December 2008 |
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There is a loud message being sent by the bond market today. And, if you listen carefully, the message is, don't mess with us! The US Government is listening and acting very carefully. While nothing today is totally clear or easy to explain, we think the bond market is the elephant in the room that nobody is talking about. This elephant is roaming around the Federal Reserve and this same elephant is making noise at the Treasury Department. And, yes, the huge beast is threatening to crush Congress as well. The bond market is there and it isn't being ignored.
The "bond market" is just a collection of large institutional investment pools of money. Think of insurance companies, pension funds, endowment funds, foreign central banks, bank trust departments and also piles of wealthy individuals.
These are the guys who lend money in return for a predictable fixed return. Yes, they also buy stocks and own companies too, but for some of their money, they just want the income stream and the money back in full. They're pretty simple-minded investors. But, they are ruthless and hold the purse-strings that drive the world's access to credit.
The credit markets have been acting up lately. Acting up is probably an understatement. Here is a little history of their temper tantrums and how the authorities (the Treasury, the Fed and our politicians) have chosen to deal with them at this point. It is a little different view of the whole bailout story.
Back in March of last year, the first near fatal blow to your run-of-the-mill bond investors was the Bear Stearns debacle. Bear Stearns was a very big borrower of money and they were totally over-leveraged.
By all accounts, for every dollar of equity Bear Stearns had, they were able to borrow another $30-$40. So, they played with $31-41 dollars and only had $1 that was theirs (the shareholders) to begin with. This was a train wreck waiting to happen. Over the year, it didn't crash and shareholders made gobs of money. And then...it crashed and burned.
Naturally, the bond investors who lent money to Bear Stearns knew that things could go wrong. But, before things could go too wrong, the common and preferred stock holders were going to have to go to zero. Think of the shareholders' capital as a cushion for the bond market guys. It can be a big or small cushion.
The required cushion agreed upon by bond market investors is negotiated every day. In the past few years, before the world turned upside-down, the required cushion was crazy thin. We actually couldn't believe how thin the cushion was. But, many bond market investors didn't see it that way and lent money to the likes of Bear Stearns on quite lenient terms. They took a risk. And they should have lost.
However, at the end of this story, just before Bear Stearns was about to kick-the-bucket and declare bankruptcy, the Federal Reserve took the unusual step of saving them. They backstopped a loan that could lead to eventual losses and orchestrated a sale of Bearn Stearns to J.P. Morgan for $2 per share and voila, the bondholders - that's right, all of them - got 100 cents on the dollar. They got out totally whole! It was an unbelievable deal for the bond guys.
This action sent a loud signal to the bond market.
"Don't worry. No company big enough to hurt the economy will be allowed to fail. Everything is okay, go ahead and keep lending on ridiculously easy terms!"
Fast forward to July and, once again, the bond investors of Fannie and Freddie debt - again, two firms leveraged about 50x - were whining about the risk of their bonds. This time the bond investors included the Chinese and other international creditors. Fannie and Freddie debt holders are simply impossible to ignore.
So, what did the Treasury Department do? They made their implicit guarantee of Fannie and Freddie's considerable debts a sort-of-explicit-guarantee. Understand they didn't quite move all the way to a totally-explicit-guarantee. We are talking about $1.5 trillion dollars here, so fully taking that on was just a little too much to do over a weekend.
However, with this deal, they decided to just kill the holders of the Fannie and Freddie's common stock and preferred stock holders. They were probably worried about the "moral hazard" risk. That is, if you are just going to bail investors out of their problems, they'll likely take on really huge risks in the future that will inevitably lead to even bigger bail outs later. It isn't a precedent that governments like to set.
Then, in September we witnessed another investment bank sinking quickly into bankruptcy - this time Lehman Brothers. And, again, this company was leveraged to the hilt with the help of, once again, lenient bond investors. How else would Lehman have gotten enough borrowed money?
Over another emergency weekend, the government hemmed and hawed about the moral hazard risk of another bailout. So, they called the bond market's bluff and let Lehman go under - bond investors and all.
The reaction was kind of like a parent letting a child pitch a fit and committing not to react to it. It sometimes works but you'd better stick to your guns.
The very next day, right on the heels of Lehman's bankruptcy, they basically confiscated the assets of mega-huge insurance company, AIG. It was a final straw event and the bond guys took the tantrum to a whole-other-level,as they say! The entire world of credit stopped trusting each other.
And...the credit crisis began in full force.
Bond prices fell, banks pulled back their lending, housing prices kept falling, the economies world-wide slowed radically and stocks fell a lot. In response, what did the governments of the world do? They simply reacted and started guaranteeing and lending against everything they could think of. So, in a sense, the government blinked and has decided to act like an inconsistent parent. And now bond investors rule the roost.
Governments have started throwing around money (they don't actually have) at the problem (they can't actually define) and they are doing it in the name of preserving jobs for their citizens. This is not a total lie. They do want to stop a frightening free-fall in economic activity. But, we all know it must come at some future cost.
But when we step back and view our capitalist economies from an objective viewpoint, don't we honestly believe that bond investors are the ones who should shoulder the losses when things go drastically wrong? That is their role and that is the deal they've struck, right? Aren't they the ones the Treasury and Federal Reserve are actually saving with all these bailouts and guarantees? The unmentioned bond guys lurk in the shadows.
To say that the Big 3 and Bear Stearns and AIG and Fannie and Freddie and the shareholders of hundreds of other totally decimated stocks are being bailed out is a joke really. These investors have all lost about 90% of their value.
What about the bond investors? They are the ones that should be paying the next level of losses. They lent the money on lenient terms with vaporous collateral backing their loans. They are the ones that bought the asset-backed securities with no real assets backing them. They are the ones that allowed the world to leverage up to these unsustainable levels.
As a closing thought, either world governments (a) choose to spend money they don't have and possibly stoke future inflation that will lead these same bond investors to demand higher interest rates in the future or (b) we choose to let the bond investors eat the losses.
However, if we just let them eat the losses, guess what the bond investors will do in return? They'll try to re-coup their losses by charging, you guessed it, higher interest rates in the future. It probably leads to higher rates, either way.
The bailout option comes with a big moral hazard risk and the let it be option comes with massive social and political risk. It appears the government (read, politicians) has made its choice and the bond market stands in the shadows watching it all very, very closely.
