Say What?

As I write this, share prices are rebounding from this morning's opening lows. From what I can tell, it seems like there are only two explanations for the stock market's curious resiliency in the face of what can only be described as rising uncertainty and the risk of other serious blindsides: extraordinary ignorance or buying by some deep-pocketed "invisible hand" (e.g., the government).

Based on the rather bizarre insight contained in the following update from MarketWatch, I guess I have to say I'm leaning towards the former [italics mine]:

U.S. stocks on Monday battled back after an early slide, with investors finding at least a temporary bottom in the wake of the distressed sale of Bear Stearns Cos. and the Federal Reserve's extraordinary discount-rate cut just two days ahead of Tuesday's slated meeting.

"Today's lack of panic-type selling is another sign that we could be near a bottom," said Ken Tower, chief market strategist, Covered Bridge Tactical.

Huh? Since when has a lack of panic-selling marked a bottom? Is he serious?

Anyway, people who actually understand how markets work and who know how to think are focusing on reports like the one that appeared this morning in the New York Times, "Fears That Bear Stearns’s Downfall May Spread."

The cash squeeze that brought Bear Stearns to its knees is fanning fears that other investment banks might be vulnerable to the crisis of confidence gripping Wall Street.

Investors are bracing for another volatile week in the markets as bankers and policy makers deal with the fallout from their bid to rescue Bear Stearns.

For now, the prospect of a new wave of consolidation in the beleaguered financial services industry seems remote. That is because would-be acquirers and everyday investors alike have lost faith in the values that Wall Street firms are placing on their own assets.

Of particular concern are the so-called marks placed on mortgage-linked investments like those that undid Bear Stearns, prompting a run on the firm that led the Federal Reserve and JPMorgan Chase to throw Bear Stearns a financial lifeline last week.

James E. Cayne, the chairman of Bear Stearns, mused eight years ago that he might consider selling the 85-year-old bank for a lofty price of four times what it values itself on its books. But now such a notion seems absurd — and not just for Bear Stearns.

The unhappy experience of Bear Stearns proves that it is a lack of confidence, not capital, that ultimately topples even the savviest financial institutions.

“Once you have a run on the bank you are in a death spiral and your assets become worthless,” said David Trone, a brokerage analyst at Fox Pitt Kelton.

In all-day meetings over the weekend, Alan D. Schwartz, the chief executive of Bear Stearns, met with his top executives at the firm’s Madison Avenue headquarters, trying desperately to persuade skeptical potential suitors that the firm was worth buying.

But the market had already passed a harsh judgment on Bear Stearns. On Friday, its stock plunged 47 percent, closing at $30. At that price, its shares were trading at a gaping 62 percent discount to the $80 book value that the firm has reported, reflecting the broad view that the fallout from the credit crisis had permanently devastated Bear Stearns’s core mortgage operations.

In Washington, the Treasury secretary, Henry M. Paulson Jr., signaled strong support for the Fed’s role in supplying a lifeline to Bear Stearns during the crisis negotiations, saying that his priority was to stabilize the financial system and to worry less right now about the problem of avoiding a “moral hazard” by bailing out errant institutions.

“We’re very aware of moral hazard,” Mr. Paulson said in a television interview with George Stephanopoulos on ABC. “But our primary concern right now — my primary concern — is the stability of our financial system, the orderliness of the markets. And that’s where our focus is.”

Indeed, investors are taking a grim view of the prospects for other investment banks like Lehman Brothers and Merrill Lynch. Managers of hedge funds and mutual funds say the problems at Bear confirmed their worst fears about the brokerages — that they have relied too much on leverage and have done a poor job managing the risks they took on during the boom.

The price of insurance on investment banks has surged in the last few days and is exponentially higher than it was last spring. Credit default swaps that offer protection on Bear Stearns debt traded as low as $35 per $10,000 of bonds in May. As of last Friday, the cost was $830.

Shares of investment banks in the Standard & Poor’s 500-stock index are down nearly 28 percent so far this year, and stock futures on Friday showed that a few investors were betting that Bear Stearns stock could lose virtually all of its value in the next few weeks.

“People have started to realize the risks that are there,” said Steven Gross, a principal at Penso Capital Markets, an investment firm in Cedarhurst, N.Y. “The question is have we reached the bottom.

Citigroup, one of the nation’s largest banking companies, is now trading below its book value. Lehman Brothers, at $39, is trading just below the book value it reported at the end of last year. This year, Bear’s stock is down 65 percent and Lehman’s has sunk 40 percent.

Bear Stearns, one of Wall Street’s oldest investment banks, had a market value of $4.1 billion as of last Friday.

But the market did not put much faith in the Fed’s bailout of the firm, announced on Friday. Bear Stearns’s hedge fund servicing business and its clearing operations have traditionally been profitable operations, although they have suffered in recent months as investors and lenders have lost confidence.

Throughout much of its history, Bear Stearns has masterfully persuaded the market that its business — narrowly focused on mortgage finance — was worth more than it actually was. To some degree this trick has been a testament to the coy gamesmanship of two of its past leaders, Alan Greenberg and Mr. Cayne.

Both men are devout bridge players and Mr. Greenberg is an amateur magician as well, so they are well schooled in the art of not showing their hand.

Mr. Cayne’s hint eight years ago — that he would only sell the firm for four times its book value — was even then a flight of financial fancy. Wall Street investment banks rarely command such a premium to their book value, given the inherent and unpredictable risks of their business.

Nevertheless, Mr. Cayne and Mr. Greenberg were adept at spreading the view that Bear Stearns was constantly being pursued by buyers as varied as European commercial banks and even JPMorgan, although it was never clear that any of these talks reached a serious level.

But Bear Stearns’s quirky culture and the high pay it awarded its senior executives made it a difficult fit for larger, more staid institutions, and it always seemed that Mr. Greenberg and Mr. Cayne were having too much fun running their business to sell it to an outsider.

In the last few days, Mr. Schwartz, a veteran investment banker whose approach to deal making is more pragmatic and results-oriented than his predecessor, raced against the clock to seal a deal that salvages some measure of value for shell shocked Bear Stearns employees, who own over 30 percent of the firm, and its investors.

And while Bear’s peers on Wall Street are not yet in such dire shape, they have surely accepted the reality of leaner times and lower valuations in the months to come.

“Banks and brokerages are a house of cards built on the confidence of clients, creditors and counterparties,” Mr. Trone said. “If you take chunks out of that confidence, things can go awry pretty quickly. It could happen to any one of the brokers.”

Comments

[Edward Charles Ponzi Jr.]

"rising uncertainty and the risk of other serious blindsides: extraordinary ignorance or buying by some deep-pocketed "invisible hand" (e.g., the government)"

Michael -- could you elaborate on how such interventions might actually work -- and how effective such things can be?

In the long run -- I can't see propping up a market that is dissolving -- but it seems you are implying that a rally can be staged.

For those of us that hold bear funds -- these are important issues!

-Edward Charles Ponzi Jr.
Futurist and member of the
Hooverville Falls Volunteer
Plunge Protection Team