Lessons From the Collapse of Bear Stearns

A Background Note

The note below, authored by John Cassidy, was published earlier this week by the Financial Times.

Cassidy, is a staff writer at The New Yorker and a contributor to The New York Review of Books. He also is the author of Dot.con: How America Lost Its Mind and Money in the Internet Era which examines the dot-com bubble, and How Markets Fail: The Logic of Economic Calamities, which combines a skeptical history of economics with an analysis of the housing bubble and credit bust. This pedigree and experience positions him superbly to write about the lessons learned from the collapse of Bear Stearns over the past two years.

Lessons From the Collapse of Bear Stearns

Two years ago on Sunday, Treasury Secretary Hank Paulson called up Alan Schwartz, the chief executive of Bear Stearns, and told him the jig was up. “Alan, you’re in the government’s hands now,” he said. “Bankruptcy is the only other option.” Thus began the epic stage of the credit crunch and 24 months on, many costly lessons have been learned.

1. Leverage kills.

In March 2008, Bear had tangible equity capital of about $11bn supporting total assets of $395bn – a leverage ratio of 36. For several years, this reckless financing enabled the company to achieve a profit margin of about a third and a return on equity of 20 per cent; when the market turned, it left Bear bereft of capital and willing creditors.

During the ensuing months, the same story was to be played out at scores of other banks and non-banks. Last year, the group of 20 leading economies agreed to impose higher capital ratios. So far, no figures have been published. Officially, the gnomes of Basel – the Basel Committee on Banking Supervision – are at work. Unofficially, Tim Geithner, the US Treasury secretary, has a maximum leverage ratio in mind. What that figure turns out to be will indicate how serious the authorities are about preventing future blow-ups.

2. It if quacks, it is a duck. If it borrows short and lends (or invests) long, it is a bank.

Officially, Bear Stearns and Lehman Brothers were investment companies; Washington Mutual was a savings & loan; AIG was an insurance company, GMAC and GE Capital were subsidiaries of industrial corporations; the Reserve Fund was a money market mutual fund. In reality, all of them were handing out money, or near money, and accumulating illiquid assets. Any such institution is vulnerable to a run by creditors and regulators should treat them alike – as banks. Failure to adhere to this principle will result in regulatory arbitrage and more blow-ups.

3. Markets are not always efficient.

Does this lesson need restating? I fear it does. Over the years, free market ideology has displayed an uncanny ability to resurrect itself. And there will always be powerful interests eager to cloak their selfish ends in the invigorating language of Adam Smith and Friedrich Hayek.

4. Big banks are like nuclear power stations.

They provide valuable services, such as channeling capital from savers to entrepreneurs. Occasionally, they blow up, causing damage to the rest of the economy and necessitating spending vast sums of taxpayers’ money on clean-up operations. In retrospect, the solutions to this problem are obvious: stricter supervision to reduce the probability of blow-ups and institution-specific “pollution taxes” to cover their cost.

President Barack Obama recently proposed such a tax, and Gordon Brown has taken it upon himself to transform this proposal into a global initiative. For once, a good idea appears to be making progress. Somewhere in the heavens, Arthur Cecil Pigou, the economist who invented the concept of negative externalities, must be smiling.

5. Statistical models are like bikinis: what they reveal is suggestive, but what they conceal is vital.

So said Aaron Levenstein, a late (and politically incorrect) professor at New York’s Baruch College. On Wall Street and in the City, the bikinis came in the form of “Value-at-Risk” models that assumed investors (and mortgage holders) were like so many molecules bouncing around randomly in a heated jar. These mathematical contraptions had the charming feature that when they were not needed they worked perfectly, and when they were needed they did not work at all.

6. Bagehot and Keynes were both right.

During a financial crisis, the role of the central bank is to lend money where nobody else will. During an economic slump, the government has to boost demand. In applying these truths, authorities from Washington to Frankfurt to Beijing prevented the Great Recession from turning into another Great Depression.

7. Rent-seeking is not wealth creation.

Some of the money that financial companies make consists of economic rents diverted from other groups, such as investors in actively managed funds, workers in companies taken over by private equity groups, and taxpayers who eventually bear the costs of excessive risk-taking. The losses that UK banks suffered in 2008-2009 wiped out roughly half of the economic valued added – wages, salaries, and gross profits – that the banking sector generated between 2001 and 2007.

8. Profits should not automatically accrue.

A century ago, progressive English thinkers such as J.A. Hobson and L.T. Hobhouse argued that much wealth is, in part, socially created, providing a justification for the state redistributing some of it to old age pensions and health programmes.

As far as modern finance goes, the New Liberals had it doubly right. Not only are some of the “profits” that bankers generate contingent on implicit state guarantees: much of the capital they put at risk belongs to others.

Given its lobbying power, the financial industry may yet head off some of the restrictions on its activities. But never again will bankers be able to argue that what is good for Citigroup is good for America, or what is good for Royal Bank of Scotland is good for the UK. Not with a straight face anyway.

At least two new asset bubbles: sound familiar?

A note on Cannon Asset Managers' annual roadshow

Last night we finished the last leg of our annual roadshow, which sees Cannon Asset Managers' team travel around the country visiting clients over the course of two weeks. It is always a fascinating time, as it gives us a chance to see different parts of the country in a short period and to interact with people from our own industry as well as many others from a wide range of South African industries and firms.

If you are interested in a copy of the presentation, please send me an email at adrian@cannonassets.co.za.

The key elements of the arguments that we presented are set out in the note below (which also is published on Equinox's website).

Hindsight is foresight

“May you have the hindsight to know where you've been,
The foresight to know where you are going,
And the insight to know when you have gone too far.”

– Irish Blessing

Last year, we witnessed the greatest economic slowdown since the great depression. This followed the bursting of the US housing market bubble and the subsequent financial market meltdown that went on to envelop commodity markets and emerging markets.

Whilst evidence of economic recovery continues to grow, it is notable that it is emerging economies that have led the recovery and sub-Saharan Africa, which has comfortably outperformed the globe in terms of economic growth since 2001, was one of the best performing regions last year. So good is this area that a cover story run by Time in March 2009 proclaimed that: “Africa offers more opportunity than any place in the world.”

Debt bubbling over

To facilitate recovery in advanced economies, however, we saw policy makers in the developed world throwing money at their problems in the hope that the troubles would disappear. Sadly, this is a far-from-likely outcome. The US federal deficit, at 9.9% of GDP, is the highest it has been since World War II and national debt is approaching 100% of GDP – well beyond the safety threshold of 90%. Perhaps the clearest anecdotal evidence of ballooning government involvement in the US is given by the fact that while the US median household income has risen 32% in real terms since 1970, government spending has escalated by 221%. This meteoric rise in spending is unsustainable, and brings to the US a debt burden that is unprecedented.

Things are no better across the Atlantic. The unfortunately-named PIIGS, Portugal, Ireland, Italy, Greece and Spain, are laden with debt and Pimco’s Bill Gross describes UK gilts as “resting on a bed of nitro-glycerine”. Again, anecdotal evidence offers enlightening insights: European capital markets are pricing the risk of large company default at the same level as government default. This is a profound feature of the capital market landscape.

Unfortunately for governments in these advanced economies, tax revenues are proving to be woefully inadequate to repay the debt and reduce the fiscal deficits. While governments could still reduce spending and wait for economic growth to play catch up, thereby retiring their national debt, countries instead have resorted to the “Zimbabwe option” of printing money.

This is clearly another bubble in the making and a sharp rise in price inflation is a likely result. Another likely implication is that advanced economy currencies will become engaged in a race to the bottom. This substantially complicates the risk of investing in these markets. As things stand, investors should avoid sovereign debt – especially in advanced economies – until pricing excess has worked itself out of the system.

But that’s not all

Simultaneously, another bubble is forming in China. While the Chinese economy has succeeded beyond all expectations, it would be a mistake to equate economic growth with investment success.

In the past 20 years, China has been flooded with capital. This has led to over investment and, in its wake, returns on capital have collapsed. But investors are mesmerized by China, to the extent that still more capital is being sucked into the country, further squeezing returns. Chinese credit extension has grown 30%, leading to high multiples on equities and real estate – each a classic sign of an asset price bubble. Other evidence of a bubble can be seen in the Graham and Dodd price-earnings ratio of 50 times in China. This is more than three times the “fair” ratio of 15 times. To boot, the view that these multiples can be justified because China is growing fast reeks of the “this time is different” approach to investing.

To be clear, the mood that is sweeping capital markets at present is a form of “one-wayism”. Investors believe that China is a one-way bet to success: this concerns me. As Peter Tasker observed: “… there has never been a bubble that hasn’t burst …”.

So where does this leave investors?

Investment success is as much about what to avoid as it is about what to buy. We need to be acutely aware of the risks posed by asset price bubbles. For this reason Cannon Asset Managers has no direct exposure to China and no ownership of advanced economy sovereign bonds in any form.

As deep value managers, we seek out-of-favour investments where assets are mispriced. To borrow from Joel Greenblatt, I know a place where great companies are sold at half price everyday and it’s called the market. Two examples of this type of opportunity are given below, and each provides a clear demonstration of our investment philosophy.

More than a flash in Japan

Japan has been written off by most investors because of its aging population, massive debt and price deflation. But, when investors become too pessimistic, there can be enormous opportunity and we see deeply underpriced assets in Japan.

The economy is highly geared to world economic growth. In the recent recession, Japanese industrial production fell by three times the world average, but in the trough to recovery phase, it is witnessing a three-fold rate of growth relative to the world average and this goes straight to the top line.

In addition to growing at a faster pace, Japan’s profit growth is 30% faster than other manufacturing-led economies. Moreover, Japan’s fastest growing market is China. So if you believe in China and want exposure, a far cheaper route is via Japan. In fact, Japanese assets are so modestly priced that the price:book ratio of Japan’s Topix index (equivalent to the US’s S&P500) is only 0.7 times the world average, while its relative p:e ratio is close to an all-time low.

The typical listed Japanese company has the equivalent of 25% of its market capitalisation in cash on the balance sheet, making these assets that much more attractive.

Building value in South Africa

Turning to the case of South Africa, while pessimism abounds at home, this should not translate into a negative market view. In spite of the despair, there are structural factors, such as our fiscal prudence and monetary restraint, which will support our economy. Our inflation rate has declined and is relatively low and stable. Infrastructure spending is to continue, supported by the budget policy statement.

Cyclical factors play to this same theme. The global economy is pulling out of recession which will support our export industries. Domestic demand and production are beginning to recover, as seen in the vehicle sales and manufacturing figures, while a fillip is anticipated from this year’s FIFA World Cup. Whilst earnings have slumped in the past 18 month, from this low base, we expect to see a recovery of some 20% over the next year.

Within this landscape, there are interesting opportunities. One of the best examples is the building and construction sector. The state is set to spend R850bn on infrastructure over the next three years. In addition, we can look to US$22bn per annum infrastructure spending in Africa, A$297bn over five years in Australasian and Pacific infrastructure and US$272bn construction in the Middle East over the next five to seven years.

South African building and construction companies are likely to be the beneficiaries of much of this spend, but this is yet to reflect in their prices. In 2007, Murray & Roberts was on a p:e ratio of 35. It is currently in single digits. Group 5’s p:e has fallen from 25 times to 6 times, despite better than 20% earnings growth over the last year.

In this setting, Aveng makes a compelling case. With a market capitalisation of R14bn, the company had cash of R8bn at its June 2009 year-end. The company’s EBITDA earnings were R3bn, yet it is priced on a price:book ratio of only 1.5 times, a p:e ratio of 7.4 and a healthy dividend yield of 4.1%.

Immediate earnings growth may be muted, and probably negative, for these companies. Beyond that, however, there is important growth, even outside our borders.

Another example of a fallen angel is GijimaAST. This technology counter has a market capitalisation R1.1bn and cash of R625mn at the December 2009 interim period. GijimaAST’s annualised EBITDA was R250mn and the counter is on a p:e ratio of 7.5 times and its maiden interim dividend puts it on a dividend yield of a high 6.3%.

Being contrarian is the only way to beat the herd

In a world that has seen much relief in the past year, we bring the view that this time is never different. Successful investing is about two key attributes. The first of these is about knowing what doesn’t work in investing or, more clearly, what not to own. Asset price bubbles provide the clearest cases where investors risk capital loss. On this score, William Bonner in Mobs, Messiahs and Markets (2007) notes “If an investor merely recognizes the way mob sentiment works, he is far ahead of most others.” The current landscape makes evident that the devastating bubbles of the past decade are not yet something of the past.

The second key attribute is a keen understanding of what works in investing. On this score, three features stand out. The first is a willingness of the investor to build portfolios that look different to the market: the only way you can hope to beat the market is by being different to the market. Equally, this contrarian stance demands a second attribute, namely perspective, or the ability to see what others miss or refuse to see. Third, by embracing these factors and seeking those stocks which are mispriced relative to their true worth (i.e. value stocks) an investor will be able to construct a portfolio which can outperform the market.

Only a small minority of professional investors has consistently beaten the market and they are overwhelmingly contrarian, value managers.

An Investor's Buffet: Eat Your Own Cooking

Last week saw Warren Buffett mail out Berkshire Hathaway’s annual letter to shareholders. As always, the letter is filled with gems. Below are nine such gems that stood out to me in terms of the way sensible investment thinking is fashioned and great businesses are run.

1. Big Does Not Equal Good, Especially In Investment Management

Buffett makes the point about the relationship between size and performance clearly: “The big minus is that our performance advantage has shrunk dramatically as our size has grown, an unpleasant trend that is certain to continue.” This is an important recognition. Whilst Buffett is making the argument in relation to a few hundred billion dollars, the point is valid throughout the investment management industry. Size counts, because investment performance and size are inversely correlated. The bigger you are, the fewer the opportunities.

2. Why Pay For Passive Investment That Poses As Active Investment?

A characteristic of many so-called “active” investment managers is that they tend towards being closet trackers. Their portfolios are heavily weighted to holding index positions and to holding what others in the industry hold. Consequently, a sadly large proportion of active managers deliver market-like performance yet charge active management fees, thereby delivering worse than market results.

In considering Berkshire Hathaway’s relative performance, Buffett notes: “Selecting the S&P 500 as our bogey was an easy choice because our shareholders, at virtually no cost, can match its performance by holding an index fund. Why should they pay us for merely duplicating that result?”

3. Investing Is As Much About What You Do As What You Don't Do

Successful investment management is as much about what you don’t own as it is about what you own. In this regard, Charlie Munger quips: “All I want to know is where I’m going to die, so I’ll never go there.”

4. Hype Kills

Hype is an investment killer. Equally, hype sets the foundation for unhappy clients as expectations become sentiment charged and unrealistic: “We make no attempt to woo Wall Street. Investors who buy and sell based upon media or analyst commentary are not for us. Instead we want partners who join us at Berkshire because they wish to make a long-term investment in a business they themselves understand and because it’s one that follows policies with which they concur.”

5. Forecasting Is Inherently Flawed And Wasted Effort

Despite our industry’s slavish obsession, forecasting is futile. Buffett notes with regard to his and Charlie Munger’s expectations: “We are certain, for example, that the economy will be in shambles throughout 2009 – and probably well beyond – but that conclusion does not tell us whether the market will rise or fall.”

6. Success Will Flow From Finding Your Element And Living It

Great businesses involve the contribution of people who love what they do, and consider their work to be a passion and a privilege. Buffett notes: “We both feel lucky to work at a business we love.”

7. Buffett's Buffet: Eat Your Own Cooking

A true test of a person’s conviction is whether they are willing to eat their own cooking. Buffett notes with regard to Berkshire Hathaway’s investment in the aviation business, NetJets: “... we eat our own cooking ... no other testimonial means more.”

8. On Leadership

On the subject of leadership, Buffett is unequivocal: “Charlie and I believe that a CEO must not delegate risk control. It’s simply too important. At Berkshire, I both initiate and monitor every derivatives contract on our books, with the exception of operations-related contracts at a few of our subsidiaries ... If Berkshire ever gets in trouble, it will be my fault. It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer.” This stance differs sharply from the common business practice of “the buck stops there”.

9. A Rare Example Of The Much-Loved Business School Principle Called "Synergy"

Finally, great businesses can feed great businesses. This makes a rare example of the business school principle of “synergy”. Thus, Buffett signs off his letter imploring the shareholders to come to the annual meeting in Omaha by rail: “P.S. Come by rail”, he writes. Berkshire Hathaway recently made a substantial investment in the rail industry in buying Burlington Northern Sante Fe.

The library of Buffett's shareholder letter can be found at www.berkshirehathaway.com/letters/letters.html. Enjoy the read.