Dumb politics

So everyone's convinced that we're headed into recession. All sorts of indicators are lining up in its favor. I'm positive we are because I hold the keys to the most correlated indicator - I'm making a push for partner. :)

At any rate, I'm a bit exhausted this week with the political rhetoric I've been listening to on the way to and from work and have to vent a little. I feel like I've heard at least 50% of our congress say the same line this week - "If this administration can rush to bail out a big, fat, greedy Wall Street bank, why can't they spend some energy finding ways to bail out mortgage holders who now may lose their homes through no fault of their own to the big, fat, greedy mortgage companies." Pffft.

I'm actually quite sure the politicians that are saying this know what they are saying but say it anyway. Just want to make sure you do.

Let's dissect this just a smidge and understand it. So the big, fat, greedy Wall Street bank in question is Bear Stearns. Even by Wall Street standards they really are big, fat, mean and greedy and had more than a few enemies. A few weeks ago their stock price was around $100/share. They only had a few 1,000 employees in New York - most of this value was held by the public markets - index funds, 401ks, pension funds, etc. Some hedge funds (also mean, fat and greedy) recognized that Bear had a lot of exposure to the subprime mortgages and start to short the stock (read: sell it). As the value of Bear Stearns started to drop, something happened that completely destroys a trading company - people lost trust that they were going to make it. If what you do for a living is trade, and people don't trust that you can make good on your trades, and no one wants to trade with you, you're dead. This is called an abrupt shift in trading liquidity. Their stock plummeted. On Friday they closed at ~$35/share. Monday morning it was clear they would be bankrupt ($0/sh). JPMorgan offered to keep the company alive and buy it for $2, but only if the Fed would back up the credit in the company to the tune of $30B, if I remember correctly. So the net effect was that the owners of Bear Stearns basically lost everything -98% of the value- in a matter of about a week. What was $18B in value fell to $240M.

Who lost 98% of their money? Mostly pensions, 401ks, investors, and the employees that had shares in the company. You, the reader, probably lost some of that value somewhere deep in one of those Fidelity mutual funds in your 401k. James Cayne, chairman of Bear Stearns, had been one of the wealthiest men in America (#388 on Fortune's Top 400 Wealthiest Americans), worth $998M two weeks ago. He sold his stake today for $61M (still a lot of money, admittedly).

I lived through a very similar situation a few years ago. I'm amazed no one has talked about the parallels between this situation and the Enron trading situation. I believe the reason is that no one really wanted to understand what happened at Enron. Kinda like this time. Everyone wanted to blame all those lost pensions and employee fortunes on big, fat, mean and greedy Ken Lay. I need to be careful here not to defend the guy because he really was big, fat, mean and greedy. However, the collapse of Enron was not about shady deals or off-balance sheet vehicles, at least not directly. Those were the stimuli that created a loss of confidence in a trading company (energy trading instead of mortgages). Shady deals were to Enron what subprime mortgages were to Bear Stearns. People lost confidence in Enron (who was #5 on the Fortune 500 at the time), so they couldn't trade.

Let's step back and give an example of what happens. If Bobby owes June $100 and June owes Billy $100 and Billy owes Jake $100 and Jake owes Bobby $100, everyone's comfortable because everyone's going to get their $100 and no one's too worried about it as long as everyone trusts each other. But if suddenly everyone realizes that June doesn't have $100 and is moving to Buenos Aires, the system is shocked. Jake freaks because he realizes Billy isn't going to get $100 from June to pay him with. The whole system starts to fall apart. Now realize that trading companies by their nature have a lot of obligations like this, but they are all "closed" - I've lent from company A and to company B. If I put $100 in the bank and they turn around and use that $100 to give someone a loan on their home, you see how this works. I don't have "open" trades unless I borrow without lending or lend without borrowing. I can have some open trades, but not many, before I need an awful lot of cash to cover.

After Enron collapsed, I worked for one of the Jakes or Billys of the energy industry. They had done nothing wrong, but their portfolio was now in utter disarray because all the trades on their books were now open and exposed (by the way, these are trades where revenue has already been booked due to mark-to-market accounting). We worked feverishly for a month to try to save the company and unwind deals the best we could. That entire industry basically unravelled. Everyone knows about Enron, but people outside of energy generally don't realize that the damage cascaded through the entire industry, destroying people's retirement plans and causing hundreds of thousands of layoffs.

What the Fed did in saving the skeleton of Bear Stearns is they tried to keep this from happening. The fat, greedy guys lost 98% of their value. Many of them had already lost their jobs. The trick was to make sure this did not roll through Wall Street. It wasn't a bailout of greedy, fat guys unless you think Americans are fat and greedy. It was an attempted bailout of the financial sector - remember, asset-light energy trading effectively evaporated.

Should the government bail out homeowners as well? Some of the same logic applies, but there are a few differences.
1) Incentives - if you bail people out (see: hurricanes and home insurance), they have no incentive not to take undue risk. Take on risk and the government will save you. The counterargument is that now businesspeople have the same incentive problem. Um, the owners of Bear Stearns lost 98% of their value and the credit managers long ago lost their jobs. I think they have a pretty strong incentive not to do this again.
2) Bear Stearns shareholders lost everything, or at least 98% of everything, but can keep people employed and the machinery working if they don't go away. Bailing out homeowners keeps them from losing anything. In many cases they don't have much to lose since their home is a borrowed asset. They go from little net worth to little net worth and bad credit living in an apartment. They don't lose everything - the creditors just take back what never was theirs, or at least only marginally so.
3) The mortgage crisis isn't a loss of faith in large trading partners, it is a reduction in faith of many. The banks never trusted mortgage holders, they just mistrusted them less than they should have. Credit management is about estimating how many people will reneg on their commitments. They were wrong in their estimates, but no one is saying, "Wow, I've been trusting the public all these years and now the public is going away. I best not trade with the public anymore."
4) I think most importantly there's a massive difference in the real value of what the Fed would have to do. In the case of Bear Stearns they put up a large guarantee, but hope not to have to exercise the guarantee. It should cost the taxpayer nothing, but could cost $30B. They just lose a bit of interest because the Fed reduced the borrowing rate. The Economist estimates the loss of value from mortgage defaults will be about $300B - real money. It's hard to come up with that kind of cash. (By comparison, the current estimate for the war in Iraq so far is over $500B)

Let's be clear. The Fed is not in the business of saving anyone, private or corporate, for sympathetic or ethical reasons. They do it to stave off economic shocks. They saw Bear as a shock that the economy could not weather, with a relatively low cost to acheive, but so far believe mortgages do not have that same precipitous impact. Perhaps the mortgage crisis needs some intervention, but it is NOT because of some sort of equitable treatment thing between mortgage holders and Bear Stearns. It is also worth considering that today's interest rates, at a nearly negative real yield, are effectively a bail out - homeowners with equity can refi at an awfully low rate and save their homes. (if they have equity - if not, again, they aren't losing THEIR house)

That, undoubtedly, is the longest most rambling post evar. I'd edit it down (same content, half as long) but I gotta get to work.