As last week began, we heard that the Fed was stepping in to help JP Morgan buy Bear Stears for $2 per share after closing the prior week at $30. Prices for other financial firms initially skidded, in contemplation of who would be next to fall. Further, if Bear was only worth $2 per share, implying a market cap of less then one third of the value of their building, then what did that mean for the valuation of like firms? Not good. But that concern was short lived. By the end of the week, market participants had given the news an entirely different spin.
That spin went like this: The sacrifice of Bear meant that others would be saved. Hmmm… sounds a little like the message of EASTER? Bear, however, is unlikely to be resurected but existing shareholders did still get some good news today with JPM announcing they are now willing to pay $10 per share.
Many great commentaries have been circulating this week listing the reasons why we witnessed an unprecendented move by the Federal Reserve to fasciliate a buy-out. In “Let’s Get Real about Bear,” a commentary by John Mauldin,which you can only find via an email subscription which I highly recommend.( www.investorsinsight.com ), he suggests that “if Bear had not been put into sound hands and provide solvency and liquidity, the credit markets would simply have frozen this morning…Hit the Wall. The end of the world. Impossible to fathom how to get out of it type of event.”
The Fed clearly “got that”, and as the week played out, market forces grabbed a hold of the Fed as the lifeline not only for the financials, but for the market in general. (With the exception of commodites, which suffered a brutal pull-back this week.) They were clearly doing everything in their power to help stablize the financial system, and they did a good job. The questions still remain however, and I for one continue to have my doubts that the troubles are over.
For me, the biggest issue is that we are still very early in the default cycle of the laundry list of assets that are in fact in trouble. It started with sub-prime, but the list now includes all residential mortgage product, commercial real estate loans, construction loans, credit cards, student loan debt, home equity loans… and the list goes on. I have heard some alarming statistics including that 30% of all homes bought in 2005 and 2006 are underwater (meaning, home is worth less than the value of the loan). Mauldin, in an earlier newsletter, suggested that in order for housing inventories to find clearing levels over a reasonable time frame, prices would have to fall another 15% from here, wiping out over $5 trillion in home equity. The banks have already taken some big write-offs but it is unlikely that they are done. With the Fed’s help to boost prices, it is hopeful that they can raise the capital they need to not only weather more write-offs but to keep the lending machine going.
The other issue that continues to worry me is counterparty risk. Bear was too big of a counterparty to let fail given that they were a huge player in the derivatives space, but others will fail, and it is unknown what will happen when they do. The bet is, of course, that the Fed will continue to do everything in their powers to keep stability in the system, but can they? I believe that the Fed can and will prevent any sort of systemic collapse which they may have witnessed had they not come to the rescue of Bear. But there will be more problems. Exactly how and where is a difficult bet indeed.
Last note. Be sure to pick up a copy of The Economist this week to catch its feature on Wall Street. This magazine is simply the best way to keep up with what is happening in the world and I would highly recommend a subscription. They also found the Fed’s mover reassuring but “the nature of liquidity in today’s ready-cash funding model of investment banking is that it is strong until suddenly it is not.” I share the sentiment reflected in their closing statement that “with housing prices still falling, credit deterioration spreading and derivatives markets deeply unsettled, is anyone willing to bet that Bear Stearns is the last of the $2 sales?”