True to our prediction in 2007, the credit crisis in America has now taken center stage as the underlying problem in the economy. Although the sub-prime mortgage crisis remains a symptom and has exponentially grown many new symptoms are also now working their way through the economy, e.g. syndicated loans, conduit debt obligations, leveraged buyouts, student loans, commercial real estate credit, hedge fund credit and state and municipal government debt as well as governmental budget deficits to name a few are all reeling from the loss of confidence in the credit markets. The issues are rooted deep and the creativity and greed of Wall Street has taken the problem to new heights by creating new credit products outside the purview of the Federal Reserve System and the Securities and Exchange Commission leaving more room than ever for greed to run wild in the mischief of creative minds. Credit default swaps and derivatives are a little understood market which is immense in comparison to the entire market capitalization of the New York Stock Exchange. Over forty-five trillion dollars in these contracts are outstanding.
Many of the looming problems are yet to unfold. A few of those will include the decline in income at local governmental levels, a potential of a derivatives crisis, and the unraveling of the hedge fund industry and bankruptcies in the financial sector.
One recent example of of this is the Bear Stearns debacle. The firm dominated the sub-prime mortgage business and was totally committed to their business model. Their President, James Cayne, took a $382 million bonus in January of 2008 and played bridge in a tournament the weekend the firm unraveled and was sold through a rather unconventional transaction forced through the Federal Reserve to J.P. Morgan for $220 million dollars. Their market cap the Friday before was $3.54 billion. Does something seem not quite right here?
The Fed bailed out Bear Stearns – there was no bankruptcy – no shareholder’s vote – no creditor’s rights – no open set of books so the whole story will never be told.
The why is simple. The Fed wanted to stop the hemorrhaging somehow and maybe for now they succeeded but the cost of this approach is much greater than meets the eye. Bear was an absolute leader in high risk leverage. On the day that they were sold, they had $33 in debt for each dollar of equity. In other words, they deserved to collapse and if every household in America acted as they did, they all would collapse as well. J.P. Morgan deserved a bargain. After all, they agreed to assume the debt and fulfill these obligations. The problem is the Fed also put their balance sheet and reputation on the line. This process opened the door for greed to once again set in and as a result the Bear Stearns sales price has been re-set to four (4) times the original amount and it is still being negotiated. The deal reeks of collusion and government bailout and perhaps, worst of all, sends a message to the large institutions of “why bother running their business with conservative prudence. After all, the Fed will bail us out if all goes wrong anyway”. Bear deserved to go bankrupt and send a message to the financial community that if you take on leverage of thirty-three (33) times your equity, no one is going to bail you out.