Wednesday, September 17, 2008

Indeed, the other shoe has dropped

The current environment demands and explanation. So let me first reiterate the impact of uncertainty and then share one perspective on the recent news of Merrill, Lehman, and AIG.

"Uncertainty" is different than "Risk." In risk, the underlying probabilities of a certain event are known, as well as the effects (i.e. you are able to quantify the payoff) those events will have. Thus, roulette is a game of risk (all probabilities and payoffs are known). War is an uncertainty, in that the effects of the same can't be accurately quantified. As I stated in a previous post, when you are unable to quantify the problem, the more likely you are to follow the herd. And the herd will demonstrate a tremendous amount of overshoot (up, if the news is good, down, if the news is bad). And the less one is able to identify the "high" and the "low," the less likely the trend will end anytime soon. The presence of magnificent leverage, or debt, exposes both institutions AND individuals to extraordinary financial risk amidst uncertainty. So I think we're in for a long ride. Unfortunately, the overshoot and uncertainty is so great, and the leverage all too common, that it has produced multiple victims (seen in high profile bankruptcies on the corporate side, and massive foreclosures on the consumer side).

Now, on to the hemorrhaging on Wall St. Merrill was sold to Bank of America (not a big deal, although alarming), Lehman declared bankruptcy and will sell off various divisions, and AIG was bailed out by the government. I don't think I will address the actual remedies of Merrill Lynch, Lehman Brothers, and AIG. Those have been treated in great detail by others more qualified than me. Perhaps the question you may be asking is, "Why was one sold, one bailed out, and one not? And what does that say about our financial system?"

Merrill Lynch was wise and found a potential buyer before things got really ugly. They realized they were going to run out of money. But unlike many of their competitors that kept the news quiet until the last moments, Merrill's CEO was forthright and honest about the current state (probably because he was only hired in November and is still in the honeymoon stage with the Board). In the words of beloved JPMorgan CEO Jamie Dimon, "It's one thing to buy a house (referring to BoA's acquisition of Merrill), it's an entirely different matter to buy a house on fire." Merrill bailed while the flames were beginning to torch the grass but have not yet reached the home.

Before discussing AIG and Lehman, let me interject here that I've been pleased with the coordination between Bernake's Fed and Paulson's Treasury (the Fed is responsible for monetary policy while the Treasury is responsible for fiscal policy, or, how the government spends money). They've both approached this disaster with very innovative ideas, which I think are in the best long term interest of the U.S. economy. The biggest problem most people have, rather, what I hear people complain about most frequently is the doctrine that government should not undertake bailouts because it creates a type of "moral hazard." Although the government is stepping in to help AIG, average taxpayers face a higher standard of living over the long run from utilizing a taxpayer-funded "bailout" to re-establish growth than they do by permitting a collapse of the global financial system. Furthermore, management and shareholders often pay a heavy price under such circumstances (which is not the case in other countries where governments have stepped in and protected shareholders).

So why save AIG and not Lehman (who filed for chapter 11)? Although Lehman is huge, AIG is the hub of a spoke and wheel network whose wheel is the global economy. Their integrity must be protected. One economist we work with said, "what we are seeing is a certain level of experimentation and sampling. The financial system has never really been stress-tested and is evolving." No one really knows how it will end up. That makes it difficult to say "bailouts" are either good or bad. Apparently, the risks of testing the system by letting a huge global giant like AIG go bankrupt are too high to assume until we have experimented with smaller companies, like Lehman. I believe we are seeing a testing-while-protecting strategy from the Treasury and the Fed, and, I think on the balance, they are doing a good job.

Again I'll end with an ominous prediction. Whose next? Wall Street seems to think Morgan Stanley and Goldman Sachs are next (based on credit default spreads, which gauge risk). I would not be surprised to see a partnership between the two. I would be surprised, if twelve months from now, those two organizations still stand independant.

11 comments:

KVB said...

(In an unrelated note)are there other blogs, podcasts, or newsletters that you subscribe to and like.

Jenga said...
This comment has been removed by the author.
Jenga said...

Good point. Yes, though not as many blogs as news sites. I'll post them in a couple of days.

KVB said...

Cool, thanks.

Nate said...

What about Washington Mutual? I heard those guys are close to the edge.

Nate said...

So, who is getting richer here? The huge amount of money these companies are losing isn't just disappearing into a hole in the ground, right?

Jenga said...

Nate,

Yes. WAMU is in deep trouble. They took a $2Billion infusion of cash from TPG, a Private Equity group earlier this year. And not just any private equity group, but considered the best in the business. And the deal was even originated from the top (as opposed to an associate or VP convincing a Managing director, which is common). I think WAMU was trying to raise $8Billion or so. So they are still in the process of doing that. JPMorgan, Citi, and Wells Fargo are all going to make offers. I'm pretty sure TPG screwed up and got in too early. Earlier last week, TPG waived their dilution rights. Dilution rights ensure you keep the same percentage of ownership if the company tries to raise more capital. In this case, TPG's dilution rights kicked in if WAMU tried to raise money below $8/share (or something close to that number). Due to the current environment, they've had to raise money at a share price substantially below that number. And TPG realizes there is no alternative.

Attorney's will make a lot of money. Security class action suits will be huge over the next two years. But the consumer will feel the costs as well. The cost of borrowing will increase, thus decreasing consumer spending, corporate profits, and, by default, GDP.

Nate said...

Well, I'm happy hear the lawyers will do OK. But, is anybody getting rich now? The attorney's will get their money eventually, but my assumption is that there is still the same amount of money in the market, so that when somebody is losing money, somebody else is making money. Is this a correct assumption? If not, why? If so, who's raking in Uncle Rico's moolah today?

Jenga said...

Nate,

Your question is more complicated than you probably assume. There's a basic answer and a more complicated one. First, the easy answer. Right now, nobody is getting rich in the financial sector from these mortgage backed securities because the market is still on it's way down. Indirectly, those holding safe and stable investments with an inflation hedge are doing really well. Those whould be commodity traders (oil, timber, etc.), because those securities have an "intrinsic" value. The current contagion is creating a flight to quality, so short-term, high quality securities, like t-bills, are also experiencing significant gains. Now, there is also a more complicated answer. It's more a question of timing. Rather, one should ask who MADE money and who will MAKE money--a fascinating question regarding basic accounting philosophies. What's interesting about this environment, is that the majority of losses are all "paper" losses only, or, unrealized. What do I mean by that? I'll leave you hanging for my next post because it is a crucial aspect to the proposed $700 Billion bailout, which proposal is only three pages long and will change a lot over the next 48 hrs. Stay tuned.

Nate said...

Did you see Bush's speech? In it he said "The markets are not functioning properly." Is this true? It seems to be that they are functioning too well by immediately devaluing overinflated stock companies.

Do you think the markets are not functioning properly?

Jenga said...

I heard parts of it. And, yes, I think it's true. In order for markets to function properly, or efficiently, you must assume 100% transparency and understanding. We don't have that. When you have a lack of understanding (in that no one knows the correct value of these mortgage backed securities), or uncertainty, you have to throw market "effeciency" out the window.

I don't think the market is correctly pricing these stocks. I think we're seeing a classic case of herd "overshoot," in this case, downwards. It looks like the $700 billion plan was agreed upon today, so expect a post by Saturday on all these same issues.

For those "black helicopter" fans out there, you could make a case (and a fairly compelling one I might add) for financial terrorism. But more on that later.