March 24, 2008
Why is Bear Stearns Trading at $6 Instead of $2?
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, J.P. Morgan would be obligated to pay it back, period. The only point at which the value of 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. Even if J.P. Morgan raises the bid for Bear Stearns, the assurances by the Fed and Treasury are not legal. That will change only when the "non-recourse" provision is withdrawn. 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
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.
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. Much has been made of the low percentage of investment advisors who are bullish - a low 31.1% according to Investors Intelligence - with some suggesting that stocks may be near a bottom on the basis of "contrary opinion." The problem , as I noted years ago (e.g. Law of Large Numbers), is that "before looking at advisory sentiment, we have to factor out the portion that is explained simply by past market movements. Once we've done this, we are left with a much more informative indicator."
All of the forecasting usefulness of those figures is contained in the "excess" bullishness or bearishness - the extent to which sentiment figures are higher or lower than what you would expect, given recent market movements. Presently, the level of advisory bullishness is not much below where we would expect it to be, given the market decline that we've observed. That's often the case early in bull or bear markets. High bullishness in early bull markets is typically not a negative, because the initial advance is generally very powerful. Likewise, high bearishness is typically not a positive early in bear markets, because the initial decline is often fairly deep.
In short, aside from some potential for a "clearing rally" to correct the short-term oversold condition of the market, even the low advisory bullishness figures provide little evidence for a "contrary opinion" call on the market. For our part, we don't have enough evidence here to remove hedges, but we are open to the possibility that improved market action could provide at least some basis for a modest speculative exposure to market risk (most likely by covering a portion of our short call options, while leaving our defensive puts in place). Again however, we do not have enough evidence at present to warrant even a limited amount of speculative exposure. We won't observe "investment merit" until we observe significantly lower valuations, but market action by itself could encourage a somewhat more constructive stance. For now, the weight of the evidence continues to demand a strong defense.
In bonds, the Market Climate remained characterized last week by unfavorable yield levels and modestly favorable yield trends. Credit spreads are blowing wider again, so that does put some downward pressure on Treasury yields as "safe havens." Still, there is emphatically no investment merit in long-term bonds, in the sense that by definition, a long-term investment in 10-year Treasury securities will lock in a total return of less than 3.4% over the coming decade. In the Strategic Total Return Fund, we continue to carry an unusually defensive position, largely in Treasury bills, and with the Market Climate for precious metals still favorable on our measures, we bumped up slightly to a roughly 17% exposure in precious metals shares on last week's swoon in that market.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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