvency
problems? At what point will investors stop begging the government to
save private companies and recognize that the losses should be taken
by the stock and bondholders of the offending financial institutions?
If the Fed and the Treasury are smart, they will act quickly to
figure out how to respond to multiple events like we've seen in
recent days, to expedite turnover in ownership and quickly settle the
residual claims of bondholders, without the kind of malfeasance
reflected in the Bear Stearns rescue.
As for the future of the free markets, Dylan Thomas comes to mind:
Do not go gentle into that good night
Rage! Rage against the dying of the light
The Fed overstepped and the Treasury overstepped. At the point where
unelected bureaucrats pick and choose who to subsidize ? who prospers
and who perishes ? in a free capital market, and use public funds to
do it, more is at risk than just $30 billion. Instead, we cross a
line, and stumble off a very clear edge down an interminably slippery
slope. We speak up now, or forever hold our peace.
On the subject of speaking up, the essays in the special section of
the Washington Monthly ? No Torture, No Exceptions ? are worth
reading. They come from both sides of the political aisle. I am
troubled that as a nation, both in economics and in foreign policy,
we have become far too willing to sacrifice principles for what some,
I think falsely, perceive to be an increase in security. But once we
begin to violate our principles, we should realize that nothing else
is secure.
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The original is here:
http://www.hussmanfunds.com/wmc/wmc080324.htm
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