Will Bear Stearns “Clean out the Garbage?”
As usual, Barry Ritholtz has been setting the table with a number of interesting questions. We shall try to catch up.
Today he points out a forecast he made months ago about a possible transition at Bear. Here is the key argument:
I thought it was worth sharing. Over the summer, I had said:
“Just
wait until Jimmy Cayne gets dinged out of Bear Stearns. The new CEO
will look at all the junk on the books – problems he had nothing
whatsoever to do with – and likely say ‘Get all this shit off of
my books. All of it. I don’t care what it cost, I don’t care what its
worth, I want all this garbage outta here.’ ”That’s
only the beginning. There’s a danger is that these sales will further
reveal the mark-to-model as the fairy tale it is. Even more ominous, it
will force other houses carrying this junk to price them
realistically. That could lead to some even larger write downs then we
have seen so far.I suspect that the finance sector still has lots of work ahead of it . . .
We agree that this is the normal behavior for a new CEO, but let us take a closer look. In another astute commentary Barry notes that Merrill Lynch hurt themselves by calling in Bear collateral, forcing a "fire sale" of CDO’s.
This was a great observation. Has anyone learned anything?
FAS 157
There was a lot of buzz a few months ago about the impact of FAS 157. Many pundits expected a bunch of confessions that week. We pointed out that this was a misreading. Many banks were already in compliance. Many of the holdings in Level 3 were rather ordinary interest rate swaps that were not trading. Those who took the total of Level 3 holdings and multiplied by some huge discount were not doing a fair analysis.
The key element of FAS 157, as Barry correctly notes, is that when something starts trading, it must be moved from Level 3 to Level 2, with the trade value assigned. This is the most important point to understand about FAS 157, not the misleading November 15th date.
The Effect of a Fire Sale by Bear
If Bear were to blow out these positions at distressed prices, it would indeed have a ripple effect on others holding similar paper. Such a move would not reveal a "fairy tale" in modeled prices as Barry suggests. The trade price would be the fairy tale, as he himself suggests. It would be a below market price. Such pricing would lead to further write downs at prices that do not actually reflect an accurate value for the holdings.
There is an alternative viewpoint that the current market marks on mortgage holdings is well below the actual value. In fact, this is why many banks have chosen not to sell the paper, but instead to take it on their balance sheets. This move has been supported by the Fed’s TAF initiative, allowing many more banks to borrow against these holdings.
Conclusion
While we agree with the general spirit of Barry’s analysis, especially since it was originally offered in August, we wonder if it makes sense in the current environment. Our own take is that this paper includes many performing loans and that holders are resisting a sale at inferior prices. [looking for more links, since many will not agree with Ben Stein on tonight’s Kudlow.]
We believe that Alan Schwartz will be sufficiently astute to appreciate this situation, as will potential buyers.
Few seem to consider that this paper has been marked down aggressively. The prices represent distress sales in illiquid markets. What if the loans perform better than the current marks?
