Neil Dwane comments on Bear Stearns' collapse, the wider implications for the investment banks and the financial sector as well as the long term consequences.
“What is genuinely terrifying for financial markets is the power of market rumour. Despite being widely quoted in the press and media as saying that they had adequate liquidity and funding, in the space of some 48 hours, many counterparties withdrew their lines of commitment with Bear Stearns, so that by the morning of Friday 14th March, Bear Stearns did have a liquidity and a solvency issue.
“The most important thing here is the speed with which this all happened. Talking to various contacts within the market, one thing becomes clear; you can get talked into going bust in these financial markets.
“The key issue here is deleveraging. We have had an explosion of bank balance sheets over the last decade. According to our banks analysts at RCM, the average leverage inside the equity portion of a bank has gone from 20 times to 40 times in the last decade. However, the return on the assets they have bought over the last decade has basically remained the same at circa 60 basis points. So the reason that the return on equity has gone from 13% to 21% has nothing to do with the improved credit control, risk control or superior management that all the bank managers have been telling us about for the last decade, it is simply because they have doubled up the leverage inside their business.
“Looking ahead, I think what makes this more dangerous than what happened in the Savings & Loan crisis in the late 80's/early 90's in the US, is that there are clearly financial intermediaries who can profit from the doom of the banks themselves. There are people who are short credit, who are short equity, and they can make a lot of money by bringing these banks to their knees. Having taken Bear Stearns to the cleaners, there will now, arguably, be other market participants who may well attempt to ruin others and to make a lot of money as a result.
“JP Morgan taking over Bear Stearns was not a case of maximising shareholder value, it was a case of protecting the industry itself from systemic risk, which was obviously in JP Morgan's interest to do so, and they have paid a very small price for maintaining that stability.
“People will remain very cautious of counterparty risk going forward. If anybody is a weak counterparty, business costs for them and their level of transparency will have to rise, so that the market can be assured that their credit is worthy.
“The moral hazard card, which potentially is stopping the ECB, Bank of England and others from aggressively following the Fed (despite the clear evidence that there are banks in Europe including the UK, which are in as much trouble as some of the banks in the US) is that the prospect of watching the kind of deflation that we last saw in the 1930's in the US and the rest of the world , is clearly significantly worse, than bailing out a few overpaid investment bankers who should have known better.
“We may well see increasing levels of shock and awe in the markets and effectively, the nationalisation of the debts of many of these banks, or potentially, the nationalisation of a lot of these banks, following the model that took place in Sweden in the early 1990's; what we will see as the quid pro quo for that, is that as citizens of these countries we will make it clear that we never ever wish to be put in this position again.
“The longer term returns from the banks will fall and we believe that regulation will rise and arguably the split between investment banking and banking could be reinstated. It will, however, take us a long time to get there. For the financial markets, this is a slow story, with the scenario of some people losing houses, cars, foreclosing on their loans, and not being able to pay their credit card bills. This situation will not clear up quickly, but move incrementally, over the next 6-12 months.
“To give you an example, 35% of Bear Stearns was owned by employees, who held equity; they may have planned to use this for their pension, to pay off a mortgage, etc, but have just lost everything. We know that these situations really hurt, as with other companies like Worldcom in the TMT bust.
“We have to remember that in parts of Europe, in particular in the UK, as well as the US, the biggest growth in jobs has probably been in finance and housing related industries, and we need to remember that many individuals may well lose their financial firepower over the next few years. We could be losing a lot of spending power in some economies, that, given the choice, we would prefer not to lose.
“At RCM, we continue to re-evaluate in what scenarios we would look to buy financial stocks. As we are now viewing this as a bear market, there are an increasingly number of stocks that look very attractive. Our Research allows us to identify companies with strong business models, sound financing, good earnings potential, so that RCM, in a stockpicking driven environment, can produce the best possible returns, even though the market may be producing poor returns.”
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