The Bear Necessities
More on Bear Stearns, from Information Arbitrage, courtesy of Roger Ehrenberg.
The Bear Necessities
The Story Line
Just to be clear: Bear Stearns isn’t Baloo the bear, Ben Bernanke isn’t Mowgli the Jungle Boy, panicked clients aren’t Kaa the serpent and we’re not talking about Kipling’s Jungle Book. That said, the law of the jungle rules in this story. We are witnessing history, to be sure. Old, been there, done that history. History that has been replayed again and again. This is no different than any other bank run, when a crisis of confidence rapidly sucks liquidity out of the firm and book value, as such, becomes meaningless. When the most basic animal instincts kick in. Wikipedia has an interesting definition of a bank run:
A bank run (also known as a run on the bank) is a type of financial crisis. It is a panic which occurs when a large number of customers of a bank withdraw their deposits because they fear it is, or might become, insolvent. This action can destabilize the bank to the point where it becomes insolvent. Banks retain only a fraction of their deposits as cash (see fractional-reserve banking): the remainder is invested in securities and loans. No bank has enough reserves on hand to cope with more than the fraction of deposits being taken out at once.
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As a bank run progresses, it generates its own momentum. As more people withdraw their deposits, the likelihood of default increases, so other individuals have more incentive to withdraw their own deposits. A bank run is a kind of positive feedback loop which has much in common with the reflexive processes described by George Soros, amongst others. Another example of a reflexive process is economic bubble.
The Bubble in Reverse
I like how the concept of an economic bubble is used, the converse of the bank run. Up momentum as opposed to down momentum. In the case of Bear Stearns, the credit bubble supported a series of unwise decisions, developing excessive reliance on a business line (mortgage securitization and associated derivative products) and structuring portfolios (such as the now defunct mortgage hedge funds) that were designed to succeed only in a “perfect storm.” It should be noted that this storm existed long enough for a passel of ill-conceived deals to get booked across the credit spectrum, from retail home loans to “toggle” PIK leveraged buyout loans. Back in April of last year I wrote a post titled Volatility Management in a Complacent World. This was the world in which Bear Stearns’ stock price was rising and enjoying the boom times of a flush credit market and a bullish economic outlook. What a difference a year makes. The bubble burst, a crisis ensued, and our first bank run (in the U.S., that is - remember the UK’s Northern Rock?) is now in our midst.
The Fragile Nature of Book Value
Book value is something that is accumulated and realized over time, and does not equal liquidation value. If investors didn’t know this before they certainly know it now. Less than liquid positions are valuable only to the extent you can finance them, and if you operate a capital structure that lacks such permanence, you are skating on thin ice (see the earlier post It’s the Liquidity, Stupid). To an extent the entire banking system operates on the edge of a precipice, running massive leverage and grossly mismatching asset cash flows with liability cash flows. In most non-financial businesses, the concept of asset and liability matching (by calculating and attempting to balance the modified duration of each) is a well-worn financial management objective. And while this is certainly discussed (and should be deeply ingrained in the DNA) within banks, their financial position seldom reflects this reality.
The Moving Target Called Liquidity
And the problem is further exacerbated by the ever-changing definition of what is “liquid” and what is not. Super-senior CMO strips? Liquid today, illiquid tomorrow. At their essence banks, especially investment banks that don’t have the luxury of core retail deposits, are like hedge funds. Much of their capital structure is short-term in nature, and leveraged to the hilt (especially when off-balance sheet obligations like derivatives are taken into account) and in a crisis can be dramatically upset as lines are suspended, additional collateral demanded and assets sold to meet short-term obligations. All of these actions, of course, only exacerbate the problem, further hastening the decline. And as I’ve mentioned previously, once a hedge fund drops 50% it is toast. It could be a $20 billion fund whose NAV drops to $10 billion. It doesn’t matter. Such a dramatic loss of value rattles investors to their core and causes a synchronous rush for the exits.
The Parallels With LTCM
This is kind of like LTCM redux. In many ways, startlingly like LTCM. A large, complex financial institution. Cumulative exposures (again, taking derivatives into account) exceeding $100 billion. A tangled web of counterparty relationships across most major financial institutions and relationships with investors large and small. A book of uncertain value, but a book whose value is likely to be far greater than it is today if only there were sufficient liquidity to carry it beyond the current crisis. Too big to fail. Too complex to fail. Sound familiar? It should. Oh, and lest anyone think this is a true “bailout,” my guess is that equity holders in BSC will only do a bit better than the GPs in LTCM. The lion’s share of the value will accrue to they who are willing to bridge the liquidity gap and carry the business until things stabilize. This is something to be gained by the risk-taker. The current equity holders are, in my opinion, largely screwed.
The Chance to Go Shopping
So what of the current market and the state of U.S. financial institutions? Clearly, they both suck. However, we’ve got JP Morgan Chase, B of A, Berkshire Hathaway, and maybe a few others who have the financial strength and business models to benefit from the rapid decline of Bear Stearns and the other inevitable meltdowns (Washington Mutual, anybody?). I think it is going to be shopping time for these firms, where they will selectively pick off people, business lines and entire firms at fire-sale prices. This is when good risk management and business judgment come in handy; parlay the crisis into an even stronger position at your less-prudent competitors’ expense. Berkshire starting up a municipal bond insurer? It is just the tip of the iceberg.
The Victims: Too Many to Count
The decline of a proud firm like Bear Stearns is really hard to stomach for a long-time Wall Street denizen. I know dozens of people who work there, who are great at what they do and who had absolutely no hand in the strategies and steps that precipitated the current crisis. And they are all major stockholders of the firm. They are screwed. And it’s just not fair. Think about retail investors who hold the stock. Firms that came to rely on Bear’s advice and support. Sure, Bear will exist in some form, likely inside another financial institution, but it will never be the same. Maybe I’m just corny or getting long in the tooth, but this stuff really gets to me. This is no Barings; this is much, much closer to home.
The Punch Line
Bear Stearns, as we know it, is gone and never to return. Why did Ace have to give up the reins? Ace was all about managing risk. It is hard to imagine this happening with him at the helm. But bottom line: we are seeing another LTCM-style bail-out, only with the Fed’s more active involvement. I believe moral hazard will be skirted because equity will largely be wiped out. This is a crisis of liquidity as well as a crisis of uncertainty. Just how much are those illiquid assets worth? Incalculable at this time. It only makes sense if a buyer can purchase them at a steep discount, much as how Citadel bought E*TRADE’s mortgage portfolio. But buyers will emerge, just as they did when LTCM needed a sugar daddy. Buffett tried to get it then, but the difference here is that it is not merely a portfolio - it’s also thousands of people. And that is a headache he likely won’t sign up for. He had enough fun with Salomon Brothers. B of A? No way. JP Morgan Chase? A very strong possibility due to the business synergies and knowledge of their book. A headache for sure, but at the right price they’ll simply take a few aspirin and call me in the morning. They’ll print the trade.
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Addendum
This from an article in today’s Wall Street Journal titled Debt Reckoning: U.S. Receives a Margin Call
Mohamed El-Erian, co-chief executive officer of Allianz SE’s Pacific Investment Management Co., says the hedge-fund community is unwinding its leverage. “This will push more of them into ’survival mode,’ further accentuating distressed sales and nervousness among the prime brokers,” he wrote to his colleagues Thursday morning. “In such a world, the quality of the assets matters less than whether you can finance them [or] how liquid they are.”
Exactly.
ilene9