Tuesday, September 09, 2008

It's a Wonderful Life, aka The Nationalization of Bear

Given the precipitous decline in the value of Lehman today, I thought I'd reprise an email I sent around to most of my co-workers and a bunch of friends and family on Sunday March 26th, 2008 at exactly 7:00 pm EST. About 25 minutes later the news broke that JP Morgan was going to buy Bear for $2/share with Fed and Treasury backing. Now, in retrospect, my email may not seem so crazy, but I can assure you that when I first sent the email, it was basically an alarmist missive. $2/share was not in the collective consciousness and Bear's collapse, much less acquisition, was still anything but a certainty. Anyway, I wasn't actively blogging then, so it's not on The Investment Linebacker. It applies virtually in its entirety again today. As an aside, I went short Lehman that next day in the high $20s/share. Lehman proceeded to rally all the way into the $40s before collapsing back down to today's close (I have not added to nor covered any of my position). Here's what I wrote:

All weekend I've been thinking about the fact that on Friday, our Federal government basically offered to nationalize Bear Stearns and that nobody is talking about it. People are saying the Fed is "providing liquidity to Bear" via the JP Morgan conduit, but, barring a deal for someone to buyout Bear by Monday before the market opens (and perhaps even that won't matter - more on that below), I cannot see how that liquidity conduit doesn't become a defacto nationalization.

Bear's problem is perception. As Robert Rubin says (paraphrasing), "liquidity is a psychological phenomenon, not a monetary phenomenon." I was using that quote a year ago when we were pitching the puts to clients who were wary of betting against the "Wave of Liquidity" in the market [TTB - long story, but suffice it to say that is a position that worked out well]. Well, psychology has changed and Liquidity seems to be rooming with the dodo and Amelia Earhart in the Lost City of Atlantis for the time being.

It is a fact that as of Wednesday a.m., Bear had ample "liquidity" but rather than a wave of liquidity, a tsunami of rumors and fear hit the Street sometime on Wednesday or Thursday and there was effectively a run on the bank. George Bailey's, I mean Alan Schwartz's, best efforts aside, the reality is most banking services are commodity-esque and no client is getting paid to use Bear. Every manager we know is taking actions to shut down all relations with Bear. And why shouldn't they? What's the upside? You can get the exact same product across The Street from any number of competitors.

Thanks to the Fed liquidity conduit, Bear is taking illiquid/trashy assets, sending them to the Fed via JPM as collateral and turning them into cash to handle the run on the bank. Great for customers of Bear and possibly for equity holders of Bear, bad for equity holders in the company that goes by the ticker "USA". It is as if the Fed is running a pawn shop minus the profit motive and asset assessment capabilities. Thus, as the run on Bear accelerates, you and I (via our gov't) will increasingly be exchanging more and more of our cash for Bear's assets. I'm afraid our citizenry has unwittingly entered the Loan to Own business but we don't have David Tepper making the loans, we have Chairman Bernanke and his foresight is obscured by the clouds of freshly minted cash raining from his helicopters. In the end, when Bear declares bankruptcy (I give it a week), the Fed will be holding most of Bear's collateralizeable assets and it will have basically nationalized Bear via that liquidity conduit. It should be Bear's equity holders, customers and counterparties that take that risk, but the moral hazard inherently produced by the Fed is being run through a Cuisinart, sucked into a syringe and mainlined by the market right now "...oh, it feels so good...oh, I need another hit...don't make me wait...what do you mean only the first one was a freebie?!?!"

There are lots of rumors swirling that Bear is going to be acquired. It better happen before the start of business tomorrow (Monday a.m.) or else that swirling sensation won't be rumors, it will be a turd-shaped Bear Stearns spinning down the toilet and flowing into a governmental sewage treatment plant. But the reality is, it is too late already. They can announce a deal tonight or Monday, but the deal won't close for a month (and one month from announce to close would set a new land speed record).

So what happens during that month? What client is going to stick around saying, "well, even though EVERYBODY else is pulling their money from the bank, I'm going to hang around because I'm dying to be a J.P. Morgan Stearns & Co. client"? What counterparty is going to say, "sure, I'll take Bear's credit for the next month...I mean, what can change in a month"? I honestly cannot imagine any rational (or irrationally fear driven, for that matter) person saying that to themselves. Why not take Goldman's credit, or JP Morgan directly, or B of A, or Morgan Stanley, or even Citi? Why on Earth would you take Bear? It's not as if Bear offers some magical access that those players can't match? Every manager we have is walking from all things Bear. So, even if John Pierpont Morgan & Company announces the acquisition, The Bear is Dead. If you want to deal with JP Morgan, pull your assets from Bear and pick-up a phone. I suspect someone at Morgan will answer the other end. I also presume JP carved out "bankruptcy" as a MAC clause.

That comes back to our nationalization.

It also leads to the inevitable next question of "who is next?" Welcome to the hell Lehman Brothers is about to face. My $100 bet against my [Little Brother] notwithstanding, he is right that they are perceived as the next weakest player in our game of Wall Street Roulette. Would you want Lehman credit risk right now? Me neither. We are not the sharkish killers that encircle the island of Manhattan. If the allegedly "contained subprime problem" (which one of those words is least accurate? Seriously, that's a tough question!) lethally infects anyone else, it is Lehman. And as we saw with Bear, it only takes some rumors mixed with some fear to create a lethal dose. I would not want to go into the week short a Rumors and Fear ETF, that's for damned sure. Conversely, I absolutely want to go into this week short Lehman.

A Lehman failure would surely test our Fed. Could they even afford to bailout two major Wall Street banks in less than one month? I'm sure they are asking "can we afford not to?"

From a Main Street perspective, these are two of the banks that caused the problems we are facing in the first place. And if one bailout could not stop the contagion, why do we think two will? Will the more voter-sensitive parts of our government have the cajones to let that happen? Fascinating questions that I am hoping will not have to be answered. Sadly, I am worried that unless everything goes the collective's way, those question are going to be unavoidable.

As an aside, I don't know if anyone noticed but there is a presidential election going on right now and the race to create the most populist platform may, ironically, lead to the most capitalistic outcome: "screw Wall Street, let those companies fail." Who knows?

So, what do we do? Can we profit from this or at least protect value?

Well, the puts will help, but if we have a major Wall Street bank or two fail, I suspect we will blow through the short/spread part of the sale, so they will only help in a limited way. We could short a basket of financials, but that's truly a speculation at this point and we clearly won't be able to get client approval in any reasonable time frame. The distressed mortgage arena will get cheaper, as will distressed assets of all kinds. But they may be cheap for a good reason. If credit ceases to be available for anything other than assets with a ton of equity and at higher interest rates, asset values will rightly fall to a range that generates a return for less levered owners. That part of the credit unwind may, in and of itself, cause more pain.

The Fed is running dangerously low on ammo. We already have negative real rates on Treasuries and TIPS. The Fed has created hundreds of billions of dollars of liquidity availability for Wall Street. They have offered to nationalize a major Wall Street investment bank. Nothing's worked. The Federal government is literally printing money and mailing it to Main Street to stimulate spending via the one time tax "rebate" (is it really a rebate if you don't pay taxes in the first place or is that just confiscating from the wealthy to give to the majority?). Just what Johnny Consumer needs to do: spend more! Isn't that part of why we are in this hell hole to being with?

So, I may be Chicken Little looking up at the sky and warning that the end is nigh, but the tenuous strings of massive leverage that Wall Street has built its sky scrapers on certainly seem to be straining.

In summary, I would be short the dollar, short the long bond, short stocks, long currencies of creditor nations, long inflation (after a potential period of deflation, due to the credit unwind), long liquidity, and I'd continue to prepare to be long distressed credit assets.

Strap your boots on, the ride is about to get rocky.


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