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Wednesday, 19 March 2008

A Reply to John Mauldin’s Outside The Box - Let’s Get Real About Bear

An Occasional Letter From The Collection Agency

A Reply to John Mauldin’s Outside The Box - Let’s Get Real About Bear

I have been, and still am, a long time fan of John Mauldin (JM). I enjoy his take on the bigger picture, even if there are areas I disagree with, from time to time. Generally my disagreements are more to do with the severity of a particular problem or the benefits of a highlight. For instance, JM might allude to a recession but think that it will be mild and happen over a certain time scale, fitting his “muddle through” model. I would agree with the talk of recession but not necessarily the depth, timing or effect. You get the point.

However the JM article “Let’s Get Real About Bear” has somewhat shocked me at a fundamental level and it deserves a reply. Let me say this from the beginning, I do not intend to start a war of words or change JMs thinking. Neither approach is constructive or conducive to open discussion of a truly fundamental part of the US and Global economy. This not a good vs. bad scenario, I have little or no doubt that JM is a well read, intelligent, honest and thoroughly nice bloke. I am a trader/blogger that very few have heard of or know, using the internet to foster thought. (As an aside, I asked JM to have a look at my writings and consider maybe using an article in the OTB edition. The answer is within his Bear article. Sometimes trying to be a “platform start up” has its knock backs. So no hidden agendas and yes, I fully expect to be viewed as the “Darkside”. Ahh the fun of blogging.)

Here is a link to the JM article at Investor Insight. Please read it before going further. I am not going to discuss the 2 other articles appended to JMs writing.

JM is an investor/advisor who looks to get real returns beyond the effect of inflation. He operates in the free markets, looking for advantages that return above the “norm”. He searches for new, innovative technology that may become the “next big thing”. He is a capitalist, using the capitalist mechanism. He knows the risks and tries to avoid being on the wrong side or if that fails to mitigate the risk to his capital. I do the same as do most investors and traders. It is the way of the financial world. There are upsides and downsides, we know the risks and rewards, and the rules of the game are simple.

Unless, that is, you decide that the rules can be bent to accommodate failures, to mitigate the downside. Such an approach leads to tyranny, it destabilises the system causing feedback loops, encourages excessive risk taking and allowing that risk to be ignored and causes confidence in the financial structure to erode.

This is big picture stuff. It is not about 17000 jobs at Bear Stearns; it is not about a loss on share portfolios suffered by employees. Protecting a company and its share price is never a reason for intervention and the introduction of moral hazard.

Bear and its employees would not be in their current circumstances if they had obeyed the rules and understood the game.

Bear Stearns went bust because of a lack of confidence in its collateral used to finance its lending. Customers and Lenders walked away because the risk of staying was perceived as too great. It was the risk that Bear Stearns took using its business model and allowing exposure to be greater than its ability to pay. The Capitalist System did its job; it rooted out a bad business model and laid it low. If you took losses, I am genuinely sorry for you but you knew the risks. We all take a loss sometime. If it wiped you out then you did the same as BS, you allowed exposure to a risk to grow well beyond acceptable limits.

Does this sound harsh, a bit heavy-handed? It probably does but it isn’t me saying it, it’s the free market shouting loud as it does every trading day.

JPM have stepped in and offered $2 a share for BS. We have seen such action before, a fast move to grab assets perceived as cheap. It happens in the capitalist marketplace. The risk is transferred to JPM equity holders, JPM write-down $6Bn to acknowledge that risk. The trouble is the whole JPM move was not a function of the free market. Without The Federal Reserve accepting who knows what BS assets as collateral on a $30Bn loan this deal would not have taken place. Even worse JPM get rewarded by asset grabbing at an extremely cheap price. (I suspect we have not heard the last of that either).

JM contradicts himself within the article as he attempts to align the adoption of allowing a moral hazard to exist within the market. I quote:

“And I can understand the sentiment, as it appears that tax-payer money may have been used to bail out a big Wall Street bank that acted recklessly in the subprime mortgage markets. But that is not what has happened. This is not a bailout.”

But just a few lines later he is forced to acknowledge the underlying fear his readers have emailed him about:

“Yes, tax-payers may eventually have to cover a few billion here or there on the Bear action. But the time to worry about moral hazard was two years ago when the various authorities allowed institutions to make subprime loans to people with no jobs and no income and no means to repay and then sold them to institutions all over the world as AAA assets. And we can worry in the near future when we will need to do a complete re-write of the rules to prevent this from happening again.”

You cannot expect market participants to accept such reasoning unless you believe intervention is right and proper. If you do think that way then your perception of risk has to be misplaced.

So, it is more than possible that Tax-payers will face a bill for this bailout. The moral hazard, as the UK Govt discovered after Northern Rock is that if you “cover one bet, you cover them all”. The extension of liability and assumed enlargement of risk becomes burdensome and affects the fundamentals underlying the national economic base.

Today in the UK, there are rumours, denied by the BofE and the bank in question, that a Bank may or has a requirement for emergency funding. Regardless of the truth or otherwise, this has directly affected Sterling vs., of all things, the dollar:

Free Image Hosting at

The ellipses are the main points when rumour surfaced and re-surfaced. This is what acceptance of a moral hazard can do to a currency. I picked the $ as a comparison because it is weak, it shows the inherent weakness of Sterling under such circumstances. This is not a theory of mine, based around musings of economic facts and figures. This is market action telling us a story. Ignore the tale at your peril.

Should Bear have been allowed to go bust? Without doubt the answer is yes and to some extent JM agrees:

“If it was 2005, Bear would have been allowed to collapse, as the system back then could deal with it, as it did with REFCO. But it is not 2005. We are in a credit crisis, a perfect storm, which is of unprecedented proportions. If Bear had not been put into sounds hands and provided solvency and liquidity, the credit markets would simply have frozen this morning. As in ground to a halt. Hit the wall. The end of the world, impossible to fathom how to get out of it type of event.”

A very scary (and quite possible) scenario. JM is saying that current market conditions are not conducive to failure of a Financial Institution.

Well I’m sorry but these events happen because of the prevailing circumstances. Banks don’t go broke at the top of the cycle, failures occur when times are getting hard. It is the nature of the beast. To say the System cannot tolerate such an event is to deny the reality of capitalism. It encourages the acceptance of a safety net, a guarantee that regardless of the poor decisions and risk calculation taken there will be no failure.

This is truly a refutation of a capitalist, free market. No wonder CEOs take what seem to be enormous risk free assumptions about the future and the effects of their actions and decision upon the prospects of the company. They have nothing to fear. CEOs get their compensation, shareholders get a ride, and all is well. Until the cycle turns. The CEO has departed by then, either as part of a merger or retirement with an enormous compensation package. The shareholders are the weak hands, the strong hands sold at the top. Who cares what happens to the weak hands? Moral hazard isn’t just about tax payers.

JM quantifies what he thinks the damage to stock markets could be:

“The stock market would have crashed by 20% or more, maybe a lot more. It would have made Black Monday in 1987 look like a picnic. We would have seen tens of trillions of dollars wiped out in equity holdings all over the world.”

Again, I agree that losses of 20% or more could happen and still might. The reason it would have made Black Monday look like a picnic is because it was a picnic. In 1987 we didn’t have the massive expansion of innovative financial instruments, back then Futures and Options were complicated! If the free market decides it needs to provide a re-pricing then it should be allowed. After all, no one worries about the same mechanism working to the upside.

Would credit markets have closed, seizing up under the financial stresses? We don’t know. Let us assume that they would. So what? The weak debt would have been expunged, albeit on a massive scale. Would there be pain? Yes, massive amounts of pain would ripple through the global economy. Would it be the end of the world? No, it would not, prices would reset on the re-opening, risk would have been priced in - in full. Markets would continue to function, even if the players had changed or some disappeared. Eventually all this will happen and the outcome will be the same, we are living it right now. Delaying the inevitable whilst a transfer of liability occurs does nothing but risk the underlying fundamentals of the economy to further attacks and stress.

Does the acceptance of an enormous level of moral hazard have a justification? Again I quote JM:

“But for now, we need to bail the water out the boat and see if we can plug the leaks. Allowing the boat to sink is not an option. And get this. You are in the boat, whether you realize it or not. You and your friends and neighbors and families. Whether you are in Europe or in Asia, you would have been hurt by a failure to act by the Fed. Everything is connected in a globalized world. Without the actions taken by the Fed, the soft depression that many have thought would be the eventual outcome of the huge build-up of debt would in fact become a reality. And more quickly than you could imagine.

As I have repeatedly said, recessions are part of the business cycle. There is nothing we can do to prevent them. But depressions are caused by massive policy mistakes on the part of central banks and governments. And it would have been a massive failure indeed to let Bear collapse. I should note that this was not just a Fed action. Both President Bush and Secretary Paulson signed off on this.”

Quite simply (and JM touched upon this) intervention has exacerbated the conditions we live in. What was a normal business recession has been morphed into a possible depression. Not by capitalism or free markets but by centralist, socialistic interference.

Remember, last year when Bear closed down and re-capitalised the failed Hedge Funds? This was viewed as one of the problems that required action by the Fed. The intervention failed. All it achieved was a redistribution of risk to the Tax payer and JPM shareholders. The risk is not diminished; adding capital to a margin call does not make the position “safer” or profitable. It just risks more capital.

Trying to justify intervention by invoking fear may work at a human level but free markets ignore such reasoning’s. As far as the markets are concerned the game rules say you are responsible for your own risk management. If you fail to play the game well, you will lose or be given a disadvantage. Attempting to change the rules to favour one side breaks the game. The consequences of that are with us now.

JM defends his stance by pouring scorn on those who believe in free markets. It may also be the reason he didn’t like my writings. (This is fair enough, not every viewpoint that is contradictory to your own needs to be accepted).JM:

“I repeat, this was a good trade from almost any perspective, unless you are from the hair-shirt, cut-your-nose-off-to-spite-your-face camp of economics.”

I am a bear in the current climate, I have been a bull in the past and I trade both ways. In other words I am a realist, I may be bearish on macro-economic fundamentals but I can ride an uptrend when I see one. To use such an expression as JM has written to pooh-pooh those who believe in free markets shows a lack of argument. I have news for you all, regardless of your economic “bent”, unless you are prepared for events now you will all have your noses cut off.

Finally we look at the outcome of the current turmoil. Again JM is specific:

“It is precisely because the Fed is willing to take such actions that I am modestly optimistic that we will "only" go through a rather longish recession and slow recovery and not the soft depression that would happen otherwise.”

Does that qualify as “muddle through”? JM was looking for a muddle through scenario until very recently. I don’t think a longish recession and slow recovery qualifies. Muddle through to me was below average growth not contraction. There is no blame to attach here, it is just recognition that realism is useful and has a place in financial thinking. It is realistic to believe that if a moral hazard in the UK can affect the worth of that country’s currency, the same should be applied to any other government that accepts moral hazard can be introduced into the game rules. As we have already seen, intervention begets a further expansion of intervention.

JM makes a final point that the problem is so large and the effects on the “small guys” would be so great (i.e. small guys do not know about risk?) that a true re-pricing event would cause devastation. He also says that a lack of intervention caused the current turmoil. Other than a non-acceptance of capitalist free markets as a true reflection of worth, the blame appears to land at the door of the Government and the Fed. Boy they can’t win in this discussion.

Regulation is what JM is alluding too, or the lack of it. At what level though, the relaxation of credit lending standards? (Surely a bank decision). A lack of oversight in mortgages? (Greed from all parties overrode risk appraisal, including the consumer). A lack of transparency in credit markets? (Transparency is there, you just have to pay for it).

What exactly were the Fed and Govt agencies supposed to do? Regulate every transaction? Greed finds away around regulation, be it loopholes or flat out illegality. You can regulate for every function but it does not stop attempts to circumvent it.

If you want to correct an interventionist prone capitalist system then allow it to purge itself and reset the boundaries of its influence based on truth. If you want to get a rating on a debt package you wish to sell in the marketplace then tell the truth. Open the books, show the risk and accept the price that the market sets. You even save money on not paying a Ratings Agency.

Only this will restore confidence in the markets. If it means prices are lower (or higher for the good stuff) so be it. Its not the price that wipes you out, it’s the re-pricing when the truth comes out. Attempting to interfere and tinker will just cause greater imbalances and risks and lead to further opaqueness.

Maybe JM has forgotten how he worried about the costs of today being visited upon future generations. Intervention will ensure that such passing on of the debt will happen.

My thanks for your time if you have read this far, I appreciate it. Now, I may be inundated with emails after this article (or not!). Please don’t be offended if I fail to reply to them all. Please remember, I have written this letter not to ignite feelings but to open up an important debate. On Sunday I will be reading and enjoying JMs email, as usual.


steve said...

Excellent analysis. But then I thought John Mauldin's was too. I do think his bias shows though at times . He is a hedge fund manager.


Orr2749 said...

Excellent analysis. But then I thought John Mauldin's was too. I do think his bias shows though at times . He is a hedge fund manager.


Orr2749 said...

Excellent analysis. But then I thought John Mauldin's was too. I do think his bias shows though at times . He is a hedge fund manager.


Aktaion said...

Excellent analysis.

I too read Mauldin's newsletter every week, and more often than not agree with him.

But, like you, I just could not swallow his rationale for the Bear rescue. He's right about one thing - it's not a straightforward bailout, it's a sly mugging of the taxpayer.

Let's rip off the bandaids and allow the system to self-correct. Let the bad air out of the balloon. As Prof. Ann Lee noted on Bloomberg last night, these 'fixes' are worse than useless, and for the benefit of the bankers only.

Jim Rogers asks, "what's wrong with banks going bankrupt? If it's a bad business model, they deserve to fail."

Mauldin is wrong - the world will not come to an end if the current corrupt and unsustainable system collapses. We will not be hurling rocks and hoarding fire.

Anonymous said...

Keep in mind that Mauldin is not a neutral observer. He makes a living shilling for hedge funds - attracting new clients for those financial roach motels. If BSC was allowed to collapse, no doubt a number of his gravy train hedge funds would all have gone down. They are probably headed down anyway over the next two years, but Mauldin isn't going to bite the hand that feeds him.

Anonymous said...

When the politicians talk, don't listen.

The Fed is the front man on a confidence scheme to pass fiat currency.

"We control inflation and print money".

Viewed from this perspective, none of this BSC business has anything to do with helping the economy. It's to maintain the state's finances. Remember BSC is/was a primary bond dealer.

It will be interesting to see what happens next, this is just the borrow short/lend long blowups -- the actual long term loan losses are still way in the future.

Anonymous said...

Hi Mick,

Thanks for posting your thoughts. I had similar reactions to JMs OTB article regarding BSC. My opinion is that much of this debacle (including the sub-prime mess) was aided and abetted by credit that was far too easy to access. I believe this easy credit is a product of our current debt money system; more specifically, that our monetary system lacks strong checks and balances that would limit credit in ways that could help stabilize the financial system. Paul Kasriel has opinied that basing money supply growth (at least in part) upon population growth could be helpful. Rep. Ron Paul has submitted a bill that, if passed, would allow silver and gold to circulate freely as currencies (to compete with the USD). In my opinion, these types of ideas could provide stronger checks against profligate (and perhaps damaging
) USD credit creation. Comments?


Anonymous said...

I´m also a fan of JM but this was the first time I really disagreed
with him (about the BS bailout).
I was truly amazed by his (JM´s)
approach to the intervention-motives. And the main reason was
that his defending was in all sweeping words without any analysis
which by the way is one of JM´s

Very suprised indeed
Christer Kamb/Sweden

Anonymous said...

I believe that economics 101 is about opportunity costs.

Unemotionally, we need to disentangle the costs of the Fed not stepping in on the Bear episode, vs the costs consequent to their stepping in(as they did).

I hope no one denies that it would be a catastrophy of enormous global proportions if any major financial instituition was allowed to fail.

I think too many have mistakenly confused the events that lead up to the necessity of any Fed action at all with the consequence of the actions themselves.

Perhaps it can be said that a natural consequence to our capitalist system, is its inevitability towards eventual failure , followed by interventions and regulations.

Anonymous said...

Maudlin is an awful, sappy, ultra-right-wing fantasist-cum-shill for his hedge funds. He wants to be seen as the voice of calm when all around are losing their heads. This will please his clients as well as offering the "level-headed' point of view. There is no downside. If he is right, he'll be a hero. If he's wrong, he'll lose his clients and his business anyway, whether or not he denies the existence of hard times.

I have had several sharp e-mail exchanges with him in the past with this ego-driven passive-agressive sap, who thinks regaling the readers each week with stories of his family's current activities is essential reading for us. I am very sorry that his daughter had a (benign) lump in her breast, but, frankly, I am so not interested.

I look forward to seeing this ass writhe and twist his way out of his "Muddle-Through" crap as the economy descends into depression.

Anonymous said...

It is slightly concerning that so many express astonishment at JM's recent writings. His bias towards his own class shows all too often and distorts some of the excellent analysis that he is at times capable of. I've written to him a few times expressing how up in the blue he is at times but he always shrugs it off. These days only if there is nothing else to read will I bother picking his stuff up, because it is often full of I told you so, last year remember. He is never that clear on what he says. The muddle through recession being just one of those points.

The best illustration of his bias is when he takes his republican hat on and starts ventilating over the democrats, because of their socialist practices.

And then he writes a totally fantasy based apologetic letter for Ben and the chums he hang out for when big government came to (their) rescue!


Long Live the Revolution!


Anonymous said...

Thank you thank you thank you!

His former writings have indicated that he does not like the kind of crap that Bear Stearns was engaging in but now he is an apologist for this action? Wow, must of gotten a call from a friend at JPM.

Yeah this action is an attempt to keep "Shtuff" from being marked to market, again, but it ain't gonna work.

I cannot believe that he believes that this is for the "Greater Good"

The Collection Agency said...

Caught your reply to JM's latest on and I was glad to see
that I wasn't alone in thinking the often reasonable JM seemed to have
pulled a fast one on all of us with his strong support of the US Fed /
JPM bail out of BS. I read JM a lot and have not always agreed with him
but use him as a counterweight to some of my own thinking - like a
checks and balances of a sort.

His recent opinions disturb me though I think I'll keep reading him for
a while as I'll keep a look out for your own Collection Agency writings.
Again, nice reply.

John M
Nice job. Don't let JM get a free pass any more.
Keep on him. You were a great counter-point.

I enjoy reading Mauldin's articles and I enjoyed your counter look. I
believe you are right in this; John is looking at it in the short term
which may be valid but you are more concerned about the long term health
of capitalism in the U.S. I agree with you and also wonder if you buy
John's take on the low inflation going on in the U.S. now. Thanks again
for your good article and I have now checked out your website and will
look around a bit more later.
Regards, Gary S
Dear Mick,
Thanks for your insightful essay. However you were WAY to polite in describing the Bear business model. In fact it did work. My guess is the employees took out 50% of the grossly exaggerated profits in bonuses over the last several years. If they had gone bust the real losses would probably have been about ballpark right for the round trip.

Another point. I am sure they agreed to the $2 buyout so they could keep their 07 bonuses which absolutely would have been clawed back under numerous fraud statutes.

Dan M

Some of the comments from my email inbox. To be honest, I'm surprised I didn't get one email disagreeing with my reply to JM.

Thankyou all for your input, I appreciate it.

Best regards


Anonymous said...

JM must have read "The power of positive thinking" many years ago and is now having difficulty seeing that train coming at us. He keeps cooking his food on the cmmp stove set up in that nice clearing with those shiny rails on either side. Oh, and that sound he hears must be thunder so he turns away from it and opens up his umbrella.
JM is a status quo clinger. He responds to change with the speed of a 200 month moving average. He won't do well at all in the immediate future.

Anonymous said...

It's about time he was exposed a little, and it's clear from the comments on here many people see his ulterior motive.

Mick keep up the good work.

Anonymous said...

I'm not keen on being "anonymous" but can't remember my Google details.

"If you want to correct an interventionist prone capitalist system then allow it to purge itself and reset the boundaries of its influence based on truth. If you want to get a rating on a debt package you wish to sell in the marketplace then tell the truth. Open the books, show the risk and accept the price that the market sets. You even save money on not paying a Ratings Agency."

Perhaps the above should be sent to Scotty Dog in bold capitals.

Meanwhile having assessed the risk/reward situation at regular intervals I remain happy to hold.



Perry Taka said...

The Collection Agency has provided some useful comments regarding the new American model of Financial Communism. Of course in the American model there is a class basis--communism applies to the financial elite like John Mauldin. But in the real world communism even for the financial elite will fail as it always does. You can only squeeze the proletariat so far because he simply doesn't make enough to afford wildly expensive housing and will default. Nothing the Federal Reserve can do can change this reality. Of course, creating inflation, the FED has again regenerated the speculative juices that lays a foundation for a truly monumental bust somewhere in the future. Bernanke is truly clueless as to reality, and isn't that the hallmark of academic theorizing--especially at Princeton?