“Man looks in the abyss, there's nothing staring back at him. At that moment, man finds his character. And that is what keeps him out of the abyss.”
--Lou Manheim, Wall Street
Following a freaky week that rocked the roots of capitalism, Wall Street is bracing for what promises to be a hectic four-session set.
By now, you’re familiar with the sordid sequence of events that set the current stage. Subprime credit concerns—the same issues that Ben Bernanke and Hank Paulson assured us were contained a year ago—have manifested into a full-fledged financial crisis. In the process, the academic debate whether or not we’re in a recession has shifted to concerns regarding the ability of the capital system to operate at all.
I attended an idea dinner in the Bear Stearns
(BSC) executive boardroom Thursday night with several prominent hedge fund managers and senior executives from Bear Stearns' credit division. We spoke about the world at large, risks in the system, potential opportunities and the correlation of hedge fund strategies. There seemed to be a general consensus that the massive move we’ve been waiting for in Minyanville
as a function of the disconnect between credit and equity is edging ever closer.
When a senior member of Bear Stearns corporate credit team offered that that we were in the fifth inning of the credit crunch, I found myself interjecting with a question. “What do you make of the long bond action yesterday,” I began before realizing I was speaking out loud, “Following the $200 billion liquidity injection by the Federal Reserve, the two-handle rally screamed to me that another shoe is about to fall. What are you hearing?”
The candor of his response was refreshingly surprising. “The story on the Street is that there are major problems at Bear Stearns.” When someone asked if the rumors were true, there was some nervous laughter before he shifted the course of the conversation. I’ve been hearing that chatter for some time. Obviously, it had now found its way into the inner sanctum of Bear itself.
I offered further food for thought that large hedge funds, many of which have healthier balance sheets than the bulge-bracket banks, would eventually buy some of the battered brokers. Those thoughts were met with raised eyebrows and incredulous stares. Ironically, The Wall Street Journal reported over the weekend that Citadel Investment Group was eyeing Bear Stearns before JP Morgan
(JPM) scooped it up for two bucks a share.
The speed in which the confidence and credibility of Bear Stearns deteriorated is astounding. CEO Alan Schwartz said on Tuesday that the balance sheet, liquidity and solvency weren’t issues for the once venerable institution. Three days later, in his words, the “rumors became reality.” We often talk about social mood and risk appetites being key elements of our financial fate. The Bear Stearns saga speaks to this point.
There are two potential scenarios battling for my mindshare as I digest the demise of Bear Stearns, Northern Rock
, Carlyle Capital
, Thornburg Mortgage
(TMA) and a multitude of smaller yet inextricably linked players.
The first is the frightening implications for our finance-based, debt-dependent globalized economy that is woven together by hundreds of trillions of dollars of complex derivatives. We’ve spoken about this repeatedly—from how we got here to the risks of moral hazard to our current crossroads—and the proverbial rubber must now choose a road
If the debt unwind is more pervasive than the tech bubble and real estate mania that preceded it, as I believe it is, the painful and prolonged comeuppance has a long way to go. It’s not a pretty scenario nor is it one that I would like to see come to pass. We must draw the lines of distinction between optimism, faith and hope, however, as the latter matter has never been a viable investment vehicle.
The second scenario is one that would seemingly surprise the most people. Given how crowded the short side currently is in the credit space—and it’s that way for good reason—the potential for a massive trading rally remains a viable possibility. If credit players turn and try to cover at the same time, we could conceivably see a melt up in the equity space.
Throughout my career, “bid wanted” situations have always proven to be an excellent entry point on the long side. We’ve yet to see that in stocks—nor have we seen the type of volatility spike that typically accompanies such conditions—but we've seen it in the credit markets. This past Friday, according to the Wall Street Journal, there were times when major dealers were unable to sell Treasurys.
The other potential upside catalyst, albeit one that's impossible to game and will take time to unfold, is the possibility that FASB 157, the accounting rule designed to force banks to move Level III assets back on their balance sheets
, caused financial institutions to over-compensate in their mark-to-markets. That’s likely a back half of the year story but the perception thereof could dramatically shift sentiment if and when that occurs.
Finally, perhaps the most ironic reason to be on the lookout for a rally is the doom and gloom around the Street. When Minyanville began monitoring the roadmap to ruin last spring, the markets were at all-time highs and we were branded Cassandras. Now, you can’t pick up a paper or turn on the tube without someone calling for the end of the world.
Without doubt, the level at which Bear Stearns was sold will create a process of price discovery as traders attempt to wrap their arms around what financial firms are worth. That will clearly create near-term volatility and with it, tremendous two-sided risk. If you were to ask me last year what it would take to become more constructive in this sector, however, I would have pointed to four primary points.
The first is time and price, both of which have come to pass. The second is analyst recommendations, which have flipped from table-pounding buys to a litany of “sells” and “holds.” The third is sentiment, which is now the mirror image of where we were. Finally, I would have said that a high profile bankruptcy would be needed and Bear Stearns qualifies as such.
It’s important to remember that the Depression was an era rather than an event
. During that period, equities enjoyed rallies that littered hope amongst the throngs of despair. I believe we’re in for a similarly sullen stretch, one that lasts a lot longer than most people think. But that doesn’t mean we can’t rally along the way.
Remember, nobody makes money in true bear markets. Not even the bears.