From one of may favorite economists, John Hussman. Good contrarian viewpoint of the FED action last week. :-k
Full comments and weekly articles at:
www.hussmanfunds.com
March 24, 2008 Why is Bear Stearns Trading at $6 Instead of $2?
John P. Hussman, Ph.D.
All rights reserved and actively enforced.
" PARTIAL ARTICLE:
Why is Bear Stearns trading at $6 instead of $2?
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.
