At least four lessons have been learned in the past few weeks that will be of lasting importance to global investors:
1. Lesson 1: “Too complex to fail” is the prevailing US economic doctrine.
The Federal Reserve has decided that while a moderate-sized US investment bank may not be “too big to fail” it can certainly be “too complex to fail.” Thus, the central bank is willing to take unprecedented risks with the taxpayers’ money to prevent such a company from going into bankruptcy.
Normally, the kind of free-market oriented economists that staff the Fed welcome bankruptcy. It is an orderly process for taking capital and human resources away from company managers who have failed and putting it into the hands of other managers more likely to succeed.
But when it comes to large financial institutions operating in the global markets and heavily involved in the payments system, US central bank officials are terrified of the uncertainties inherent in the bankruptcy process. That is because bankruptcy judges have enormous discretion about whether to honor or abrogate contracts. Any large financial institution, even if not among the very biggest, has perhaps hundreds of thousands of contracts outstanding at any point in time. The minute a bankruptcy petition is submitted, no counterparty can be entirely sure whether its particular contracts will be honored or not. Entire markets can seize up until the disposition is resolved. That determination may take months. It is to be avoided almost at all costs.
We found out that this threat was a serious concern of the Federal Reserve back in 1998, when the giant hedge fund Long Term Capital Management, LTCM, nearly failed. The case of Bear Stearns proves that the “too complex to fail” doctrine is still decisive.
2. Lesson 2: Shareholders and employees suffer, but other interested parties are bailed out handsomely, especially bond holders.
Some observers have asserted that Bear Stearns was not bailed out, because their shareholders did not lose their entire investment in the company. But the losses were spectacular, even if the pay-out was at $10 per share rather than $0. No serious stock market investor is going to go near a bank or other financial institution with any likelihood of following in the Bear’s footsteps. Many employees of the company suffered the double indignity of losing a huge chunk of their personal net worth and their jobs, as well.
But holders of Bear Stearns bonds—and the modern equivalent, writers of credit default swaps—came out exceedingly well when an institution of indisputable credit quality, JP Morgan Chase, took it over. In an instant, they became creditors of JPM and the bonds they held went from deep discounts nearly back to par. Conversely, those market players who had shorted the bonds (or, more likely in this day and age, bought default protection in the CDS market) were big losers. The value of CDS protection essentially collapsed, forcing enormous losses on those who had feared the company was heading toward insolvency and who chose the prudent course of buying insurance against that eventuality. In the future, CDS markets will be less of a playground for risk-averse strategies, because they can backfire. That will put more of the pressure on the stock market valuations of troubled financial companies.
Lesson 3: Old myths are extinguished by financial trauma.
It used to be considered fatal for a company to lower its dividend. How could it avoid a punishing reaction in the stock market? Not any more. In numerous instances dividend cuts have been greeted almost with a sigh of relief. During the subprime crisis, almost every sizable financial institution in Europe and the United States has been caught with significant losses. So far these are largely “mark-to-market” losses, but such exposures can easily turn into actual losses if there is any whiff that liquidity problems can lead to forced selling of under-water securities. That makes it almost inevitable that banks will have to raise fresh capital. Getting started earlier, rather than later, is now viewed as a positive by investors. And the cheapest form of equity capital is to use funds that ordinarily would have been paid to existing shareholders, for one reason because there is no investment banking fee to pay.
Lesson 4: Banks are capitalists until they need government hand-outs but will revert to type once the crisis fades.
Ordinary citizens are not surprised that, when free capital markets stopped functioning properly, those firms most deeply involved would run to the Fed seeking liquidity. Common sense tells us that if the Fed (meaning the taxpayer) is going to get involved, the banks better provide data on their exposures. But most investment bankers are already opposing any efforts to toughen the US system of financial regulation once the current crisis fades. However illogical their position may be, it may prevail. Investors beware!
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