It’s ironic, and more than a bit alarming, that the investment banks’ most toxic products are those that were originally designed for their protection, and that their best clients these days are the ones most likely to eat them.
The products are credit default swaps (CDSs) and collateralised debt obligations (CDOs) which have been turned from insurance contracts into betting slips, and the best clients are hedge funds selling short – they’re the people who are making the most money now.
As Challenger’s Mike Tilley explained in Business Spectator on the weekend (KGB Interrogation: Mike Tilley, March 15), it’s like taking candy from a baby: you borrow stock at a cost of less than 1 basis point per week, start a rumour, cover the position when the price falls, make a profit.
Bear Stearns was hit by rumours a week ago; by Sunday JP Morgan was eating it. Hedge funds are now able to cover their Bear Stearns short positions with JP Morgan stock in the ratio of one for 18, which equals about $2 per share, down from $57 a week ago.
Bear Stearns is thus the greatest shorting triumph of the age, and a huge spur to do it all again.
Were the rumours about it true? Doesn’t matter – they turned out to be true because by Wednesday and Thursday a run had been sparked and Bear Stearns didn’t have enough cash to meet it.
The New York Federal Reserve agreed to provide the cash via JP Morgan Chase to prevent a colossal fire sale of CDSs and CDOs, even though Bear Stearns is not a commercial bank and not the Fed’s responsibility, and JP Morgan got the Bear Stearns equity on Sunday for virtually nothing.
Last night, JP Morgan’s price actually went up 8 per cent amid the chaos, while Bear Stearns’ employees found a $2 note stuck to their front revolving door when they got to work.
The difference between them? Up to yesterday JP Morgan’s share price had only fallen 30 per cent, compared to Bear Stearns’ 80 per cent, and the market price of its credit default swaps had only gone up 13-fold, compared to Bear Stearns’ 23-fold.
In this crisis the relatively strong will get stronger (as long as they survive); the relatively weak will be eaten. We are in what the Darwinians call an evolutionary spurt.
The next to go, according to rumour, is Lehmann Brothers. Its share price fell 15 per cent on Friday and 38 per cent last night. Moody’s quickly reaffirmed its credit rating at A1 and said the bank had sufficient liquidity; management denied rumours that South East Asia’s biggest bank, DBS Group, had instructed its traders not to deal with it any more, something DBS has not denied. Perhaps DBS is short Lehman as well.
And last night the world’s biggest brokerage of exchange traded options and futures, MF Global, saw its share price drop 80 per cent on rumours that its clients, who are all speculators, are pulling their money out because of rumours that, well… clients are pulling their money out.
There is nothing fundamentally new about this process, but the combination of a sophisticated hedge fund short-selling industry and investment banks that are geared 20:1 with many of the assets either goodwill or speculative instruments that have no, or at best shaky, intrinsic value, is entirely new.
In my view the essential problem with short selling is much the same as the problem with online bookmaking, where you can back a horse to lose as well to win – or a tennis player for that matter.
It is far easier to throw a race, or a match, than it is to win. It is far easier for a hedge fund to force a price down than it is to force it up – especially during a bear market, and especially when we’re talking about very highly geared firms with a lot of intangible assets.
Whether anything can, or should, be done about this is another matter. It means the survivors will have to adapt.
Markets must adjust to the new reality that highly evolved predators now patrol the jungle looking for stragglers from the herd – indeed any vulnerability at all.
When I was young, everybody walked to school; nowadays most kids are driven because the streets are perceived to be more dangerous. The world has quietly adapted to a new perception of danger.
Likewise air travel since 9/11. It seems every time I fly my clothing is checked for explosive residue; on board we eat with plastic knives.
This crisis will result in some new regulations for sure, because if the Federal Reserve has to provide cash to unregulated investment banks to stop them unloading their toxic waste into the banking system’s rivers, then it might as well regulate them.
But short selling won’t be stopped. Those who use the market will simply have to adapt to the new predators and protect themselves accordingly.
Meanwhile, last night Wall Street was digesting the implications of the JP Morgan Bear Stearns takeover. Distressed Bear Stearns shareholders were talking to their lawyers; analysts and investors were thinking about price-to-tangible-asset ratios.
If investment banks are priced according to their tangible assets, as opposed to their goodwill and their bets, then they are, as a group, about double the price they should be, including the so-called strong ones.
This issue will provide plenty of food for the predators in the months ahead.
One thing is for sure: Bear Stearns is not the low market mark.