Looking Out For the Next Bear Stearns Is the Wrong Idea
It was the Friday before St. Patty’s Day. There were already so many indications of trouble that week, big trouble. The earthquakes seemed fairly regular by then, an all-too-common occurrence alongside the cluelessness and clumsiness with which officials reacted to them. Carlyle Capital was seized by creditors (repo). Then it was Bear.
March 14, 2008, it was announced FRBNY was bailing out one of Wall Street’s most superlative names. The firm with a long and respected history was somehow down to its last options. JP Morgan would be providing the direct funding, but it was borrowing at the Discount Window on Bear’s behalf.
The firm would never reopen as an independent name. The following Monday, March 17, it was reported that JP Morgan would just buy the firm, with considerable support, for $2 per share. On January 12, 2007, Bear Stearns’ stock price was a record $171.51. In a little over a year, the whole thing had vanished.
In the ten years since, everyone has been on the lookout for the next Bear Stearns. They found some here and there, a cluster of them in September 2008, but that has missed the point to a substantial degree. There will never be another Bear, not really. And that has left us with a much bigger problem.
If August 9, 2007, was the date of the systemic break for the eurodollar, March 14, 2008, was the day the whole paradigm broke. Conventional wisdom that had survived, seemingly, crises before under this framework were now threatened in ways that nobody thought possible. Not only that, the costs of these unexpected downsides were suddenly tangible and real. Failure could happen. It just did.
Northern Rock, for one, had gone under the year before, but it was an out-of-the-way mortgage-exposed outfit in operating in the UK. Countrywide was lost, too, but again that was specific to mortgages. Bear wasn’t some subprime peddler. It was Wall Street.
The whole affair, sorry Mr. Bernanke, was never about subprime nor really mortgages. Two days before Bear’s reckoning, one of Carlyle’s sponsored funds (Carlyle Capital) was taken insolvent. This massive vehicle, about $22 billion in assets, had been set up in July 2007 largely to bet against the looming housing debacle. It foresaw that as investors grew increasingly uncomfortable with the “toxic waste” of subprime MBS there would be money to be made for those holding good MBS paper. That was Carlyle.
Only by the end of 2007, mere months after inception, there was no longer any such thing as good MBS. That was Carlyle’s big mistake. And the company protested vociferously at the end. In its statement, the parent firm complained:
The last few days have created a market environment where the repo counterparties’ margin prices for our AAA-rated U.S. government agency floating-rate capped securities issued by Fannie Mae and Freddie Mac are not representative of the underlying recoverable value of these securities.
What else might you expect Carlyle’s management to say? Everyone says that right before the lights go out, “it’s not our fault.” The thing is, though, they were right! The value of these securities was in many instances total nonsense.
But that’s where they were also wrong. You have to live in a world of sometimes nonsense, and more so appreciate where and how that nonsense comes about. In other words, again, it wasn’t about value and subprime but liquidity and money. Carlyle Capital had bet on a valuation arbitrage created from overzealous housing bubble characteristics, but what they had really done was step in front of the eurodollar steamroller for those few nickels.
Carlyle’s fund was an example of “good” mortgages leading to failure. Bear was then the next logical progression, and it happened only a few days after. It was the good bank going under in the same way that officials had worked tirelessly to prevent ever since 1929.
Part of the myth of the Federal Reserve after Volcker was its near-omniscient treatment. They were supposed to be the adults in the room, the priggish scolds who when the children of speculation got themselves and others into trouble they would step in reluctantly and solve the issue before it ever got out of hand. That was the playbook used in LTCM’s case, and it was the attempted one for Bear a decade later.
It didn’t work in 2008 because it was all a lie. It was the imposition of interpretation, after the fact, by a bewildered establishment intent on cultivating it. Greenspan’s Fed didn’t save the system from LTCM because LTCM was never really a danger to it (the eurodollar was in its vast expansion phase by then). Greenspan was given credit for the Crash of ’87, too, meaning that it was his actions that supposedly cushioned the blow and prevented a repeat of 1929 as many, including the maestro, had feared. That wasn’t true, either, for the same reasons.
What changed between those and Bear was August 9, 2007. The eurodollar was all the time behind Greenspan but then it wasn’t for Bernanke.
A very big part of its allure was the seeming mathematical precision underneath. The final phases of this monetary evolution and rise were entirely quantitative in nature, starting in 1995 with the introduction of RiskMetrics and what that proposed for efficiency, in mathematical terms, for balance sheet construction worldwide. Risk was to be a number, or a set of numbers, easily understood and often as easily manipulated (through the widespread use of derivatives).
That was really the mania, the insanity that went on for so long it was called normal. This was the idea that the very risky could be transformed into the riskless, a modern alchemy all its own.
On the liquidity side of it, there were enormous structural redundancies, substantial looking processes and factors that impressed anyone from the outside both in their complexity as well as their apparent range. These served to fill out the illusion more comprehensively.
A mortgage structure was sliced into discrete pieces each with well-defined, mathematically determined risk and reward characteristics. The biggest part, the super senior, could be massively leveraged with no perceived risk of default nor liquidity. Having so much protection (“thickness”) above it, given the actually appropriate AAA-rating, one need only sell commercial paper against it or stand it out in repo markets. Any price movements would be easily handled, with minimal cost, by the purchase of protection (CDS or IRS).
It is so easy to provide a guarantee in a world that doesn’t seem to need them. It becomes mostly a sales tactic, something you tell your prospect who might be into common sense about such realistic complexity. Hey, if for some totally outlandish reason the whole commercial paper market freezes, or because a zombie apocalypse causes the repo market to blanketly reject the best quality MBS, then we got your back! And if we won’t, the maestro will.
Risk was no longer thought of in terms of total failure under this sort of approach. The worst case was making 5% rather than 8%; and it didn’t matter what was actually in that 8%.
Bear Stearns wasn’t just an idiosyncratic failure. It was a paradigm shift forcing the whole system to re-examine what it was that was in the 8%. More than that, it forced everyone to start to rethink how it could be everyone came to assume the 8% in the first place. How in the world could it get to the point where it no longer mattered what you put money into, just that you put money into this way of doing business?
The whole thing had been turned upside down. The process had come to be the valuable property, as if it alone could turn out gold from lead. This was the “franchise value” for Wall Street that Ben Bernanke had in 2009 wrongly determined would lead the global economy into full recovery after the worst was over.
No paper was safe. Those redundancies were all an illusion. No one was safe. Just as those bank backstops proved woefully insufficient, so, too, was the systemic guarantee of the central bank.
Of the very few commentators who have taken note of what’s been going on with global banks ever since, shrinking, they almost always seek out regulation as the cause (in a few cases to blame). Government prudence, it is claimed, is why banks have been cajoled and clubbed into their post-crisis lethargy. And it is a good thing, they say.
Long before there was a Dodd-Frank or Basel III’s ridiculously belated familiarization with short-term funding, you find all manner of paradigm shifts in prices and statistics each pointed directly at March 2008. Behavior not regulation.
What’s absent still today is any substantial appreciation of this. The missing ingredient all along has been actual explanation for what happened. As such, even good ideas, like money-good paper in 2008, are so easily dismissed. The eurodollar as broken as it is doesn’t allow the global economy to grow, but at the very least it has kept the lights on for much of the last ten years.
Earlier this year, the Treasury Secretary slipped up (or inadvertently revealed) as to the Trump administration’s dollar policy. Mnuchin claimed, before backpedaling, a weak dollar wouldn’t be the worst thing.
It was, as I wrote, stupid. And it was so not because official policy has always been for a strong dollar, but because nobody, including the Treasury Secretary, seems to understand what a strong dollar actually was and might be. It has nothing to do with the dollar’s exchange value except insofar as the reasons, the real reasons, behind changes in it.
To be blunt, the weak dollar ended on March 14, 2008. Ever since that day, the dollar has been moving up. It hasn’t gone, and won’t go, in a straight line. Instead, it works in fits and starts, some more disruptive than others and in different ways and areas each time. In 2008, the “rising dollar” hit pretty much everyone everywhere but was focused primarily on the US and Europe. In 2011, it was mostly Europe (and global repo). In 2014, Asia and EM’s (and global FX).
Gary Cohn recently resigned as director of President Trump’s National Economic Council. Apparently, the recent tariffs and prospects for trade wars were too much for Mr. Cohn. Those, however, were at least consistent with the economic fallout from such an unstable dollar (fragmentation).
To replace him, Trump has nominated CNBC personality Larry Kudlow. For once, someone who understands a strong dollar might be given a position of some considerable influence. While he said, “I would buy King Dollar and sell gold,” he also clarified that stance more appropriately by further explaining, “I'm not saying the dollar has to go up 30 percent, I'm just saying let the rest of the world know that we are going to keep the world's international reserve currency steady.”
Yes, yes, a thousand times yes. Kudlow has the right idea, but, unfortunately, he has provided no answer for his disqualifying Bear Stearns problem.
Since his nomination just this week, several in the media seeking to eagerly discredit him (modern politics) have mentioned that specific firm. It’s nothing substantial, of course, more so intended to be weak guilt by association. He used to work there.
Kudlow’s real problem with the bank has nothing to do with his ancient history with the firm (he left in 1994). Rather, Larry has no idea how to accomplish the real strong dollar he righteously seeks. He has demonstrated time and again having no real grasp of the monetary system (he is, after all, an economist).
On January 16, 2008, Kudlow said, “[B]anks are taking significant steps to repair their balance sheets. Even though some people might not be happy with the speed, the reality is things are improving.” On February 5, 2008, “I’m going to bet that the economy will be rebounding sometime this summer, if not sooner. We are in a slow patch. That’s all. It’s nothing to get up in arms about.”
Worse than getting the crisis so wrong, the possible next director for the National Economic Council was an inflationista over QE in the aftermath. Time and again he criticized Ben Bernanke’s post-crisis “stimulus” as too much. On October 18, 2010, he wrote:
“As we all know, Ben Bernanke believes the unemployment rate is too high and the inflation rate is too low. He’s certainly right about the former.
“However, regarding inflation, booming gold and commodity prices and the sinking dollar suggest that U.S. inflation will be rising in about a year, not falling.”
A month later, Kudlow was using his view of determined economic strength (in 2010!) as an argument against any need for QE2 which had been initiated just weeks before.
“However, in the QE2 cease-and-desist category, there is no deflation for the manufacturing sector. Factory output increased 0.5 percent in October and is running 6.1 percent ahead of last year. Along with a strong retail sales number, it looks like the economy's growth rate is getting a bit better, and certainly not worse.”
His goal for a strong (meaning stable) dollar directed him to overemphasize tepid and smallish recovery attributes over concerns QE would weaken the currency instead.
There is just no understanding of how these things work, or how they had worked. That’s the biggest problem, even among those who have some partial view of what we should be doing and working toward. You can’t just say you are in favor of a strong dollar and expect it to magically happen.
What really goes on is and has been very different, including the Federal Reserve’s roles, both presumed and in reality, in the process. What the Fed actually did all throughout 2008 was conclusively prove the fallacies of the prior paradigm; those monetary redundancies that ended at its doorstep were all delusions. This was “rising dollar” stuff because it further demonstrated real risk.
This didn’t change after 2008. QE was never money printing but the next step in the proof. The Fed did more than it ever had, more than anyone in 2007 ever imagined any central bank would ever do, and the results were, starting in 2010, the same. Rather than show the global monetary system that what was missing in 2008 was its resolve and the size of its intent, it settled once and for all how the Fed was effectively powerless. It was “rising dollar” risk demonstrating conclusively (especially by 2014) monetary policy’s highest setting is still some version of deceptive flailing.
If in pursuit of the noble goal of a stable dollar you view the world this way, you are going to defeat yourself. Worse than that, your distinct lack of understanding how the global monetary system works will eventually discredit the very theory you intend to put forth as an actual solution. Should you have no realistic idea how to stabilize this modern “dollar”, then you won’t. That much, out of everything, is quite simple.
In very broad and general terms, that’s what happened on March 14, 2008. The global monetary system was fatally, permanently destabilized on that day. Risk was, once more, risk. The math was devalued, not the dollar.
So long as this system continues to exist, instability in money and economy will be the result; can only be the result. Not all at once, or in a straight line, but over time the system can achieve no recovery nor actually growth.
Everything that has been tried in the ten years since to alleviate this glaring (interest rate fallacy) deficiency has failed because no one in position to try something has ever truly appreciated Bear Stearns. Until that changes, we are stuck with these “best” of times, the latest nothing more than inflation (weak dollar) hysteria which now predictably subsides without leaving behind the slightest meaningful improvement. Last year was in so many ways like 2010 and early 2011.
Looking out for the next Bear Stearns is the wrong idea. The world marches further toward fragmentation, this new era of consequences, because, apparently, the one was all it took