Five Things You Need to Know: Too Small to Save
The question equities investors should be asking is not which institutions are too big to fail, but which are too small to save.
Kevin Depew's Five Things You Need to Know to stay ahead of the pack on Wall Street:
1. Too Small to Save
The Federal Reserve's Crisis Management Game Plan is simple: prolong and extend the unwind for as long as possible to avoid sharp(er) financial market dislocations. There's nothing fancy or glamorous or particularly intellectual about it; so far, the playbook is virtually identical to the 1930s.
With that in mind, every story quoting a talking Fed Head can be contextualized as an operational piece working toward the scenario of crisis extension and market preparation, nothing more.
The same goes for the chiefs of the banks involved - Jamie Dimon of JP Morgan (JPM), for example, or Merrill's (MER) John Thain. None of these firms adequately prepared for the crisis, so why should we expect their CEOs to be able to navigate successfully through the heart of it, except by accident or happenstance. Those who go back and read the financial press during the Great Depression will see many, many similar pronouncements of optimism and encouragement from doomed financial chieftains... all the way to the end.
The latest piece of groundwork being laid by the Fed appeared on Bloomberg this morning - "Bernanke Tries to Define What Institutions Fed Could Let Fail."
"There is some hard thinking that needs to be done,'' Philadelphia Federal Reserve Bank President Charles Plosser told Bloomberg in an interview last week. "The Fed has a terrific
reputation as a credible institution. We have to be cautious not to undertake things that put that credibility at risk.''
That last part may or may not be true. The question equities investors should be asking is not which institutions are too big to fail, but which are too small to save.
2. The Auction Rate Securities Debacle Explained
We first wrote about Auction Rate Securities at the end of January here: See Five Things Number Three. At that time Bristol-Myers (BMY) was the victim of a $275 million loss related to their investment in Auction Rate Securities. How? Simple, they were using ARS's to pick up a little extra yield for their cash. The problem is that these were supposed to be very liquid short-term securities, when in fact corporate cash managers later learned that the liquidity was very superficial.
The market for ARS's, although large in nominal dollar volume, has always been quite thin, controlled often by one dealer. Under ordinary circumstances, if there are too few bids the dealers would prop up the market by entering to place a final "clearing" bid. Given credit issues that began surfacing late last year, there became far less incentive for dealers to step in, both due to balance sheets constraints and concerns about the quality of the underlying assets.
As one banker involved in the market put it in the Journal earlier this year, "We're not a liquidity provider." What the banker meant by that is they are not required to be a liquidity provider. Of course, the fact that the banks were liquidity providers for that market during the good ol' days may have led some ARS investors to conclude otherwise.
ARS's are not new. For nearly a decade companies have been using them. What's new is the rapid deterioration in the perception of the credit quality of the underlying that began late last year. While the vast majority of the securities in this market, more than 90%, were rated AAA. The problem was that, increasingly, they were simply not trading that way, and at the end of the day that's what matters. The AAA rating is only as good as its perception in the marketplace.
3. Meet the New Models, Same As the Old Models
The computer age helped pushed credit markets into an era of supposedly sophisticated modeling techniques that were presumably able to strip out and isolate credit risk. These models gave investors false confidence that, barring some kind of unforeseen event, the risk of default on credit assets was foreordained. Well, now we have that unforeseen event.
It doesn't take an overactive imagination to reconstruct the gist of thousands of conversations between salespeople and investors about the expected behavior of these models:
Investor: So what's the worst case?
Salesperson: There is no worst case.
Investor: Right, but just suppose...
Salesperson: Ok, the worst case is that if something were to happen, nobody knows what that could be, but just if... then the worst case will be the least of our worries.
Investor: What do you mean, least of our worries?
Salesperson: I mean it would be like jumping out of an airplane without a parachute and worrying about what kind of shoes you're wearing.
Investor: Well, I'm not jumping out of any airplanes.
Salesperson: That's my point. And that's exactly what the models tell us.
4. Me First
An interesting piece in the Financial Times this morning looks at how certain financials firms, notably Morgan Stanley (MS) and Goldman Sachs (GS) are revamping the way they make lending decisions for hedge fund clients, using the market's view of their own credit worthiness as a basis for lending.
"The message is that "if our firm is in trouble, we would rather fund ourselves than fund you [hedge funds]", a brokerage executive with knowledge of the arrangements told the FT.
Morgan Stanley currently ties financing to hedge fund clients to the prices of credit insurance on its own debt. If the cost of the protection rises to certain levels, that triggers a reduction in MS credit to hedge funds, the article said. Goldman is using a similar model with its bond prices as a basis.
5. The Return of Price-Fixing
Think about it, when is the last time you heard anyone discuss "price-fixing" in the mainstream media? That's why we were surprised to run across the following piece in the Wall Street Journal today: "Price-Fixing Makes Comeback After Supreme Court Ruling."
"For the better part of a century, punishing retailers for selling at cut-rate prices was an automatic violation of antitrust law. However, a Supreme Court ruling last year involving handbag sales at a Dallas mom-and-pop store, Kay's Kloset, upended that original 1911 precedent, potentially altering the face of U.S. discount retailing," the Journal says.
From a socionomics perspective, this is right on time.
"State attorneys general are warning that minimum pricing, also known as "resale price maintenance," will feed inflation," the Journal says. Don't worry. No they won't. Although Supreme Court Justice Stephen Breyer, in his dissent in the case cited by the Journal, estimated that legalizing price-setting could add $300 billion to annual consumer costs, that's an overly "optimistic" presumption based on rear-view mirror consumption spending and habits.
As deflation begins to take shape, inflation fears will fade and legislative bodies will face increasing pressure to embrace selective price-fixing to protect small retailers from predatory pricing.
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