A Reply to John Mauldin's Outside The Box - Let's Get Real About Bear
An Occasional Letter From The Collection Agency
I have been, and still am, a long time fan of John Mauldin (JM). I enjoy his take on the bigger picture, even if there are areas I disagree with, from time to time. Generally my disagreements are more to do with the severity of a particular problem or the benefits of a highlight. For instance, JM might allude to a recession but think that it will be mild and happen over a certain time scale, fitting his "muddle through" model. I would agree with the talk of recession but not necessarily the depth, timing or effect. You get the point.
However the JM article "Let's Get Real About Bear" has somewhat shocked me at a fundamental level and it deserves a reply. Let me say this from the beginning, I do not intend to start a war of words or change JMs thinking. Neither approach is constructive or conducive to open discussion of a truly fundamental part of the US and Global economy. This not a good vs. bad scenario, I have little or no doubt that JM is a well read, intelligent, honest and thoroughly nice bloke. I am a trader/blogger that very few have heard of or know, using the internet to foster thought. (As an aside, I asked JM to have a look at my writings and consider maybe using an article in the OTB edition. The answer is within his Bear article. Sometimes trying to be a "platform start up" has its knock backs. So no hidden agendas and yes, I fully expect to be viewed as the "Darkside". Ahh the fun of blogging.)
Here is a link to the JM article at Investor Insight. Please read it before going further. I am not going to discuss the 2 other articles appended to JMs writing.
JM is an investor/advisor who looks to get real returns beyond the effect of inflation. He operates in the free markets, looking for advantages that return above the "norm". He searches for new, innovative technology that may become the "next big thing". He is a capitalist, using the capitalist mechanism. He knows the risks and tries to avoid being on the wrong side or if that fails to mitigate the risk to his capital. I do the same as do most investors and traders. It is the way of the financial world. There are upsides and downsides, we know the risks and rewards, and the rules of the game are simple.
Unless, that is, you decide that the rules can be bent to accommodate failures, to mitigate the downside. Such an approach leads to tyranny, it destabilises the system causing feedback loops, encourages excessive risk taking and allowing that risk to be ignored and causes confidence in the financial structure to erode.
This is big picture stuff. It is not about 17000 jobs at Bear Stearns; it is not about a loss on share portfolios suffered by employees. Protecting a company and its share price is never a reason for intervention and the introduction of moral hazard.
Bear and its employees would not be in their current circumstances if they had obeyed the rules and understood the game.
Bear Stearns went bust because of a lack of confidence in its collateral used to finance its lending. Customers and Lenders walked away because the risk of staying was perceived as too great. It was the risk that Bear Stearns took using its business model and allowing exposure to be greater than its ability to pay. The Capitalist System did its job; it rooted out a bad business model and laid it low. If you took losses, I am genuinely sorry for you but you knew the risks. We all take a loss sometime. If it wiped you out then you did the same as BS, you allowed exposure to a risk to grow well beyond acceptable limits.
Does this sound harsh, a bit heavy-handed? It probably does but it isn't me saying it, it's the free market shouting loud as it does every trading day.
JPM have stepped in and offered $2 a share for BS. We have seen such action before, a fast move to grab assets perceived as cheap. It happens in the capitalist marketplace. The risk is transferred to JPM equity holders, JPM write-down $6Bn to acknowledge that risk. The trouble is the whole JPM move was not a function of the free market. Without The Federal Reserve accepting who knows what BS assets as collateral on a $30Bn loan this deal would not have taken place. Even worse JPM get rewarded by asset grabbing at an extremely cheap price. (I suspect we have not heard the last of that either).
JM contradicts himself within the article as he attempts to align the adoption of allowing a moral hazard to exist within the market. I quote:
"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."
But just a few lines later he is forced to acknowledge the underlying fear his readers have emailed him about:
"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."
You cannot expect market participants to accept such reasoning unless you believe intervention is right and proper. If you do think that way then your perception of risk has to be misplaced.
So, it is more than possible that Tax-payers will face a bill for this bailout. The moral hazard, as the UK Govt discovered after Northern Rock is that if you "cover one bet, you cover them all". The extension of liability and assumed enlargement of risk becomes burdensome and affects the fundamentals underlying the national economic base.
Today in the UK, there are rumours, denied by the BofE and the bank in question, that a Bank may or has a requirement for emergency funding. Regardless of the truth or otherwise, this has directly affected Sterling vs., of all things, the dollar:
The ellipses are the main points when rumour surfaced and re-surfaced. This is what acceptance of a moral hazard can do to a currency. I picked the $ as a comparison because it is weak, it shows the inherent weakness of Sterling under such circumstances. This is not a theory of mine, based around musings of economic facts and figures. This is market action telling us a story. Ignore the tale at your peril.
Should Bear have been allowed to go bust? Without doubt the answer is yes and to some extent JM agrees:
"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."
A very scary (and quite possible) scenario. JM is saying that current market conditions are not conducive to failure of a Financial Institution.
Well I'm sorry but these events happen because of the prevailing circumstances. Banks don't go broke at the top of the cycle, failures occur when times are getting hard. It is the nature of the beast. To say the System cannot tolerate such an event is to deny the reality of capitalism. It encourages the acceptance of a safety net, a guarantee that regardless of the poor decisions and risk calculation taken there will be no failure.
This is truly a refutation of a capitalist, free market. No wonder CEOs take what seem to be enormous risk free assumptions about the future and the effects of their actions and decision upon the prospects of the company. They have nothing to fear. CEOs get their compensation, shareholders get a ride, and all is well. Until the cycle turns. The CEO has departed by then, either as part of a merger or retirement with an enormous compensation package. The shareholders are the weak hands, the strong hands sold at the top. Who cares what happens to the weak hands? Moral hazard isn't just about tax payers.
JM quantifies what he thinks the damage to stock markets could be:
"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."
Again, I agree that losses of 20% or more could happen and still might. The reason it would have made Black Monday look like a picnic is because it was a picnic. In 1987 we didn't have the massive expansion of innovative financial instruments, back then Futures and Options were complicated! If the free market decides it needs to provide a re-pricing then it should be allowed. After all, no one worries about the same mechanism working to the upside.
Would credit markets have closed, seizing up under the financial stresses? We don't know. Let us assume that they would. So what?
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