Bear Stearns Tears

By Dr. Duru written for One-Twenty

March 17, 2008


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There are plain ol' lies. There are white lies. There are damn lies. And there are statistical lies. But the trickiest and slickest lies have to be the financial lies. Financial lies are tricky because it is often hard to distinguish the lies from the reckless bravado from the blind hope from the ignorance. We have had a lethal mix of all four as the financial industry has danced around the gradual decline of our financial system. Ever since the sub-prime stink bombs started dropping early last year, we have had to bear witness to a parade of CEOs and CFOs from the financial industry reassuring us that the books are just fine. And as things just keep getting worse, we have come to understand that things are definitely just fine as long as everyone agrees to keep pretending that a whole swath of assets and securities are still worth something north of zero. Things are just fine if we assume debt ratings will remain inflated. Things are just fine assuming that counterparties will continue to provide the cold hard cash to keep the leveraged bets going and to "play nice" in their trading. Things are just fine assuming that the Federal Reserve will figure out a way to bail everyone out of this mess if all else fails.

Well, the Federal Reserve bail-out machine started cranking in high gear these past few days. The Federal Reserve scrambled to prevent Bear Stearns (BSC) from utter collapse and thus tearing up some delicate fabric in our increasingly brittle financial markets. The Federal Reserve is using JP Morgan (JPM) as the conduit for roughly $30 billion in assurances that the risk in BSC's questionable debts is now on the hands of the Feds (and the American taxpayer). In just two days, the various parties to this deal realized that BSC was not likely to survive the original 28-day lifeline, and JPM bought BSC outright for a mere $2 with the Fed's immediate blessing. One must wonder how in the world could this venerable company be worth so little when just on Friday the market was still willing to pay $30? At the beginning of the year, the market was willing to pay $85. A year ago, the market was willing to pay $145! Heck, almost to the bitter end, BSC CEO and President Alan D. Schwartz defended his company, insisting that liquidity was just fine. You can find videos all over CNBC/MSNBC. For example, on March 12, 2008, Schwartz told us that BSC had $17B in cash for a liquidity cushion that had remained unchanged all year. He insisted that the balance sheet was strong. (Perhaps it was QUITE fitting that CNBC has to briefly interrupt the interview to announce that Eliot Spitzer confirmed his resignation as NY state governor!). Even if we cannot pin a specific label on the stories we get from the financial world, we do know that the tales can be very powerful: many billions in market value can be constructed, floated in thin air, and maintained for a quite a bit of time - all with the comforting complicity of all of us as long as it seems like we are making money.

For good measure, the Fed did not stop its liquidity press with the BSC bail-out. The Fed immediately cut its primary credit rate from 3 1/2 to 3 1/4 percent. In an unprecedented move, the Fed also extended a lending facility to primary dealers "...to provide financing to participants in securitization markets." Should we be worried that the last time the Fed made such a move was during the Great Depression? Bill Fleckenstein argues that these Fed "giveaways" simply will not work. The core rot in the system is in the decline of housing prices - which soared so much higher than they ever should have based upon the real purchasing power of consumers. There is plenty of support for his well-worn points. For example, on Feb 28, 2008, the Senate Committee on Finance held a hearing called "The Real Estate Market: Building a Strong Economy." Most striking was testimony from Dr. Lawrence Lindsey, President and Chief Executive Officer, The Lindsey Group. Dr. Lindsey provides an excellent history of the mortgage industry in the U.S. We have had one failed innovation after another where the Federal government steps in to provide the latest fixes. (Of course, he seems to think that he has finally figured out the perfect solution). Dr. Lindsey lays out the case plain and simple that our latest innovations in housing finance relied on ever-soaring housing prices. Further erosion in housing prices will cause definitive damage to the economy. Remedies that do not directly prop up these prices will be doomed to fail. So far, the Fed moves are failing to prop up prices because confidence has been all but lost and homes remain unaffordable to too many people. Moreover, the Fed moves are creating increasing worry that the situation here on the ground is even worse than any of us can imagine, at least in the short-term. Taleb must be having a field day: black swans are flying north to south and west to east and all points in between.

So what does trading look like in the stock of a large and important company teetering on the precipice of a massive devaluation? Well, on Friday, the options market added March strikes as low as $5 on BSC...and they actually traded! Sure it was only a volume of 6303 contracts in the Mar 5 puts, but I still called it nuts. At the open Monday morning, these puts will soar from about 20 cents to a value of $3, a 15x increase in price. Puts at this strike also traded for April and July expiration with a trickle in October. Folks who bought puts at other strikes will of course make out with a lot more in absolute terms. The put call ratio for March was a lofty 2.4 across all strikes. But for April it was "only" 0.9, and for July it was 0.8. In other words, the market was trying to anticipate a very negative and colossal event coming in this week - and it got it.

The stern tears of Bear Stearns are a sobering lesson for all of us. BSC has solidified and verified my designation of 2008 as "the year of Taleb". My triumvirate of zoological metaphors also prevails: the black swan, the turtle, and the chiru. We continue to under-estimate the likelihood of low probability events until they are staring us right in the face (the black swan). The downward trends tell us all we need to know about the direction of the best risk/reward bets (turtles). And above all we simply cannot be too quick to believe anything we hear that tries to explain why the black swan cannot exist and how the prevailing trend is overdone (chiru).

Be careful out there...and chiru!

DR. DURU®, 2008