Bad News for Bear Shareholders is Good News for the Markets

Two dollars per share is an astonishingly low price to pay for Bear Stearns: when I first saw it I honestly thought it was a misprint. If Bear is essentially worth nothing, that means other banks – Lehman seems to be the latest in the crosshairs – are also worth less than the market thought on Friday. But overall the rescue of Bear Stearns by JP Morgan is a good thing for the international financial system, and a good thing for the markets. Here’s a bit of late-Sunday-night analysis to set you up for what’s likely to be a very volatile Monday.

One of the more admirable things about Bear Stearns was always its strong culture of employee ownership. And one of the good things about being able to name your price is that you can buy a venerable investment bank for $2 a share. But, as Ken Houghton points out, the two great tastes don’t necessarily go well together:

It’s always been especially true at BSC that the assets walk out the door at the end of the day. The question now is how many of them will bother to walk in the door on Monday.

My guess is not all that many. JP Morgan on its conference call Sunday night talked about the costs of "retention for key people at Bear Stearns" – but more to the point the Bear Stearns bankers are now JP Morgan bankers, and JP Morgan has never been particularly stingy with its bonuses. The Bear Stearns bankers want this deal to go through, because it means they will continue to be employed. The alternative is bankruptcy and liquidation, which is much riskier for them – so they’re likely to vote their shares in favor of the deal.

Institutional investors, too, are likely to be sanguine about this deal, they might not be happy, but they know that $2 is better than nothing. Individual investors might vote against – one individual who somehow managed to get through on the conference call was clearly unhappy and said he would do just that – but those individuals don’t own enough of the stock to make much of a difference. The individuals who do have large shareholdings, like Joe Lewis, are likely to accept the deal and then, if they feel particularly aggrieved, litigate in its wake: an unspecified chunk of the $5 billion plus in closing costs that JP Morgan outlined in its presentation come under the general heading of "litigation".

One thing which was clear from the conference call is that JP Morgan seems to be taking Bear Stearns at its word when it comes to the $84 (ish) book value: CFO Michael Cavanagh said that he was "very comfortable with the levels at which Bear Stearns has marked its positions". The discount to book is a function of having to do a complex deal within the space of one weekend, as well as the difficulties of digesting a major investment bank during a period of extreme market volatility. Oh, and the fact that the chances of any other bidders coming along are remote.

And what about the $30 billion non-recourse Fed facility? It seems that this is a case of JP Morgan getting all of the upside (it’s buying the equity at a price-to-book ratio of 2.4%, and a price-to-extra-future-earnings ratio of 0.24) while the Fed takes most of the downside. But even there JP Morgan said quite explicitly that the Fed facility is very much expected to be repaid in full, and that the reason for its existence was that they simply didn’t want to have to dump tens of billions of dollars’ worth of illiquid assets into this market as they delever Bear. "JP Morgan is perfectly comfortable with the assets that we’re acquiring, but with the financing support of the Fed, the deleveraging will be a very orderly process," said Cavanagh.

The big risk with this deal is that the markets will take the price paid for Bear as a mark, and will sell off the other four investment banks accordingly. After all, if you strip out the value of the headquarters building, Bear’s shareholders are essentially paying JP Morgan $1 billion to take the bank off their hands. If Bear’s worth less than zero, is Lehman really worth $20 billion?

And that’s why I’m not a huge fan of the cut in the Fed’s primary credit rate, either: it seems panicky and prone to backfiring. What’s more, if they’re cutting the discount rate – and it seems that that’s exactly what they’re doing – they should say so, rather than just talking about a "primary credit rate" which no one’s ever heard of. In any case, given that they were scheduled to cut the discount rate on Tuesday, did they really need to do that now, and make themselves seem even more jittery and panicky than they needed to?

In any case, the Fed is now lending money to investment banks – which it doesn’t regulate – at exactly the same rate at which it lends to regulated commercial banks. While Jamie Dimon has shown himself to be decisive and opportunistic this weekend, Ben Bernanke looks increasingly like a schmuck who’ll do anything Wall Street asks him to do.

General stock-market sentiment in the wake of this announcement seems bearish, but not catastrophic, with Asian markets down 2-3%. Certainly this is the kind of deal which only gets done when things are Really Really Bad, and there are a hell of a lot of stock prices right now which don’t look Really Really Bad at all. Personally I think a nice down day for the Dow could be just the ticket, especially if it coincides with a little bit of spread tightening on the fixed-income side of things as traders start to pile into the moral hazard play. That would help bring stock prices into line with bond prices, and even possibly set the stage for a nice rally when the Fed cuts rates by 100bp on Tuesday.

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The New Committee to Save the World

Ben Bernanke hasn’t caught very many lucky breaks of late, but the fact that Bear Stearns hit its liquidity crunch and got downgraded by all three ratings agencies on a Friday is probably one of them. The downgrade wasn’t welcome, of course, but it did inject a sense of urgency into proceedings: a clearing investment bank can’t function with a BBB rating.

Over the course of the weekend, a new Committee to Save the World was convened. And so, before the markets reopen on Monday, Ben Bernanke, Tim Geithner, Hank Paulson, and Jamie Dimon can announce, with no little sense of relief, that Bear Stearns is being bought by JP Morgan.

That news will likely send stocks up – with the exception of BSC, of course, which is being acquired for the bargain-basement price of $2 a share, despite the protestations of Bear’s management that the bank’s book value is still over $80.

This is a much better outcome than Bear being bought by Chris Flowers: if that had happened, there would have been question marks over his ability to withstand major further write-downs. With JP Morgan, there’s no such question: JP Morgan Chase is enormous enough, and was fortunate enough to avoid the worst of the mortgage meltdown, that no one’s going to worry about it failing.

The mooted price for Bear Stearns – roughly zero, despite the fact that Bear’s headquarters alone is worth over $1 billion – is low enough that it gives Dimon a lot of room for maneuver. He can keep Bear as a going concern, take what bits he likes, and then close or sell off the bits he doesn’t want over time, as the chaos dissipates. So my feeling is that there won’t be mass layoffs in the short term, although Bear’s top earners might well walk out the door on their own if they feel that this year’s bonuses are likely to be nugatory.

But the price is also so low that it implies a huge amount of risk in the deal. And so the next question arises: if there’s that much risk in Bear Stearns, how much risk is there in Lehman Brothers? Lehman’s shares fell by almost 15% on Friday, and are now within shouting distance of falling below book value. Merrill Lynch, Morgan Stanley, and Goldman Sachs, by contrast, seem safe for the time being.

Still, I can’t remember a time when investment banking, as an industry, was in as perilous a position as it is now. The LTCM crisis of 1998 was bad, but this is worse. Brad DeLong, in an excellent blog post, explains that the crisis has blindsided the markets precisely because no one thought that the investment banks were as bad at risk management as they in fact turned out to be. Now, no one trusts those banks to be good at risk management any more. And the existence of trust is a necessary precondition for efficient markets.

The other must-read post of the weekend comes from Steve Waldman, who would like to see a return to the days when trust was a central part of the banking system: the days when JP Morgan himself told Congress that "a man I do not trust could not get money from me on all the bonds in Christendom". "We shouldn’t go back to the world as it was at the turn of the century," says Waldman,

But I do think that it’s an interesting technical question, going forward, whether we couldn’t set things up so that the criteria by which investors decide where to put their money map more closely to what we would recognize as trustworthiness or character.

There are two levels of trust which matter here. One is trust in financial institutions individually: fear of Bear Stearns suffering from a liquidity crisis was self-fulfilling, and the same could happen to other banks too. But the other is trust in the financial system more generally, and that’s where the Fed’s bailout comes in. The TED spread is still unhealthily wide, indicating that there’s a huge amount of nervousness surrounding the health of the banking system as a whole, and it’s the Fed’s job to reassure the markets that the system will survive. One way of doing that is to make sure that liquidity crises like the one which hit Bear Stearns are dealt with in some semblance of an orderly and effective manner.

So it was very weird to read this, from Gretchen Morgenson, on Sunday:

Regulators must do whatever they can to keep the markets open and operating, and much of that relies upon the confidence of investors. But by offering to backstop firms like Bear, who were the very architects of their own — and the market’s — current problems, overseers like the Fed undermine a little bit more of that confidence.

I think this is exactly wrong. Morgenson is right that the confidence of investors is needed if the markets are to remain open and operating. But letting Bear fail and default would boost the confidence of absolutely no one. Settlement risk alone would be reason enough for the Fed to provide support, even if the general mood of the market weren’t so nervous that a major bank failure would risk a broad-based panic.

What the Fed’s doing here, with the help of Jamie Dimon, isn’t rescuing Bear Stearns, so much as trying to provide some kind of safety net for the financial system more generally. It’s an open question whether or not the Fed has the ability to do that. But it surely has to try.

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Extra Credit, Weekend Edition

Nothing to Fear but Fearmongers Themselves: A Look at the Sovereign Wealth Fund Debate

Official: Euroland GDP Passes U.S.

Betting the Bank: Krugman on the desperation of Bernanke.

Triple-A Trouble: Justin Fox on the ratings agencies.

Common Wealth: Jeff Sachs discusses his new book with Martin Wolf.

How to read The Economist and Are you smart enough to enjoy the Economist? "The Economist flatters readers who aren’t quite intelligent enough to realize how shallow it is into thinking that they are more intelligent than they are because they read it."

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How Systemically Important is Bear Stearns?

Nouriel Roubini thinks the world could absorb the failure of Bear Stearns:

It is true that Bear is a large broker dealer; but its systemic importance is much smaller than that of much larger institutions. The world and financial market can survive if Bear disappears.

Willem Buiter thinks much the same thing:

Bear is not a deposit-taking institution. It plays no role in the retail payment mechanism and is of no significance to the proper functioning of the wholesale payments, clearing and settlement system.

But when I quoted Buiter saying that, Alea immediately popped up in the comments:

Bear Stearns is a HUGE clearer, so huge that they got away with paying peanuts during LTCM rescue. Talking about serious negative externalities, Bear is one of 2 or 3 whose failure would be catastrophic.

Alea is the #1 credit crunch blog right now, so I’m inclined to give him the benefit of the doubt; Buiter is a (former) central banker, but isn’t really concentrated on the US, and I’m sure Bear Stearns is much less important in London than it is in New York.

Bear certainly talks up its clearing services, but this is a pretty obscure arm of the investment-banking world which I’m not at all familiar with. Are they really a huge player in clearing the transactions of other market participants? I have a feeling that Alea’s right, and they are. Which means that Roubini and Buiter might well be understating the systemic consequences of a Bear Stearns failure.

I have a feeling that it also might provide another reason why JP Morgan might want to buy Bear Stearns. If Bear is a major JPM competitor on the clearing front, then this could be a nice way for JPM to sew up a very large chunk of a lucrative market with extremely high barriers to entry.

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Did the Fed’s Bear Bailout Prevent a Stock-Market Panic?

Willem Buiter explains today why he thinks the Bear bailout was unwarranted. I apologise for quoting at some length, but believe me, it’s a lot shorter than the 2,150-word blog entry:

While the Fed, like any public institution, should support institutions and arrangements with public goods properties, like markets, it should not as a rule support private businesses, even when these private businesses are misleadingly called financial institutions. The Fed should support individual businesses only if failing to do so threatens serious negative externalities. In the financial field these externalities often are through contagion effects, as in the case of the classical bank run by depositors…

Deposit-taking institutions are deemed to fall into this category because they are an important part of the retail payment mechanism. Other institutions are deemed too systemically important to fail because they play a key role in the wholesale payments, clearing and settlement system.

Finally, some institutions are provided with liquidity on non-market terms or bailed out when they are insolvent because it is feared that their failure would trigger a chain-reaction of contagion effects. Fear and panic would spread through the markets and first illiquidity and then insolvency would threaten institutions that would have remained both solvent and liquid but for the failure of this ‘focal institution’.

How does Bear Stearns line up according to these three criteria for special Fed attention? Bear is not a deposit-taking institution. It plays no role in the retail payment mechanism and is of no significance to the proper functioning of the wholesale payments, clearing and settlement system…

Since Bear Stearns is not a deposit-taking institution, and appears to be of no other systemic significance, there is no need for a special resolution regime of the kind managed by the FDIC for troubled deposit-taking institutions. The firm could have been left to go into receivership.

If the Fed fears the risk of contagion effects and financial panic, it could have requested the nationalisation of the investment bank. This should have been done at a zero price. The existing shareholders could, if the US government were feeling generous, be granted the privilige of claim on whatever value is left after all other creditors have been paid off.

While I have a certain amount of sympathy for this tough-love approach to the banking system, in the end I’m quite glad that Ben Bernanke and Tim Geither, softies that they are, went down the route that they did. Not because I think Bear’s shareholders deserve their $30 per share or whatever they’re going to end up receiving, but rather because of the sheer amount of wealth that could have been wiped off the stock and bond markets as a result.

It turns out, you see, that every mom-and-pop stock-market investor is actually, and rather unwittingly, taking investment-bank default risk. Which is why it’s nice to have a Fed on the lookout for them. So far, retail stock-market investors haven’t panicked; let’s try and keep it that way, shall we?

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Whither Bear’s Chinese Billion?

Heidi Moore has the understatement of the day:

CITIC has not yet closed its proposed investment in Bear, and today’s moves suggest that will be more difficult.

Er, yes. Not least because at today’s closing price Citic’s proposed $1 billion investment in Bear would buy 24% of the company, and it’s not allowed to breach the 10% level without US government approval. My feeling is that at this point the agreement is toast: for one thing, there’s no way that Bear itself is going to find $1 billion to invest in Citic, as per the original plan.

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The Death of the Moral Hazard Play

Brad DeLong has a good point today: whatever happened to the moral hazard play? It’s an easy enough game: if you think a bank is going to get bailed out, you go long, safe in the knowledge that Ben Bernanke will throw enough money at the problem to make you whole.

And so Brad looked at Bear Stearns trading below book value, and said that’s a buy, it’ll get its bailout. And he was right on the bailout and utterly wrong on the buy.

Which raises an interesting question. If you believe in Helicopter Ben riding to the rescue with Wagner playing in the background, or some equally mixed metaphor, what do you buy?

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How to Privatize Fannie and Freddie

Matt Cooper has a column in the April issue of Portfolio advocating the privatization of Fannie Mae. The big problem is how to do that: for all that the US government repeatedly reiterates that there is no federal guarantee, no one believes them. And Fannie already has a stock-market listing, so the IPO route clearly doesn’t work.

I asked Matt about the practicalities of his proposal, and he pointed me to a 2004 paper by Bert Ely entitled "How to Privatize Fannie Mae and Freddie Mac". If Cooper’s proposal piques your interest, this should definitely be your next stop. It’s not easy, and it’ll take a few years, but it can be done. As a bonus, the plan involves a way of incentivizing banks to set up "mortgage holding subsidiaries" which would be more attractive than the securitization route which fuelled the subprime bubble. It’s tantalizing to think that if Ely’s proposal had been acted on, we might not be in our present mess at all.

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The Bear Facts

Are here.

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Liveblogging the Bear Stearns Conference Call

12:56: It’s over. They put on a brave face, and clearly tried to indicate that they’re profitable, they have high-quality collateral, and they’re looking out for shareholders. It didn’t seem to help the share price, though.

12:55: "This is a bridge to a more permanent solution." The strategic alternatives "can run the gamut," says Schwartz, it’s not clear what that means: what options does he have beside an outright sale?

12:50: The conference-call technology doesn’t seem to be working too well, but we’re getting through the questions. Bear’s planned backstop liquidity facility "will be in the market probably next month, unless we do something different before then". OK. But the JPM facility announced today should be enough to meet any liquidity needs. They say. They also say there’s "no material changes in the various liquidity ratios", the change is that counterparties weren’t willing to provide financing against "relatively liquid" collateral.

12:48: The book value is fundamentally in the mid-$80s. The share price is fundamentally in the mid-$30s.

12:46: Guy Moskowski of Merrill wants to know where the liquidity crunch came from. Molinaro defends Schwartz’s CNBC interview earlier this week, saying the liquidity situation was just fine, then. So I guess the TSLF wasn’t devised to be a Bear Stearns bailout device.

12:44: On to the Q&A. Karen Morley of Blackrock, wants to know about gross derivatives exposure. Sam Molinaro doesn’t know.

12:43: He’s comfortable with first-quarter results, but at this point the first quarter is ancient history. "We are going to be continuing to pursue some of the alternatives we’ve been talking about". In other words, we really want to sell the company.

12:42: He’s been shopping the firm around already, Lazard has had a mandate for a while!

12:41: "A lot of people wanted to get cash out. We were meeting those needs in every case, but they accelerated yesterday, especially late in the day, and we recognized that at the pace things were going, there could be demands which would outstrip our liquidity resources".

12:40: Alan Schwartz, CEO, is up. "We attempted to try to provide some facts, but the rumors intensified". Obviously rumors beat facts.

12:39: Sam Molinaro, CFO, is on. The Q1 earnings are now being released on Monday, after the close.

12:38: Elizabeth Ventura from IR gets on. "Our actual results could differ materially," she says, from what the executives are about to say. No shit.

12:37: It’s started!

12:35: A live operator! Name, company, phone number, and then it’s back to the hold music. I guess we always knew this thing wasn’t going to start on time.

12:30: The conference call is meant to have started, I’m being asked to "please stay on the line for the next available operator". No sign of the webcast we’ve been promised.

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Bear Stearns Could Go Bust

So, those liquidity rumors? Turns out they were true – or, at the very least, self-fulfilling. The official statement from Bear Stearns CEO Alan Schwartz:

Bear Stearns has been the subject of a multitude of market rumors regarding our liquidity. We have tried to confront and dispel these rumors and parse fact from fiction.

Amidst this market chatter, our liquidity position in the last 24 hours had significantly deteriorated. We took this important step to restore confidence in us in the marketplace, strengthen our liquidity and allow us to continue normal operations.

The attempt to prop up Bear is interesting: basically, the Fed is lending money to JP Morgan, who in turn is lending money to Bear Stearns. JP Morgan Chase is a commercial bank (Chase Manhattan), which gives it access to Fed facilities investment banks don’t get to use. But it certainly looks as though JP Morgan is taking on Bear Stearns credit risk, despite its statement that "it does not believe this transaction exposes its shareholders to any material risk."

(Update: according to Barry Ritholtz’s excellent liveblog of the Bear meltdown, in fact it’s the Fed, and not JPM, which is taking on the Bear credit risk.)

Why couldn’t Bear use the Fed’s brand-spanking-new TLSF, which is open to investment banks? Because it’s not active yet: it doesn’t go live until March 27.

Shareholders in Bear Stearns are far from reassured: the stock is plunging today, last seen below the $40 level. (Update: Now below $30.) Clearly the market thinks the problems are bigger than mere illiquidity: they’re worried about Bear’s solvency. As a commenter wrote here yesterday, if Carlyle Capital can be wiped out, so can Bear. While Carlyle’s leverage was enormous at 32x, Bear’s is actually even larger, at 33x. And that’s valuing Bear’s assets as of the end of 2007; those assets have surely deteriorated in value since then.

So make no mistake: Bear’s very survival is on the line here. Bear is a large Carlyle creditor, to the tune of $1.7 billion: that can hardly help either its liquidity or its solvency. But it’s not curtains for the bank quite yet, says Richard Beales of Breaking Views:

Bear is, of course, much bigger, its assets and revenue sources are more diverse, and its financing is not as concentrated in short-term repurchase arrangements. That makes it much less vulnerable even if creditors suddenly demand more collateral – the margin calls that exhausted Carlyle Capital’s limited supply of cash.

But Bear’s relatively small size and its focus on the US mortgage market – where the rot that began in subprime loans is now permeating even the safest loans – makes it an obvious early target for other banks’ repo desks and credit committees bent on cutting credit exposures across the board, and consequently for investor concerns.

The market is a brutal place, and once the sharks smell blood, that’s often the beginning of the end. This is the right time for a deep-pocketed savior to swoop in and buy up one of the most storied names in investment banking on the cheap: unless it has a creditworthy parent, it’s hard to see how Bear Stearns can operate as a bank when no one really believes in its credit.

In the absence of such a white knight (a/k/a the "strategic alternatives" that Schwartz is talking about), the immediate future for Bear seems fraught. That said, however, Bear’s credit default swaps have actually tightened this morning, by about 150bp. That could be because of the credit line, it could be "profit taking". My guess is that the credit markets are happy to see the equity taking the first and most serious blow. The Fed is likely to ensure that Bear’s creditors get paid in full; it has no interest in protecting Bear’s shareholders.

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John Mack: Overrated

Dan Colarusso takes his stiletto knife to John Mack today, and I’m very happy he did. As Dan shows, Mack has a long history of pulling defeat from the jaws of victory, and it’s far from obvious why he’s the best person to run Morgan Stanley. The stock has lost more than half its pre-credit-crunch value – a much bigger drop than at arch-rival Goldman Sachs – and Mack doesn’t seem to have the strategic vision to turn things around.

This chart says it all, really: it compares Morgan Stanley’s share price to that of Goldman Sachs and the S&P 500 over the past two years. The S&P is basically flat; Goldman is in nice positive territory. But Morgan Stanley has plunged into nasty negative territory.

John Mack has an outsize reputation, but he’s rarely delivered on it. At the very least, it’s time for him to step down as chairman, and hand the job over to someone who can help out on the big-picture strategic side of things.

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Google: Not Buying the New York Times

Russ Mitchell has a must-read interview with Eric Schmidt in the April issue of Portfolio. It gets off to a cracking start, with Schmidt saying that a combined Yahoo-Microsoft would have "certain applications–like instant messaging and email–that could be used essentially to break the internet". And there’s lots of other cool bits in there:

  • Schmidt says Google could do well in a recession: "There’s evidence that more-measurable advertising does better than unmeasurable advertising during a slowdown." I buy that: indeed, I listed Google VP Omid Kordestani as one of the winners in the event that things went south.
  • Schmidt also has a good reason for Google not to buy the New York Times: "We’d be picking winners," he says. "Our principle is providing all the world’s information." But there’s also a hint of arrogance in his answer when he says that "we’d be disenfranchising a potential new entrant."
  • And he’s even – I hope you’re sitting down for this one – nice about Verizon.

    Verizon has shown a commitment to open access. It concluded that it was good for Verizon’s customers. The senior leadership of Verizon actually visited Google to talk to us about this and make sure they got it right. And I think it’s great. I wish everybody else would open up their networks.

I’ve always liked Schmidt; hiring him was probably the smartest/luckiest thing that Larry and Sergey ever did. Normally I don’t buy in to the Great Man theory of CEOs, but given how many technology companies have underperformed their promise, Google’s success is really quite astonishing, and I do think a lot of that is Schmidt’s doing.

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The Prius Conundrum

Dan Ariely asks why people are more willing to shell out for a Prius than they are to spend a similar amount of money to save much more CO2 by making their houses energy-efficient. And I think a large part of the answer is connected to the popularity of 2/1 and 3/1 ARM mortgages.

If you’re going to do things like install energy-efficient appliances and well-insulated windows and solar panels and so on and so forth, you’re going to worry about the cost, which will be earned back over the years in lower energy bills. If you’re not going to stay in your house for very long, you might end up negative. And there’s really no way in which a house with energy-effiencent appliances is going to be more valuable than one without them.

One of the causes/effects (I’m not sure which, it’s probably both) of the housing boom was that homeownership moved from being a decades-long thing to being something with a much shorter time horizon: often just the two years after which you could sell your house without paying capital gains tax. Parents would buy apartments for their kids to live in while going to university; newlyweds would buy houses which were too small for the families they were planning; and, especially in New York, people would buy unsuitable apartments they didn’t really like just for the sake of getting one foot onto the property ladder and the hope that they could trade up in a couple of years.

When people took out 3/1 mortgages, they didn’t worry about the resets often because they had no intention of staying in their house for the full three years. And in that kind of context, home improvements which only pay back over the long term are much less attractive: it’s the people you sell to who will get most of the benefit with none of the cost.

This is one of the pet peeves of Amory Lovins: while it makes sense from a simple economic perspective to install these energy-efficient devices, any one actor, in reality, has little incentive to do so. The plumber won’t use wide-gauge pipe because it’ll make him seem overpriced. Landlords, renters, contractors, homeowners – all end up concentrating much more on up-front costs than on net present value.

So why is the Prius a success? Well, for one thing, it isn’t, really, not outside Berkeley: it accounts for a tiny fraction of cars sold in this country, and the US as a whole has atrocious gas mileage. And it turns out that insofar as the Prius is a success, it’s a success precisely among the small class of people who don’t tend to concentrate on up-front costs. And even they won’t buy a Prius unless and until they need a new car; windows wear out much more slowly than cars do.

This is really why we need a carbon tax, or a cap-and-trade system, or some other way of using a market mechanism to somehow provide incentives to jump on to the energy-efficiency bandwagon. If there’s money in it, someone will invent a way to arbitrage people’s discount curves. And with arbitrageurs comes efficiency.

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Extra Credit, Friday Edition

Credibility and public borrowing: "Forecasts for public borrowing have always been subject to huge margins of error. There’s a rule of thumb, which dates back at least as far as Nigella’s dad, which says that the average error is 1% of GDP for each year of forecasting horizon – for both Treasury or private sector forecasts. "

Oil is Priced in Dollars: It Doesn’t Matter: Dean Baker has more patience for reiterating this than I do.

Markets in Everything: Adam Smith’s House

The Fed May Run Low on Unconventional Ammo

Grossly distorted picture: GDP vs GDP per capita.

Unintended Consequences: Fed Kills Carlyle

The Twittering of Ben Bernanke

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The Price-to-Book League Table

It’s not just Bear Stearns which is trading below book value. Here are some closing prices from Yahoo Finance:

Bank Price/Book
Countrywide 0.19
Bear Stearns 0.73
Wachovia 0.74
Citigroup 0.93
JP Morgan Chase 1.06
Lehman Brothers 1.12
Bank of America 1.15
Morgan Stanley 1.44
Merrill Lynch 1.53
Goldman Sachs 1.60

Can someone explain to me why it makes sense for Merrill Lynch to be trading on twice the price-to-book ratio of Bear Stearns?

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Off-Target Reporting

A lot of people are very worried about credit card debt right now: there’s a feeling that it might be the next shoe to drop, now that people can’t use home equity to pay off their plastic. So you can imagine my surprise when I found out this morning that credit-card receivables are being sold at twice their expected value:

Discount retailer Target Corp. said it is in talks to sell a half interest in an $8 billion credit-card portfolio for $4 billion, twice as much as analysts had expected, to an "investment partner" that it wouldn’t identify…

In January, analysts forecast a sale would garner about $2 billion, if it went through at all. Credit-card companies have run into trouble as the economy continues to worsen, leading some to doubt an attractive deal was possible.

Except, it’s not that analysts expected the half-interest to go for $2 billion, as this story implies. In fact, Target isn’t selling its loans at a premium at all, as the Bloomberg story makes clear. The "twice as much" doesn’t refer to the price for the half interest, it refers to the proportion of the total loans being sold. If anything were to have sold for $2 billion, it would have been a quarter interest, not a half interest.

If the WSJ had modified the "half interest" part of their lede, as opposed to the "$4 billion" part, there wouldn’t have been a problem. To be fair, these things are always easier to spot in hindsight. But still, one expects better from the WSJ.

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Crazy Like a Bear

Bear Stearns stock first traded this week at $70.28 a share. Earlier today it was at $50.48 a share: basically a $20 drop in the space of three and a half trading sessions. Right now, it’s at $54.68, which puts it down 22% so far this week with all of tomorrow still to come.

Meanwhile, notes Paul Murphy, the five year CDS has gapped 120bp to 700bp, which is not the kind of level any bank wants its CDS trading at. And all this on strenuously denied rumors that Bear might be suffering from liquidity problems. If you believe the official story, Bear’s a screaming buy at these levels: its price-to-book ratio is just 0.73.

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What’s Missing in Paulson’s Report: Regulatory Consolidation

Looking over the full report from the President’s Working Group today, I’m struck by one thing above all: that it makes no mention of the alphabet soup in Washington which enabled regulatory arbitrage and a general lack of accountability or transparency. As no less than Tim Geithner said last week:

The regulations that affect incentives in the U.S. financial system have evolved into a very complex and uneven framework, with substantial opportunities for regulatory arbitrage, large gaps in coverage, significant inefficiencies, and large differences in the degree of oversight applied to institutions that engage in very similar economic activities…

We need to move to a simpler framework, with a more uniform set of rules applied evenly across entities involved in similar functions, and a more effective balance of regulation and market discipline. And institutions that are banks, or are built around banks, with special access to the safety net, need to be subject to a stronger form of consolidated supervision than our current framework provides.

The Working Group report, by contrast, repeatedly talks in a vague, hand-waving kind of manner about "regulators" as though there’s no problem there at all. Here’s a taster of the kind of language used:

Federal and state regulators should strengthen and make consistent government

oversight of entities that originate and fund mortgages…

State and

federal authorities should coordinate to enforce the rules evenly across all types of

mortgage originators…

Overseers of institutional investors (for example, the Department of Labor for

private pension funds; state treasurers for public pension funds; and the SEC for

money market funds) should require investors (and their asset managers) to obtain

from sponsors and underwriters of securitized credits access to better information

about the risk characteristics of such credits…

Supervisors of global financial institutions should closely monitor the firms’

efforts to address risk management weaknesses, taking action if necessary to

ensure that weaknesses are addressed…

U.S. banking regulators and the SEC should promptly assess current guidance…

Regulators should adopt policies that provide incentives for financial institutions

to hold capital and liquidity cushions commensurate with firm-wide exposure…

It goes on and on like that for 5 pages of recommendations. Regulators this, supervisors that, with no names named and no indication that these regulators and supervisors have clearly failed at all this and that there might be something broken which needs fixing on the regulatory side of things.

This was why it took an Eliot Spitzer to come along and bash some heads together: the existing regulators (OCC, OTS, SEC, FDIC, NY Fed, NCUA, CFTC, etc etc etc) were a mess. Some institutions had far too many regulators; others, essentially, had none. And no one had any desire to prosecute financial institutions which were misbehaving. If the current system remains in place, does anybody seriously believe that "supervisors of global financial institutions" will be any better at monitoring "risk management weaknesses" than they have been up until now?

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Steve Schwarzman Takes a Pay Cut

Talk about adding insult to injury. Not only have Steve Schwarzman’s Blackstone shares plunged since its IPO, knocking billions off his net worth, but the firm has also cut his annual pay to less than $1 million per day.

Stephen Schwarzman received $350.2 million in cash distributions last year, a 12% pay cut from 2006, when he received $398.2 million in cash distributions.

At that rate, he’s going to have to work through the morning of April 14 this year just to earn back the $100 million he’s donated to the NYPL. Still, on April the 15th he can still celebrate the fact that he’s only paying 15% tax on his "carried interest".

As for Schwarzman’s claim that he pays 36% of his income in taxes, it’s worth remembering that New York city and state taxes alone run at 11.34% for a man in Schwarzman’s tax bracket. Which means his federal tax rate is a maximum of 25%, and could be much lower depending on what other taxes Schwarzman might be including in that 36% figure.

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Fuel Datapoint of the Day

Steven Mufson reports on rising gas prices:

Gasoline rose to a nationwide average of $3.246 a gallon for regular unleaded. Diesel, which has been setting records almost daily for the past three weeks, hit a nationwide average of $3.876 yesterday.

Which means that diesel is now 63 cents per gallon more expensive than regular gasoline. I don’t have a graph of the diesel-gasoline spread, but I’d guess that’s at or near all-time highs; it wasn’t so long ago that diesel was cheaper than gasoline.

Mufson reports that "more and more Americans are driving cars that use diesel because they get better mileage," but that trend is unlikely to stay strong for long if diesel is 20% more expensive than gasoline. The calculations can get very technical, and involve resale values as well as fuel-economy considerations, but with today’s fuel-injection technology it’s unlikely you’ll find a diesel-powered car which gets 20% better mileage than the equivalent gasoline model.

Why is diesel more expensive than gasoline? Here’s the official answer, from the Energy Information Administration:

Until several years ago, the average price of diesel fuel was usually lower than the average price of gasoline. In some winters when the demand for distillate heating oil was high, the price of diesel fuel rose above the gasoline price. Since September 2004, the price of diesel fuel has been generally higher than the price of regular gasoline all year round for several reasons. Worldwide demand for diesel fuel and other distillate fuel oils has been increasing steadily, with strong demand in China, Europe, and the U.S., putting more pressure on the tight global refining capacity. In the U.S., the transition to low-sulfur diesel fuel has affected diesel fuel production and distribution costs. Also, the Federal excise tax on diesel fuel is 6 cents higher per gallon (24.4 cents per gallon) than the tax on gasoline.

What that means for the diesel-gasoline spread, I have no idea. But don’t expect to see the US becoming a Europe-style land of diesel-powered cars any time soon.

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Carlyle Deserved to Collapse

Should Carlyle Capital be aggrieved that its lenders are seizing its assets? There is a case to be made – and it’s made quite well by Robert Peston – that this is all the fault of the Fed and its new TSLF facility. Rather than dump Carlyle’s assets, the banks can use them as collateral at the Fed’s new window, and get lovely liquid Treasury bonds in exchange: something Carlyle can’t do itself.

So maybe Carlyle got unlucky, in that it might have been able to negotiate something with its lenders had the TSLF window not been in existence. On the other hand, Carlyle was clearly the architect of its own unluck, as would be any insolvent fund with 32x leverage. No one has any business taking on that kind of leverage in this kind of market, and efficient markets demand that when such outsize bets sour, the bettor collapses.

In any case, Carlyle is now in default on $16.6 billion in obligations: that’s a huge default, even if recovery value is going to be very high indeed. And it’s yet another striking datapoint for whomever is going to write the history of this credit crisis.

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Moody’s to Rerate Munis

Laura Levenstein of Moody’s says that she’s going to start rating munis on the same scale as corporates. Alistair Barr reports:

"Moody’s recognizes that the municipal bond market has evolved, and with it we have taken steps to respond to the changing needs of investors and issuers," she said in prepared testimony to a congressional committee on Wednesday.

Moody’s and other agencies currently use one system for rating muni bonds and another for companies, sovereign issuers and structured finance. However, recent studies have shown that muni bonds default less than corporate bonds and much less than structured securities such as Collateralized Debt Obligations. The mortgage crisis has shed harsh light on such differences.

The different scales mean that it’s more difficult for municipalities to get an AAA rating. Rating them in the same way as corporations and countries will likely mean a lot of muni bonds will probably be upgraded.

I’m not clear what Barr means here by "other agencies"; S&P has said that it only has one ratings scale. But if Moody’s upgrades a lot of munis, then there will be some big discrepancies between the Moody’s and S&P ratings, which currently tend to be identical or at least within a notch of each other.

Of course, in taking this action Moody’s risks upgrading a large number of bonds just as their risk of default is rising. Let’s hope they don’t end up with even more egg on their face than they have already.

(Thanks to Jesse Eisinger for the tip.)

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Should the US Government Buy Bank Equity?

David Wessel has been hanging out with Myron Scholes, who wants the US government to start buying equity in US banks. Yikes!

Should the government (the U.S. government, that is, not foreign governments’ sovereign wealth funds) put capital into banks?

"I think they should be considering it, at least thinking about it," Mr. Scholes said. "It seems to me that recapitalizing these entities would give us an opportunity to preserve the assets — as opposed to dissipating their value through liquidation or foreclosure — and provide a way for more capital to be infused into them without destroying value." …

Mr. Scholes’s solution: Let government invest both in debt senior to existing debt and in preferred stock senior to existing shares. Neither is advantaged versus the other. The bank doesn’t dump assets and expands lending. If all goes well, the government gets out with a profit. One big caveat: This works only if assets truly are worth more tomorrow than they’ll fetch today.

I think Scholes is a little bit behind the curve here: the government is already investing in "debt senior to existing debt". It’s called the TSLF, it’s the Fed’s newest and shiniest toy.

As for the senior equity, I guess that what Scholes has in mind is something a little bit similar. The Fed would put up $100 billion, say, which would be available at equity-like rates, maybe 8% or 9%, to any bank wanting to issue a perpetual bond. (Perpetual bonds can be considered senior equity.) The bonds would be puttable back to callable back from the Fed at any time.

Doing it that way might deal with Hyun Song Shin’s objection that injections of government capital risk bailing out existing equity holders: if the government ends up losing any of its money, then existing equity holders would be wiped out.

I’m personally not convinced that extending unsecured credit to banks is a particularly smart way to go, especially not when there still seems to be appetite in the capital markets for bank capital securities. (See SocGen.) Still, if things continue to deteriorate, there is a chance that desperate times will require desperate measures.

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Paulson Seeks to Prevent Future Crises

We’ll get all the details later this morning, but judging from Damian Paletta’s curtain-raiser in the WSJ, Hank Paulson has some pretty good ideas about shoring up the US financial system and ensuring that a crisis like the one we’re going through won’t happen again. Of course, no crisis is exactly like the last, so the chances that we’d get a second

crisis like the one we’re going through were always pretty minimal to begin with. But still, the changes are overdue and generally a Good Thing.

None of the ideas are particularly surprising; some of them were in a speech Paulson made back in October. Regulating mortgage brokers and lenders is long overdue, and as I’ve said before doesn’t even go far enough: brokers should be given a fiduciary duty over their borrowers. But it’s certainly ridiculous that banks operate under a massive system of regulatory oversight, while mortgage lenders are essentially unsupervised.

Paulson also feels that the fiction of a single ratings scale has outlived its usefulness: there should be separate ratings scales for plain vanilla credit and for structured instruments. (And, maybe, for munis, too?) If a ratings agency rates an asset-backed security, he wants the agency to scrutinize the underlying loans more carefully: that too is surely a good idea.

And if you thought Basel II had any chance of getting implemented across the US any time soon, think again. Which also makes sense: it’s been tested by this crisis, and parts of it – the bits relying on banks’ internal risk-management systems, or on triple-A ratings – have been found to be too weak.

None of this, of course, will help to solve the present crisis, and nor is it meant to. But there’s never a bad time to strengthen the financial system so it can better weather future crunches.

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