Let’s Get Real About Bear

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Reams of articles and comments have appeared over the past few days on the Bear Stearns debacle. A particularly interesting viewpoint has just been penned by my business partner John Mauldin in his Outside The Box newsletter. I realise that a large number of my readers also subscribe to John’s newsletters, but I nevertheless thought it appropriate to republish his article for the sake of those not receiving his newsletters directly.

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“I already have a slew of e-mails 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.

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Source: StockCharts

“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 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. It should be pointed out that 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.

“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.”

Source: John Mauldin’s Outside The Box, March 17, 2008.

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4 comments to Let’s Get Real About Bear

  • We are basically on the same wave length so I applaud your comments. Because my politics are rather far left, we would most likely find little else to agree on. I see Greenspan and this administration as the primary architects of this mess. I note that Fleckenstein is all over the ex chairman – I say “pour it on!” When I watched Paulson being interviewed by Stepanopolus on Sunday, I actually felt the pain and stress this guy is feeling, but I feel little compassion because he too is part of the problem. Keep up the good work!

  • Don Rose

    John Mauldin makes some compelling points to counter the anger in the popular press about the Fed bailing out the big guys. Analogies can be memorable and useful, so I wrote to my family:
    ‘Mauldin implicitly compares the US economy to a boat that is taking on water and threatening to sink. He argues persuasively that we can’t let it sink, because we are all in it together. Extending his analogy, the boat has become flooded [inflated housing values], has been burdened with a top-heavy superstructure [an alphabet soup of financial derivatives], has some rotting pieces [excessive credit] and is springing new leaks [hedge fund collapses, Bear Stearns]. A proper role for the Fed is to apply enough baling wire and duct tape to keep the boat afloat so that it can be brought to a safe harbor for an overhaul. We need to “bail the water out of the boat” [gradually lower the prices of inflated assets] and remove excess superstructure [unwind and control derivatives] on its journey. It will arrive a bit lighter and leaner, but it will be serviceable and repairable.’

  • Dan Modricker

    Is anyone giving any thought to how using corn to make ethanol is adding to our inflationary problems? Ethanol is not only a “hidden tax”, it is also inflationary.

    One pays the same .. or more .. for a gallon of gas diluted with ethanol .. as for a gallon of just gas. But the gallon with ethanol in it get at least 10% less mileage per gallon.

    By allowing this situation to continue .. and by fostering development of the ethanol industry .. our government is adding to inflationary woes. The cost of using the kernel of corn for ethanol makes everything from corn fructose to chicken feed and cow feed more expensive. We don’t need such misguided nonsense.

    Perhaps Mauldin can clue-in his friends in high places to the demerits of ethanol. By the way, ethanol also adversely affects (etches) certain parts in an internal combustion motor. Those who use ethanol may wish they never did.

    So, lets stop masking the true retail cost of gasoline by lacing it with 10% ethanol.

  • Oh boy

    There goes the Basle Accord.

    Where are Tier 1 Capital ratios now?

    Marked-to-market!….Ha Ha Ha……

    Where is the counterparty now?

    The mother of all ‘flations is in the pipeline people, having been apparently contained in ever inflating house prices but now looking to manifest itself in all manner of real asset classes…

    If you are correct in your reasoning, John, then it only demonstrates the impotence of the Fed to hold back the tidal wave.

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