This week's Outside the Box is going to be a little different. I am going to write about the extraordinary action by the NY Fed to foster the Bear Stearns deal with JP Morgan, and give you three brief notes from Michael Lewitt of Harch Capital Management and Bob Eisenbeis (former executive vice-president of the Federal Reserve of Atlanta) of Cumberland Advisors.
John Mauldin, Editor
Outside the Box
Let's Get Real About Bear
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.
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.
First, from Michael Lewitt, writing last week before the Fed bailout of Bear:
The Risks of Systemic Collapse
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!!
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.
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,