Monday, March 17, 2008

Delusions of Grandeur - The Link between Bird Poo, Coral and Subprime Mortgages

Why Nauru is like Bear Stearns.

Nauruans were high on the hog on a mix of Bird Poo and Coral until they dug it all up and spent the money on frivolous things. And then along came Kevin Rudd and shut down their last cash cow, the immmigration detention centre with about two refugees and two hundred employees. Cash cow to beat all cash cows.

Nauruans realise that the party is well and truly over.

Now comes the hangover and then, with luck, some sort of recovery. But it will take squeaky clean governance, hard work and rock-solid investments for Pleasant Island to once again live up to its name.

It may not yet be paradise lost, but it is most definitely paradise postponed.

And delusional Bear Stearns employees, who believed that everything would always go up in value lost that bet when their customers smelled the roses.

The deal values Bear Stearns, which has been at the centre of the US mortgage debt crisis, at just $236m (£116m).

Its shares have lost 98% of their value since their high of $158 in April one year ago, when the bank was worth $18bn.

Sometimes life is just not as rosy as we would like to think it should be.

Cross Posted at Adelaide Green Porridge Cafe


  1. Interesting account of an unusual conference call on Sunday evening, in which executives from JPMorgan Chase quickly walked investors and analysts through their $236m acquisition of Bear Stearns, says DealBook on Monday.

    The half-hour call, announced with just one hour’s notice, was aimed at explaining how JPMorgan could justify buying its 85-year-old rival at a 93 per cent discount.

    “This is a good economic transaction for JPMorgan shareholders,” Michael Cavanaugh, the firm’s chief financial officer said in kicking off the call. Cavanaugh was joined by the firm’s co-heads of investment banking, Steven Black in New York and William T. Winters in London. (One person not on the call: JPMorgan’s chairman and chief executive, James Dimon.)

    Cavanaugh, according to DealBook, stressed the importance of the additions that the deal will bring to the banking giant, all bought at what he termed a “reasonable price”. JPMorgan, he noted, has a no material adverse change clause, an escape hatch that allows a buyer to walk away from a deal.

    He added that JPMorgan expects to have a Tier-1 capital ratio of 8 per cent at the closing of the deal, expected to take place by the end of the second quarter.

    In a moment that has now been picked up by bloggers around the world, the brief call was broken up as a Bear Stearns shareholder sought an explanation of why he would be better off approving this transaction rather than seeing Bear file for a Chapter 11 bankruptcy. “The JPMorgan executives demurred,” reports DealBook, “instead referring the investor to Bear Stearns executives for an explanation.

    The shareholder declared he would vote against the deal.

    Undeterred, Cavanaugh and Black later said JPMorgan felt comfortable in doing the deal despite the short due-diligence process. “We’ve known Bear Stearns for a long time,” Cavanaugh said.

    Black followed by recounting a little of the run-up to the deal: JPMorgan sent a team of 200 people to pore through Bear Stearns’ books for two days.

    “We certainly anticipate the market will act differently than it did on Thursday and Friday,” he said.

    And Cavanaugh asserted: “We’re highly confident in our ability to execute here. It makes a lot of strategic sense…The financial logic is compelling.”

    Not according to Felix Salmon at, who writes that one thing which was clear from the conference call is that JPMorgan seems to be “taking Bear Stearns at its word” when it comes to the $84 (ish) book value: CFO Michael Cavanagh said he was “very comfortable with the levels at which Bear Stearns has marked its positions”.

    The discount to book is a function of having to do a complex deal within the space of one weekend, as well as the difficulties of digesting a major investment bank during a period of extreme market volatility. Oh, and the fact that the chances of any other bidders coming along are remote.

    James Hamilton at Numis. I think he sums up the general mood.

    Wave 1 - liquidity, funding and capital strength: See Bear or Northern Rock for details.

    Wave 2 - Tighten lending criteria and pass on funding costs: This has started but the impacts are yet to be felt. We expect prime borrowers to see the cost of their debt increase materially reducing their ability to spend or invest. For the less prime customers expect credit to be removed and where (mortgages) this is not possible expect a move from a discounted rate to SVR (4.5%-7.5%). This will place significant pressure on those least able to afford it increasing defaults and insolvency. Expect forced asset sales and deleveraging impacting asset prices. UK property prices remain 44% over valued we expect them to go to a discount to fair value.

    Wave 3 - Higher impairment, RECESSION lower loan demand and more saving: This is the traditional point in the cycle where banks see profitability decline. The surge in unsecured impairment eighteen months ago was linked to excessive indebtedness (which still remains) rather than the economy which was growing above trend with full employment. The household savings ratio is 3.4%, the 35 year average is 8.1% and the last cyclical peak was in 1992 at 11.7%. This is key to the UK’s economic performance as savings and consumption are inversely correlated and circa 70% of GDP is consumption. A return to the average savings ratio will drive recession with an increase in unemployment corporate and personal insolvency. If this drives the pound to PPP equilibrium 1.62 vs. the dollar inflation will be imported into the UK and this could drive the nightmare scenario where the BoE increases interest rates heading into recession.

    How much is priced in and what is the right investment strategy: We believe that much of the risk is now priced in but in many cases the situation is binary either the stocks are worth double or nothing. Bradford & Bingley (Target price 193p) has a leveraged balance sheet and is exposed to relatively risky assets. Cattles (Target price 215p) is the most exposed to a weakening macro picture. It does have a strong balance sheet (with significant liquidity risk in 2009) and a high ROE but its assets are entirely sub prime. Its customers (40% have mortgages) will be hit hardest by credit tightening, have a propensity not to pay even in good times and have a weak employment track record. Strategically we like HBOS (Target price 1007p) which has a 44% average LTV on its predominantly prime mortgage book, the strongest liabilities franchise of any UK Bank and is being valued at just 1.1x book.

    On the Bear give-away, this is from UBS

    NH: Bear Acquisition = Great Deal for JPM Jamie’s patience, discipline, and “fortress balance sheet” mantra are paying off, as JPM gets Bear Stearns – a decent strategic fit – for very attractive terms. JPM is only paying $2 a share (~$260mm) and is getting a $30bn non-recourse backstop facility from
    the Fed to mitigate some of the risk it’s taking on.
    .. Economic Terms Appear to Be Very Attractive The way we see it, JPM just paid ~$260mm for a company that was thought to have $11bn in tangible book just last week (so 0.03x tang book or 0.25x expected earnings). Considering the transaction-related costs of ~$6bn pretax/~$4bn post tax, we think JPM’s definitely getting paid for the risk & opportunity cost of this deal. The price compensates JPM for the risk it’s taking on, the environment we’re in, and reflects the fact that JPM is one of very few firms that has the ability to take this on (especially over 1 weekend) – right place right time.

    Nice Strategic Fit Too – Filling out Targeted Growth Areas 1) JPM becomes an instant player in prime brokerage without the pain & cost of building;
    2) Commodities: helps the ongoing build-out;
    3) Adds to capital markets platform by retaining select teams (w/o having to also hand out retention bonuses as had been typical of past IB deals);
    4) Additive to asset mgmt & the private bank.
    .. Valuation: Staying at Neutral While we think this is a great deal for JPM and its one of the best positioned banks we can see, given the environment we’re staying at neutral on the shares. Estimates and price target, $43 based on 10x ’09 EPS, are unchanged.

    And from our fabulous analyst, one of the few who predicted this shambles, and received death threats for her honesty, this note from Meredith Whitney

    PM: BSC Fire Sale to Cause Valuation Adjustment for All Financials: Banks at
    Lehman Brothers Holdings Inc.(LEH $39.26)

    BAC(BAC $35.69)
    JP Morgan Chase & Company(JPM $36.54)
    Wachovia(WB $26.54)
    Wells Fargo & Company(WFC $28.45)
    Goldman Sachs Group, Inc.(GS $156.86)
    Morgan Stanley(MS $39.55)

    CITIGROUP INC(C $19.78)
    Merrill Lynch & Co.(MER $43.51)
    UBS AG(UBS $27.76)

    PM: Summary:
    Sunday night, it was announced that Bear Stearns was bought by JP Morgan For $2 a share, a mere 2% of the stated book value at the end of the fourth quarter. While we believe BSC’s case is unique, what will not be unique, in our view, is a resulting major negative revalution of financials. For this reason, we provide a detailed examination and explanation of why we believe financial stocks have further downside of as much as 50% based upon 1990/1991mutiples of tangible book values.

     On the basis of book value, most banks do not appear expensive as they trade near price to book multiples of the 1990-1991 credit cycle. However on the basis of tangible book value, banks look expensive and are trading well above tangible book value.
     * We argue herein that due to the adoption of purchase accounting in 2001, goodwill has grown to unprecedented levels on bank balance sheets. As we believe we will begin to see goodwill write-downs during the first half of this year, we believe investors will focus more on tangible book value and stocks will quickly revalue to far lower levels.
    * Merrill Lynch announced on 3/5/2008 that it was discontinuing the mortgage origination business at its subsidiary First Franklin and would explore the sale of the mortgage loan servicing unit Home Loan Services. The sale of the mortgage unit was due to the deterioration of the subprime market and
    leaves roughly $922 million or $1.12 per share in goodwill and intangibles at the end of 2007.

    And on this side of the Pond, the BofE
    The Bank is today, at 11.00am, holding an exceptional fine-tuning Open Market Operation. The Bank will offer, at Bank Rate, Stg 5bn of extra reserves in a three-day repo maturing on Thursday, when the regular weekly short-term OMO will be held.
    Stg 5 bn is equivalent to 25% of reserves targets. The range around reserves targets within which reserves are remunerated remains unchanged at +/-30%. The Bank will keep the range under review.
    This action is being taken in response to conditions in the short-term money markets this morning. The Bank will take actions to ensure that the overnight rate is close to Bank Rate. Along with other central banks the Bank of England is closely monitoring market conditions.

    There's blood on the screens, and there could be blood on the streets before this all ends.
    We're maybe one third into this at the moment.
    California (a county in) is laying off 20,000 teachers, - can't pay wages. Various other counties are contemplating bankruptcy. This is moving into the real world.
    Euribor and libor very high.

    The fan is spinning and the shit has been thrown!
    Tin hats fail.
    Time for the bunkers.
    Banks at risk in the UK, - RBS, Barc, A&L. - IMO

  2. I do like the fact that you've created a Label for 'bird poo'. There can't be that many bird poo related stories to cover.

  3. Thanks indeed Colin nnd a very interesting post indeed. I've been away, it is true from blogging but will post tomorrow. Thanks for posting this again.

  4. James.
    What do you think of the moral hazard of the fed providing a rolling credit to JPM, (them again) to enable them to buy out Bear?
    The net result will be that the toxic paper that destroyed Bear will end up on the fed balance sheet as collateral for the loan to JPM.
    It will stay there, at the value that was given for it, (plus interest) until JPM feel that they are able to pay it down. Never marked to market.
    In other words the quality of the fed balance sheet eventually becomes toxic.
    Do you seriously think that JPM will have an incentive to pay down a debt on worthless toxic paper held by the fed as security for their loan?
    The only way that will happen is if the fed becomes violent with JPM, and given that JPM probably is a part owner of the fed...... bingo!
    We've squared the circle!
    Bernwanke is doing the bidding of his employers. Period.
    In the process he is destroying the $. But what choice did Greenscam leave him?
    Eventually the contradictions in the EU (Med economies in collapse) will cause the ECB to lower rates.
    $ will rally against the euro.
    £ will move between them.
    International holders of dollars are frantically trying to get out, without destroying the value of their existing holdings. If they panic, (and they could given the moves in the next few months), the $ is toast, and bernwanke will raise interest rates. BofE will be forced to raise interest rates (if that scenario develops). Either way the UK economy is toast for the foreseeable future.
    No wiggle room left for gordon.
    His lies are exposed.
    Everyone recognises him for the filthy turd that he is.
    Such a pity that UK mortgages are "full recourse", rather than "no recourse" as in the US. Screwed mortgage holders in the UK, in negative equity could then walk away without the banks following them to hell and back to extract their pound of flesh.
    The economic collapse would be quicker, problems resolved earlier, banks take more losses, realise that they are NOT the moral code arbiters in an atmosphere of immoral banking practices, but that reasonable contract law takes precedence.
    Joe public would NOT become a wage slave to overvalued debt obligations, created by a corrupt industry, from A to Z.
    But every cloud has.....
    1)Be nice to see JPM go under, although it is remote. Who will pay the master liars mortgage then??
    (Liar Blair)
    2)Pressure in the EU economics may cause the collapse of the euro, or collapse of the EU. Either way it's good for the British, - or is it English these days.

    Oh well, that's my 2 cents.

  5. Bear was an investment bank.
    No deposits from punters, etc, just investments from rich-joes seeking high returns.
    If JPM wanted them, they should have bought.
    To answere your question.
    Extreme moral hazard, but fed boss only obeying his true masters

  6. The fact that those two (fucking?) idiots got together to issue such a statement, is testimony to their total ignorance of the true feelings of their respective electorate towards them.
    Given their track record, why would anyone believe them?
    That they can't see the obvious is deeply concerning!

  7. BTW, $158 was not the peak for Bear.

    Why buy gold when you can buy the Swiss Franc? Gold will be sold as the longs are shaken out as too many of them own gold for the wrong reasons. Also, we are seeing an unwinding of all fad trades. And one of the biggest is the rise of ETFs. These will be shaken out as commodity investments come under pressure as deflation sets in. The gold ETFs will suffer like the rest of them. You can bet that thousands of traders who will lose their jobs in the next couple of months think they are terribly clever keeping their private money in these things. They probably own gold too. These they will sell them to pay the mortgage on the debt they cant refinance on the house they cant sell. The micro and the macro. Thus will gold fall while the Swiss Franc will continue to it is so un-trendy. I then expect the gold lease rate to rise as central banks to stop leasing the stuff. This will turn it around. That is a little way off. Apart from Swiss francs as I have said for a while, buy German government bonds....the only way to be sure of owning Deutschemarks MarkII when the euro breaks.
    Also sell everything connected with carbon, global warming crappy nonsense. The renewable fad will collapse. Anyone want to know why?

  8. A system of feudal debt usury has been created by Wall Street and the City Of London over the last few years for most of the inhabitants of the western world and particularly Great Britain and America.

    Great Britain should have been renamed Great Bankerland. Back about 120 years ago we used to put women and children down the coalmines, and we would work them for up to 18 hours a day,7 days a week in conditions of absolute depravity. At the end of the week not only would they be paid pittance, if at all, but they were often paid in tokens to be used in the company shop.

    As a nation we eventually gained a conscience and we passed laws to deem that although this was the free market at work, it was morally wrong.

    Why can’t I sell crack Cocaine to your children during their school breaks? I would make a fortune, many of them would provide me with a demand, and I would have the supply, the free market at work. Or maybe a slavery business? I cannot run my new free market businesses, and this is quite correct, because I would be a menace to society and it is morally wrong. This is an instance whereby we need a judgement over a free market.

    Roll forward to 2008 in Great Britain an average house now costs £190,000 and the average person earns about £24,000 per annum. So it costs nearly 8 times the average annual earnings in Great Britain to afford the average house. You will lose approximately 25% of your average annual earnings in Income Tax and National Insurance contributions so you will be left with £18,000 or about £1500 per month in your pocket.

    Assuming the usual 5% deposit to purchase the average house and a mortgage at the average of 7% it will cost you £1052 IN INTEREST per month to have a basic home.


    Please remember this is just the interest you are not actually paying any of the mortgage or “Death loan” back. This is usury and it is just as morally wrong as putting women and children down the mines, or selling crack cocaine to your children. It is also just as damaging to society as crushing debt load is one of the major factors in broken families and substance abuse, so it should either be outlawed or very strictly controlled.

    Nobody minds working hard to achieve success for your family, that is the hope and dream of a free capitalist society, but is it right that the vast majority of your income needs to be handed across to greedy bankers to provide a very basic human right a home? Have the bankers earned this money?

    The reality in Great Britain is that people work hard earning money in the real economy to pay usury payments to the new feudal lords and masters of our country the international investment Banks WHO DO NOTHING, PRODUCE NOTHING, AND ADD NO VALUE TO SOCIETY. These tribute payments consume just like they did in feudal times the majority of a persons income.

    The City Of London and the Government are now acting like hardcore Communists and are trying to install some wacky form of command and control manipulated economy as their debt, deck of cards collapses. They are already nationalising one of the worst usury offenders Northern Rock these clowns were lending up to 125% of a properties appraised value!. The City of London want the big fat fees and profits and bonuses during the boom and they want pure Communism during the bust, they want the Government and the taxpayer to sort out the mess that was 100% of their own making, they took a business judgement to lend all this funny money, that was their judgement and theirs alone, if as time now proves it was the wrong judgement then they should bear the consequences.

    Can you believe that they are now lowering interest rates which caused this very mess in the first place, in a desperate attempt to try and keep the bubble inflated !!. Our own Government is doing everything it can to keep the population in debt to the Investment Banks, as this we are told is the solution. Can it really be a solution to try and keep us all in as much debt as possible?

    A far more elegant solution a far fairer solution would be for the very simple free market to work its time proven magic and mean revert. This would mean that people who have been sensible and saved can afford to buy a basic human right a home as prices fall. Those people who have taken on sensible mortgages would also be just fine. Unfortunately those who have not been very sensible with their borrowing and greedy speculators would receive a very valuable lesson in what happens when you buy into an overpriced illiquid market, using far too much margin. The merchants of Usury the Banks who lent this speculative margin would also get a hard lesson in basic risk and credit management.

    The real tragedy of this orgy, this feeding frenzy of speculation that has existed over the last few years is the REAL ECONOMY which has now been so inflated that a whole new word has been invented to describe the inevitable effects to our industries, that word is called OUTSOURCING. The real economy has now been exported offshore to less inflated economies. We are left with crippling debt for vastly overpriced houses and a Government and financial sector hell bent on trying to keep this calamitous and desperate state of affairs going in a futile attempt to try and stop the market completing a natural mean reversion.

    I am no Socialist that has a 100% historical failure rate, As Winston Churchill remarked “The tragedy of Capitalism is that the fruits of labour are unfairly divided, the tragedy of Socialism is that everybody gets to share the misery”

    I believe in capitalism, the free market, initiative and innovation, together with sound money, balanced budgets, small Government, and true freedom for the individual if I was an American I would not hesitate to vote for Ron Paul. However the free market needs some basic rules otherwise we revert back to children working in the mines, and my proposed crack cocaine/slavery business would become a reality.

    I suggest that the City Of London AND Wall Street mend their ways and fast, they are the minority and we are the majority. Major revolutions and change have always sprang from the disgruntled masses, who find themselves once again at this particular point in history lied and cheated to by the International Bankers, and their subservient lap dogs the British and American Governments. Maybe the time is rapidly approaching when we need something like our own Polish Solidarity to force real change on our own communists!

  9. I agree on the house buying thing - we are insanely addicted to it - basically you borrow money and repay like 100 times the amount you borrowed. Its quite mad. Yet there are kids of 18 or so living on no money to "get their feet on the housing ladder"...

  10. Thanks for the Anon dominated comments. Bit of materiel here.


Your thoughts on this?