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Who Will Be Next Bear?


The good, the bad and the ugly in credit markets.


There are two kinds of people in the world, my friend. Those who have a rope around their neck and those who have the job of doing the cutting.
- The Good, the Bad and the Ugly

The Great Debt Experiment has now morphed into the Great Credit Unwind, and we are asking ourselves how this will all end. My answer has been 'I Don't Know,' as I wrote in my piece last December. The reason for the answer was that I felt (and still do) that the buildup in debt, leverage and derivatives is so unprecedented that the fallout from the buildup should be unprecedented as well.

So while I keep hearing tales of bailouts and a bottom forming in the credit markets, I could not disagree more. In my mind, the unwind has just begun and if anything will accelerate in coming months as more and more companies, mostly financial institutions, will have an incredible need for capital-capital that is needed to simply remain in business. This may sound draconian, but as I have been saying for years, when the unwinding process begins, it will not be pretty.

Forced Marriages: The Good Bank/Bad Bank Scenario

Several weeks ago, I wrote about the balance sheet issues surrounding Bear Stearns (BSC) and Lehman Brothers (LEH). Considering how leveraged these have become, any misstep is magnified and results in a lack of financing, which is critically needed to remain solvent. Simply stated, if your balance sheet is levered 35 to 1, and you have four times as many 'Level 3 assets' as you do capital, you could be in deep trouble if one or more counter-parties decides they don't want the other side of your trades.

This occurred in the case of Drexel Burnham Lambert about 20 years ago, and happened to Bear Stearns two weeks ago. Since all of the major investment banks, commercial banks and hedge funds are so intertwined, the Federal Reserve stepped in and took $30 billion of 'hard to price' securities off the hands of J.P. Morgan (JPM) and let it buy Bear Stearns for a song. Whether or not it'll be able to retain Bear's talented people after giving them $10 per share (down from $160 last year) remains to be seen. Many of these talented individuals could flee to other firms in exchange for large signing bonuses and we still don't know exactly what was on the balance sheet of Bear after the $30 billion of truly esoteric securities were handed to the Fed.

This type of behavior occurred in Japan in the early 1990's after its real estate and stock market bubbles were deflated. The good bank (in this case, JPM) gets a steal while the bad bank (in this case, Bear Stearns) gets the shaft. The question in my mind, however, is how many "good banks" are left to absorb all of the "bad banks"? In a nutshell, I believe the answer is "not enough." In the middle are the "not-so-good banks"-those that are too big to be taken over and too leveraged to play "good bank." I guess they are just stuck in the middle.

Yes, I'm stuck in the middle with you
And I'm wonderin' what it is I should do...
Clowns to left of me, jokers to the right
Here am I stuck in the middle with you.

-Stealer's Wheel

Bad Banks Defined

Without naming names quite yet, what would you think of a company that accomplished the following in 2007?

  • Wrote down book value from $39 billion to $32 billion or from $41.35 to $29.34 per share.
  • Increased shares outstanding from 868 million to 939 million.
  • Increased Treasury Stock from 351 million to 418 million.
  • Increased long-term borrowings from $147 billion to $201 billion.
  • Increased preferred stock issuance from $3.1 to $4.4 billion.
  • Increased Total debt to common equity to 2816.81%.

I could cite 20 or more similar financial ratios and they are all stunning. Who is this firm? Merrill Lynch (MER). This is not a 'market call' on Merrill, although my firm does maintain a position in Merrill options, but this would certainly be considered a "bad bank" in my book. Could it end up in the hands of a "good bank" like JPM? Maybe, maybe not.

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No positions in stocks mentioned.

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