I Am the Bearer of Bad Tidings Posted by: Dale Franks
on Saturday, March 15, 2008
The market took a hit today. It was a body blow. And, whether you know it or not—although, if you're reading this, you'll know now—the economy took a body blow, too. The only thing we don't know is how much damage was caused. But there was damage, and it will become apparent before too much longer.
It's all about liquidity, you see. For the last several days, there's been concern about whether Bear Stearns, one of the Big Five investment banks, wasn't going to be able to meet its financial obligations to client and creditors because of it's exposure to bad mortgage loans. Company executives have been saying, "Yes, we will," right up to this morning, when they said, "No, we can't."
On the verge of a collapse that could have shaken the very foundations of the U.S. financial system, investment bank Bear Stearns Cos. was bailed out Friday by a rival and the federal government. The near-miss raised new alarm about the credit crisis — and whether other big firms might be in jeopardy.
The rescue came from JPMorgan Chase & Co. and, in an extraordinary step, the Federal Reserve, both rushing to pump new money into the venerable Wall Street firm after its financial state deteriorated so much in a 24-hour period that it threatened to fail...
Two hedge funds managed by Bear Stearns failed last summer, setting off a credit crisis that has swept up banks and brokerages around the globe.
For Bear, the crisis started when market speculation grew that it might have to seize collateral — mostly mortgage-backed securities worth next to nothing — from the private equity firm Carlyle Group.
Carlyle runs a bond fund and has come under intense pressure during the past week from creditors demanding collateral to back their investments.
As speculation swelled in the market, investors, customers and lenders raced to withdraw their money or rescind their credit lines. By Thursday night, Bear Stearns Chief Executive Alan Schwartz said, the bank realized the withdrawals might outpace the bank's resources — so it reached out to JPMorgan for help.
JPMorgan, the nation's third-largest bank, has been hurt far less by the mortgage mess than other financial institutions. It will provide secured loans to Bear for four weeks — insured, in essence, by the Fed.
Essentially, JPMorgan Chase will step in to provide financing for 28 days, and those loans, while coming from JPMorgan's coffers, will be underwritten by the federal Reserve.
If you're a Bear Stearns stockholder, by the way, you're screwed. What will probably happen is that, to prevent the firm from going under completely, JPMorgan will acquire Bear Stearns for pennies on the dollar. At the least, the chances of Bear Stearns continuing to exist as an independent entity are probably over for good. Bear Stearns' CEO admits as much, saying the firm is seeking a "more permanent solution".
The CEO also confirmed — as many on Wall Street had suspected — that Bear Stearns could be up for sale. He told analysts on a conference call that the bailout is a "bridge to a more permanent solution."
Bear is working with investment bank Lazard Ltd. to explore its options. That may include an outright sale of Bear Stearns to JPMorgan, something top executives from both banks were discussing, according to a person familiar with the talks who was not authorized to speak on the record.
As exposure to bad loans causes foreclosures to increase, huge sums of money are just being written off—basically disappearing from the economy.And if Bear Stearns can't make it, you have to wonder what the actual position of Merrill Lynch, which is also exposed to the Carlyle fund problems, or Thornburg Mortgage, which failed to meet some margin calls earlier this week. Countrywide Home Loans is already involved in a bailout from Bank of America, and has had foreclosure rates double.
At the heart of the problem is an ongoing liquidity crunch. As exposure to bad loans causes foreclosures to increase, huge sums of money are just being written off—basically disappearing from the economy.
The primary effects of this disappearance—the failure of the banking institutions, is bad enough.
Wall Street firms like Bear Stearns conduct business with many individuals, corporations, financial companies, pension funds and hedge funds. They also do billions of dollars of business with each other every day, borrowing and lending securities at a dizzying pace and fueling the wheels of capitalism.
The sudden collapse of a major player could not only shake client confidence in the entire system, but also make it difficult for sound institutions to conduct business as usual. Hedge funds that rely on Bear to finance their trading and hold their securities would be stranded; investors who wrote financial contracts with Bear would be at risk; markets that depended on Bear to buy and sell securities would screech to a halt, if they were not already halted.
Beyond those effects, however, there are effects on the economy as a whole, because these large write-offs not only remove money from the economy in terms of the amount of the disappearing loan assets at the institutions themselves, individuals who do business with these institutions lose the ability to borrow money. Their credit lines disappear. the institution's borrowers lose their money as well.
This money supply shrinkage usually causes people to hoard cash, because they worry that they won't have enough cash to meet their future needs. They stop investing, for example, because they lose faith in the institutions. The dearth of available loan money causes people in the building trades to lose jobs, because new housing starts decline, so they have to begin saving up their own cash, and cutting purchases. And the effect ripples outward through the economy.
We generally call this widespread hoarding of cash a "recession".
That's certainly what the National Bureau of Economic Research calls it. Iscalling it, in fact. And they say it may be the worst recession since World War II.
Harvard University economist Martin Feldstein, a member of the group that dates business cycles in the U.S., said the nation has entered a recession that could be the worst since World War II.
``I believe the U.S. economy is now in recession,'' Feldstein, president of the National Bureau of Economic Research, told the Futures Industry Association conference in Boca Raton, Florida. ``Could this become the worst recession we have seen in the postwar period? I think the answer is yes. I would emphasize the word `could.' ''
Feldstein's remarks represent the first time that a member of the NBER's business-cycle dating committee has publicly described the current downturn as a recession. The economy may not respond quickly to Federal Reserve interest-rate cuts, and a package of tax rebates and investment incentives will offer only a temporary boost, he said...
The economy expanded 0.6 percent at an annualized pace last quarter, and economists surveyed by Bloomberg News this month predicted the pace will slow to 0.1 percent in January to March.
The U.S. unexpectedly lost jobs in February for the second consecutive month, a government report showed on March 7. A private report today showed consumer sentiment this month sank to a 16-year low.
The worst recession in my lifetime was the back-to-back recessions in 1982, when unemployment rose to almost 12%. If we're in for a worse ride than that—well, I don't even want to think about that.
But, apparently, we have to.
And, frankly, I don't expect monetary policy to have much of an effect on stopping the slide in the economy. With short-term rates already at 3%, and the expectation among market watchers that the Fed will drop the Fed Funds rate target a full point to 2% on Mar 18's meeting, and probably set a discount rate, cureently at 3.5% to about 2.5%. At those levels, there's not too much room left for monetary policy to have an effect. After all, you can't have rates lower than 0%, and we're not too far off that now.
I don't expect monetary policy to have much of an effect on stopping the slide in the economy.The problem is that this is not really a business cycle downturn. This is really a downturn spurred by the lack of liquidity arising from bad loans whose write-off are sucking money out of the economy at an accelerated pace.
And the problem isn't just mortgages. So often, we hear that the size of the bad mortgages isn't really bad enough to cause all these problems. The thing is, the American monetary structure is a big, inverted pyramid, with the health of the larger sectors hugely dependent on thre smaller sectors below them. As the Wall Street Journal points out, in an article entitled, "Recession is Inevitable", the problems of liquidity in banks have percolated up through the larger layers of the pyramid, expanding the credit crisis exponentially.
The Fed understands the structure of the liquidity pyramid (from central bank money at the bottom, through bank lending, to the even bigger securitized debt markets, up to the huge derivatives sectors at the top). So far its liquidity injections have got no further than the banks. Now it hopes to reach higher. Unfortunately, it won't work.
The Fed is like King Canute with a difference — it is trying to halt an ebbing tide rather than a rising one. Its liquidity injection seems huge at $200 billion (with perhaps more to follow), but it is still only equivalent to one-third of the expected losses in the NDFI sector.
Moreover, the Fed's readiness to accept almost any asset at just below face value as collateral will prevent price discovery. That means the U.S. financial system will remain burdened with uncleansed balance sheets that penalize future lending and economic growth.
Creating a lot of liquidity does not resolve an issue of solvency, which is now the driver of credit contraction. All the Fed will achieve is a dollar that will be further debased and inflation that will be higher. It cannot stop the process of deleveraging and asset price decline...
Prime brokers and banks are reining in credit to leveraged investors. This is a direct consequence of the damage done to banks' credit capacity by the writedowns of loans in other areas, such as structured finance and mortgages. This reduces their risk-free capital (value-at-risk ratios have doubled in the last year in the U.S.). In order to maintain adequate reserves as a proportion of risk assets, lending must be cut...
Credit contraction translates through the financial system into a reduction in available credit for the non-financial corporate sector, and thus into reduced investment and growth in the real economy. The size of that contraction can be estimated from the leverage ratios of the financial sector and their impact on real GDP growth.
We estimate that nonfinancial corporate debt ultimately will have to shrink by 11%-12%. This will generate a decline of five percentage points of real U.S. GDP growth and push the U.S. into recession. Europe's real GDP growth will contract by two percentage points.
Globally, total credit losses of $1.4 trillion will cause a contraction in world GDP of 2.5 percentage points, or half the current rate of global growth. So the global economy will become a gray, dull world of semi-recession and sticky inflation that will last a long time.
What has happened is that the liquidity crunch from mortgage credit problems—too many subprime loans, too many second mortgages, plus declines in housing values—have been amplified from bank lending up through securitized debt, then again amplified in the derivatives markets.
This decline in available credit—i.e. money—is not going to be fixed by a 3% drop in short-term interest rates. And it certainly isn't going to be fixed—or even noticeably ameliorated—by a one-time rebate of $600 per taxpayer.
I'm afraid we're in for an awfully bumpy ride. The problem with Bear Stearns today is not the problem. It is the most visible symptom, though, of the real problem with the economy and one that we'll be facing soon.
I too lived through that recession when the Fed deliberately jacked up interest rates to wring inflation out of the economy. It was bitter medicine indeed but perhaps the most courageous thing Reagan ever did. He stuck with Volker when most of the politicians were calling for his head and his own approval ratings were in Bush territory.
By ridding the economy of inflation, it set the stage for the resulting boom - a boom that is finally coming to an end.
Let’s hope the next president has the courage to stick with whatever policy will get us out of this mess.
I think there’s a misunderstanding of who & what is exactly in trouble.
Bear Sterns, itself as a company, and its elite clientèle are the ones in trouble. Their mainstream customers are not.
Basically BS and its elite clients engage in highly speculative endeavors and some of that is tide to things like the mortgage mess. They took a hit on that crap as how all speculation eventually ends with someone holding the bag.
If BS goes down, its not a good thing. But we’re talking about the company itself and not the markets it participates in. BS works in various financial marketplaces, they aren’t those marketplaces. Yes those markets will react negatively, but it will be a recoverable hit.
It seems that they’ve successfully conned people into thinking that they deserve to get high government bailouts to spare them their fate of their speculative ventures, though.
There’s a lot that isn’t understood about this economy. There’s a "steady state" enormity to it, which allows it great flexibility, such that its capacity to restructure itself without a full-blown (’82 type) recession might be something that the bears are underestimating by focusing on technical indexes and the like.
Then there are the cyclical forces of oil prices, which historically, on the very predicate of high prices, start diving. Everyone always expects oil prices to stay at their highs, but they never have, and the lows of the ’90s after the highs of the ’80s are a good example.
My greatest fear about this economy is that it’s weakening in an election year. You saw that idiot Schumer out yesterday talking about Herbert Hoover, blah blah, and by implication saying that FDR-style intervention was the real solution to economic woes. That type of pressure and meddling can only get worse as the election gets closer. Someone should remind Schumer that FDR’s record with the economy was horrible.
One quick point of correction. NBER has not yet determined that we are in a recession as you stated. Martin Feldstein, the former head of NBER recently gave an interview in Bloomberg in which he said we are in recession and that it could be bad. He heavily qualified his comments with coulds—’...this could be worse than recent ones [recessions]...it could get very bad...’
That’s not positive news, but it is far conclusive. We all know that U.S. home prices got far too high in certain regions. And, hedge funds, SIVs and all the many alphabet soup vehicles that levered mortgages into towering edifices have rightfully fallen on hard times. Having them collapse is not all bad.
As he implied and others have stated, this is really a financial panic, not a classic recession. It has more in common with panics in the 1800s and early 1900s, than it does with recent recessions such as 2001, which was caused by the end of the tech boom, high interest rates and 9-11.
It is also important to note that we have 4.8% unemployment now. Will unemployment go up as this progresses? Probably it will. But is it really likely to hit double digits as it did in 1982-83? Inflation is on the rise and heading to 4%. Again, that’s not great, but consider that inflation averaged over 7% in the 1970s and hit double digits twice during that decade. Mr. Feldstein is right to invoke the seriousness of this financial panic, but we are still far from the conditions we saw back in those difficult decades.
One quick point of correction. NBER has not yet determined that we are in a recession as you stated.
To be sure, we won’t know for sure until after two quarters of negative growth are recorded. I think Silussa’s right in what is likely to happen. I also think we’re going to experience a very painful adjustment because we’ve been living on bubble economies — the stock market and property bubble, augmented by the artifically low price of oil in the 90s, and the increase in total debt.
Susan Strange wrote an article in 1999 (before her death) called "The Westfailure System," where she argued that the state system we’ve had can’t handle the demands of globalization. One failure she saw coming was that credit market regulations were inadequate to handle the changes brought by globalization. The result would be a credit crisis of the sort we now are experiencing. I think we’re seeing a fundamental disconnect between the old economic order and the new conditions brought about by globalization.
Feldstein no longer speaks for the NBER, so the NBER has not declared us to be in a recession yet, but....
To be sure, we won’t know for sure until after two quarters of negative growth are recorded
This is a common misperception. Recessions are not determined by GDP growth. "Recession = two quarters of negative growth" is a myth.
We rely on the NBER to judge the start and end dates of recessions, and they use a complex set of standards to evaluate whether or not a recession is happening. Or, more commonly, whether it has happened. More often than not, they set the dates well after the fact, when the data is more certain.
In the US we generally rely on NBER. In general, in macroeconomics the view is that two quarters of negative growth equal a recession. NBER alters the definition somewhat (I forget exactly how they define it). I tend to like the two quarters macroeconomic definition, though it has problems: what if you have negative growth, followed a slight positive quarter, and then another negative quarter? Also, didn’t NBER announce a recession in 2001, but then later economists decided it really wasn’t one? Ah, objective science!
As you know, this has been something I have been harping on for a while, but the people I know in banking and the debt markets say this is the worst they have ever seen it. That includes the seventies and eighties. I am most certainly a bear, but an optimistic one. This will be real bad, but I don’t think for the economy as a whole it will be as bad as the early eighties. The market rout however may be just as bad as valuations are far higher.
That being said, the risk of a much more negative scenario is very real. As I told our investment committee in 2007, and repeated this year, at some point it really doesn’t matter how bad it might get, the solution is the same. If you are about to fall off the side of a building, debating whether it is a 30 story versus 60 is pretty damn irrelevant. The only solution is don’t go over the edge. In fact, it is better not to get up on the roof.
Now, we have other options at my shop, but for most people I will quote Jeremy Grantham (who should be read every quarter)
"Cash is the ugly answer no one wants to hear."
Maybe this will all turn around, I won’t deny it, though it seems unlikely. The question is risk vs. return. I see lots of risk relative to what you might get if things work out.