Thursday, July 31, 2008

Great Bears and greater bailouts

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Bear Sterns was and is ruthlessly quoted everywhere for its weak approach to doomsday. And it knows it was at fault. However, in the huge ocean of cashplay, there are several others who are hiding their Achilles Heel inside their financial shoes. Question is: Who’s next?

After the Bear Stearns collapse, the question everyone’s asking is who, not whether there, are the other Bear Stearns that are lurking in the financial closets in the US? The reason: there seems to be some form of a ‘Domino Effect’ in the American markets. The Federal Reserve chief , Ben Bernanke, has admitted there could be more Bear Stearns in the near future. UBS has admitted that the combined loss due to sub-prime crisis could be as high as $600 billion for the financial services industry. The expectations are that Citicorp will probably announce poor results for Q1, 2008.

At this moment, investment banking, brokerage and banking firms like Lehman Brothers, Goldman Sachs and UBS are being touted as the next casualties. Most experts feel that Lehman Brothers is probably the “weakest” of the Wall Street titans, after Bear Stearns, and also one of the leading players in the mortgage-related derivatives and in other mysterious credit-related derivatives. But the negative impact may well spread to other sectors in the US over the next few quarters. Read a recent Wall Street Journal piece: “As recently as a few months ago, it looked as if the damage from a battered US real-estate market would be limited to banks, brokerage houses, and other financial firms that played a key role in inflating the housing bubble. But as the perception grows that the United States may already be in a recession, the gloom is spreading to other parts of the business world. This is raising questions about the prospects for overall corporate earnings…”

However, in the financial services space, analysts contend that all of them are ‘vulnerable’ to a certain extent of a run like the one witnessed in the case of Bear Stearns. The bright side is that the financial status of firms like Lehman Brothers may be better than Bear Stearns. Bear Stearns was more occupied with the mortgage-backed market, far more leveraged than many others. Although many banks ended up owning some of the derivatives packets that originated from Bear Stearns, many didn’t keep on stacking them up. On a positive note, if the other firms had the liquidity, their ‘Bear Stearns’ positions might have twisted out to be very profitable, even in these extremely difficult days.

But, in the short term, almost everyone will suffer. For instance, JP Morgan Chase, which agreed to buy out the beleaguered Bear Stearns for $2 a share, has been under pressure from the latter’s shareholders of a possible legal action. The reason: Stearns’ investors thought the price was too low. After all, Bear Stearns reported $80.3 billion in total long-term capital at November 30, 2007, and generated net revenues of $5.9 billion for 2007. Moreover, Chase’s acquisition bid price was much less than Bear Stearns stock price of $160 less than a year ago. So now, Chase has decided to hike its offer price by five times to $10 per share. It has also decided to fund the first one billion dollar losses.

“Going forward, the maintenance of strong capital ratios is important because JP Morgan Chase’s ability to generate capital will be challenged in 2008 by its need to take heightened credit costs in its own businesses,” said Moody’s Senior Vice President Sean Jones. “Despite a challenging environment, JP Morgan Chase’s effort to consolidate its numerous business platforms in recent years gives it the flexibility to absorb this acquisition”, feels Jones. But such optimism is on the decline these days.

The day Chase initially announced its takeover, the Federal Reserve reduced interest rates, as it did again on March 18 by three-quarters of a percentage point. It seemed as if the Fed was rewarding those who were responsible for the financial crisis. So, the next question is how many Wall Street firms may follow Bear Stearns into the void? More importantly, will the Fed efforts help to enhance buoyancy in the American financial system and improve sentiments among all US & global investors?

Since the 1929 Great Depression, the Fed has not only taken a unique action – by lending money directly to major investment banks – but has put taxpayers on the hook for billions of dollars in dubious trades the same bankers made when the good times were rolling. To complement the environment, the Fed has agreed to fund, on a non-recourse basis up to $30 billion of Bear Stearns’ less liquid assets to JP Morgan. It may seem like a one-off bailout, but who can ensure that such help will not be required for other ailing brokerages, investment bankers, and banks.

In midst of all this, if not a recession, are we likely to have a longer and deeper slowdown that we’ve had, at least in recent times? The fascinating thing is that the slowdowns have been a little too long, but much shallow – to our surprise! The feeling is that the stock market may not pick up until 2009, although 2008 might offer pleasant surprises in the second half. In all, it’s going to be a very gentle recession in the US, if at all one happens, feel market experts. But then, who knows what surprises are in store in the future?

In the middle of all these technicalities, the investors are in a dicey situation. Well, it’s interesting in terms of when you should sell. One thing which is to be looked at is market sentiment and there have been certain indicators that have given out negative signals on the part of individual investors. But then a market turnaround can always be expected when investors are all wary. The Fed is doing everything to make sure that liquidity is in the system. While we take comfort from the proactive policy response being undertaken by the Fed, investors should still be cautious regarding the heightened levels of volatility in the financial markets over the coming quarters.

However, most experts are convinced today that Bear Stearns will not be the last major sufferer in the American financial markets since the additional write-downs announced by Lehman Brothers and Goldman Sachs indicate that there is no clarity yet on the losses feeding through the system from defaulting mortgages and falling US house prices.

Sunanda Roy

For more articles, Click on IIPM Article.

Source : IIPM Editorial, 2008

An Initiative of IIPM, Malay Chaudhuri and Arindam chaudhuri (Renowned Management Guru and Economist).

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