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Thursday, March 20, 2008


The Ides of March

The Ides passed over the weekend, and with them went Bear Stearns, apparently, all but given away to JP Morgan Chase for $2 a share. Bear's liquidity fell apart dramatically as clients deserted the firm amid rumors, hedge funds shorted the stock, and even simple repo agreements turned toxic. Ironically, on a going concern basis, Bear was no less healthy than when it was trading at $150, but the combination of a horrible market for fixed income securitizations and the mark-to market regimen for investment banks proved fatal. Maybe the powers that be should reconsider mark - to- market for securities that have no active market. Our financial system would certainly not be under such enormous pressure if some form of amortized cost accounting could be used by investment banks for securities not imminently available for sale.

Still we would be in trouble enough anyway, since it is now very apparent that there has been a massive fraud, not merely a bubble, in the mortgage industry. Driven by fee income, banks and mortgage brokers dispensed with the risk appraisal tools of the trade, such as income documentation, and gave mortgages to all comers, and second mortgages too. The latter tool enabled home buyers to avoid private mortgage insurance even on fully leveraged purchases (the so-called piggy back loans). The Fed was a willing accomplice, inflating the balloon with too low interest rates for too long. Finally, even the buyers were part of the fraud - in too many cases, knowing they would be unable to sustain their purchases and planning to walk away from their homes once they defaulted. So they had virtually rent free homes for as long as they could keep their new homes.

Completing the circle of fraud, mortgage providers packaged the bad loans into non-transparent securities as quickly as possible, obtaining ridiculously high ratings from the ratings agencies as they did. Relying on those ratings, the big national banks and investment banks lapped up the securitizations without really understanding the quality of the loans they were buying. So now, in the midst of the weakest dollar in at least a generation and a looming inflationary spiral, we have deflation in the housing market. Those who predicted declines in home values of 5-10% will find in reality that prices will decline by triple that amount in much of the country. There is no way the economy can hold up in the face of that.

Helicopter Ben is throwing as much money as he can find at this situation, and we have seen a couple of relief rallies as a result. Some are arguing this will prolong the pain in the long run. For the 14,000 BSC employees whose 401(k) plans evaporated and whose jobs may be next, the pain is sufficient already, thanks. I still think that Washington Mutual and a few others will also be taken over at fire sale prices.

Meanwhile, hedge fund performance is all over the place, because their leveraged bets have been huge winners for some, catastrophic for others. When your comp is 2 and 20, you swing for the fences on every pitch. I still say we could see as many as half of those funds fail by the end of the year (their corpses are already littering the field).

A lot of this amounts to a failure of regulation. Hedge funds by definition are unregulated, but that's a problem since their behavior is often predatory as with the ones who shorted Bear and hastened its downfall. The big bank regulators (Comptroller of the Currency and the Fed) are cheerleaders for their regulated companies, not watchdogs. The SEC does a so-so job of protecting investors, but other than issuing traffic tickets to the wirehouses and broker/dealers, there is no effective risk management discipline in place. Rather than blame either political party, this is simply a systemic weakness, and it is largely mirrored across the pond.

Does this mean a depression is looming? I think not. Worldwide demand is simply too bracing. But we could have a pretty severe recession by recent standards, considering how many people are going to be laid off by US companies.

BSC was once on my buy/hold list and for the record, these were my transactions:
10/12/2000 - Bought 100 shares at 52.69
11/15/2000 - Bought 100 shares at 55.38
3/3/2004 - sold 200 shares at 88.05

I took the stock off the buy/hold list because I recognized that too large a portion of Bear's earnings were derived from proprietary bond trading, so I was not confident they would recur reliably. The firm was always under capitalized, and its price to book did not fit my value orientation. It wasn't all that pleasant watching the stock almost double from my sale price, but I feel pretty fortunate now. I still hold preferred shares in my IRA, and apparently Morgan Chase will continue to service them.
Meanwhile, I continued to buy in a down market punctuated by impressive short covering rallies. On 3/12, I bought another 20 shares of Precision Castparts (PCP) at 101, a "zero buy." Monday, I picked up another 100 shares of the plummeting Ceridian (CRDN) at 27.89. Today, it was back to the trough for 400 shares of Limco-Piedmont (LIMC) at 5.42. All of these went to the IRA. I haven't sold anything since taking BRLI off the buy list on January 2nd, but we are getting close to reducing cash to the 20% target. Since Lindsey Manufacturing (LNN) skyrocketed this week, we could pare that holding back or maybe high flying Axsys Technologies (AXYS).

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