Monday Morning Quarterback: War is Hell
Debt destruction is necessary, but it will pass.
"You cannot qualify war in harsher terms than I will. War is cruelty, and you cannot refine it; and those who brought war into our country deserve all the curses and maledictions a people can pour out. I know I had no hand in making this war, and I know I will make more sacrifices today than any of you to secure peace."
--General William Tecumseh Sherman
History is littered with battles that redefined the global landscape.
Anxiety built, friction manifested, conflict emerged and tensions reached a tipping point.
When diplomacy failed, war was declared.
And that is what we’re now seeing in the financial markets.
This isn’t something one would wish for.
Lives are being destroyed, fortunes lost and the world as we know it will never be the same.
It’s most certainly scary but it’s also nothing new.
War is hell, but it most often passes.
This is an incredible juncture in the history of financial markets, a rebalancing of risk as the cumulative imbalances that built since the back of the tech bubble come home to roost.
We’ve monitored them in Minyanville for the last six years, wondering aloud if they would self-correct as a cancer or a car crash.
That question is being answered before our eyes.
As we define the path to the ultimate destination of debt destruction and price discovery, it’s incumbent on us all to remain lucid.
Don’t get lost in emotion or buried in regret.
Operate in the now, with an understanding of the past and an eye towards the future.
As unpleasant as this process is, it’s a necessary step that must occur before a legitimate economic recovery could ever take root.
I’ve long said that to get through this, we must go through this.
We’re going through it now and as strange as it seems, that’s a positive development in and of itself.
Where to Begin?
Many folks awoke this morning confused as to why Bank America (BAC) would buy Merrill Lynch (MER).
The answer is simple—with Lehman Brothers (LEH) filing for bankruptcy, the derivative dominoes would have toppled directly towards Merrill.
This deal is akin to someone chasing a fuse furiously firing towards a pile of dynamite and stamping it out before it blows up.
It was a proactive step, at least in the context of the widespread denial that permeated since our government told us sub-prime mortgages were contained early last year.
What’s unclear is why they would pay a 70% premium, particularly when the Federal Reserve had a hand in the transaction.
To be sure, few organizations have the capacity to absorb properties at distressed prices and those that efficiently execute will be in a position to prosper when this period passes.
Bank is still digesting Countrywide Financial and it has substantial consumer risk through its 2005 purchase of MBNA.
While this shotgun marriage might make strategic sense on the margin, the outsized premium is the single, biggest overnight nose scrunch.
But Wait, There’s More…
We’ve long offered that the other side of socialization was a false sense of security and the perils of moral hazard. That’s an easy academic debate but it becomes prickly when experienced in real-time.
The death of Lehman Brothers, while tragic and sad, isn’t today’s root cause of concern.
There are hundreds of trillions of dollars in complex derivatives tying the global financial machination together. When a major player can’t pay its counter-party, the seeds of contagion are set.
In addition to the marriage of Merrill and Bank , other avenues of assistance have been explored.
The Federal Reserve widened the collateral it accepts—including equity—and increased the size of the Term Securities Lending Facility from $175 billion to $200 billion.
Additionally, a consortium of ten banks created a $70 billion fund to insure liquidity and help with the resolution of Lehman derivatives.
While this is akin to wounded soldiers setting up a hospital tent in the middle of a battlefield, the hopeful goal is to prevent further industry toe-tags.
Casualties of War
As all eyes were on Lehman and Washington Mutual (WM) last week, we highlighted the big, bad elephant that is AIG (AIG).
American International Group turned down an investment from a private equity group this weekend because it would have meant turning over control of the company.
The alternative strategy? To seek $40,000,000,000 from the Federal Reserve.
It might be “too big to fail” but a Federal reprieve is precisely the perception Hank Paulson and Ben Bernanke are trying to distance themselves from.
They may not have a choice.
The most likely scenario from my perch is the creation of a conservatory not unlike the Resolution Trust Company. The government has already established itself as the buyer of last resort and I expect that role to further expand.
The primary difference between 1989 and now is the finance-based global economy is inextricably linked together by derivatives.
The reaction by foreign holders of dollar-denominated assets will play a huge role in how that process plays out.
It is, in many ways, what we warned of as we watched our Wishbone World unfold in real-time.
The Process of Discovery
A wide chasm remains between equity markets and credit markets.
We’ve offered that one of two things must occur—either credit must improve or equities would trade demonstrably lower.
September is a huge month for credit issuance and further supply looms on the horizon. That’s not good news, particularly as risk appetites abate.
Those who traded through the Asian Contagion, Long-Term Capital, the dot.com implosion and the days following September 11th understand that price discovery is a process rather than a point.
Each was a painful reminder that there are two sides to every trade and risks to every reward.
Our current situation is the culmination those imbalances and the result of years of financial engineering designed to prolong the inevitable.
The business cycle isn’t dead and recession isn’t anathema.
Indeed, the sooner we go through it, the quicker we’ll get through it.
It’s a bitter—yet necessary—pill.
There will certainly be opportunities to prosper for those with fresh powder and preserved capital.
They will exist—and continue to present themselves in both stocks and real estate—as we edge forward through this multi-year malaise.
One Step at a Time
I will again remind Minyans that the only true medicine for what ails the market is time and price. There are no quick fixes or easy solutions regardless of which way the market trades today.
Social mood and risk appetites shape financial markets.
It’s a theme we’ve discussed for quite some time, offering that the 1929 stock market crash didn’t cause the Great Depression, the Great Depression caused the stock market to crash.
The point isn’t to precisely pontificate on the coming price action, it’s to highlight that the period was an era rather than an event. I continue to foresee a few lean years as debt is destroyed and a more sustainable socioeconomic foundation is built.
That’s the bad news.
The good news is what awaits in the great beyond.
The Internet prophecy came to fruition—everything they said the Internet would be has proved true, albeit not without a tech crash.
Globalization will play out much the same way, albeit not without debt destruction.
These aren’t easy days in the world, Minyans, but as my grandfather Ruby used to say, “This too shall pass.”
We’ll get through this and we’ll be better people because of it.
Think positive, operate intelligently and understand that it could worse.
We will find our way through this as we do all else.
May peace be with you.
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Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at firstname.lastname@example.org.
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