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Bear Stearns and the Narratives of Systemic Risk

Summary:
In May 2007, Bear Stearns – one of the crown jewels of Wall Street – traded at nearly 0 per share. The S&P 500 peaked five months later, in October 2007. Five months after that, in March 2008, Bear Stearns was taken out in the street and shot in the head by regulators. The stock closed at per share that day. A few weeks later, the Bear Stearns carcass was sold to Jamie Dimon and JP Morgan for just under /share, although the effective price (long story) for most people who hung on to the bitter end (employees mostly) was /share. So ended the House that Ace and Jimmy built. Everyone who has been in markets long enough has their Bear stories, and I’m no exception. I liked Bear Stearns the company and I loved Bear Stearns the people! Bear was one of my two prime

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Bear Stearns and the Narratives of Systemic Risk

In May 2007, Bear Stearns – one of the crown jewels of Wall Street – traded at nearly $160 per share. The S&P 500 peaked five months later, in October 2007. Five months after that, in March 2008, Bear Stearns was taken out in the street and shot in the head by regulators. The stock closed at $2 per share that day. A few weeks later, the Bear Stearns carcass was sold to Jamie Dimon and JP Morgan for just under $10/share, although the effective price (long story) for most people who hung on to the bitter end (employees mostly) was $5/share.

So ended the House that Ace and Jimmy built.

Everyone who has been in markets long enough has their Bear stories, and I’m no exception. I liked Bear Stearns the company and I loved Bear Stearns the people! Bear was one of my two prime brokers (Morgan Stanley was the other), and we had a wonderful business relationship. Didn’t stop me from shorting them from $145 down to the bottom (with a borrow from Morgan Stanley, natch), and it didn’t stop me from moving our prime business over to JP Morgan in January 2008, but as Hyman Roth said, this is the business we have chosen. Nothing personal.

Anyhoo … while Bear Stearns was enduring an old-fashioned run on the bank in March of 2008 (it was hedge funds taking their money out of the prime brokerage that killed the company), the overall market was in a severe correction. Not a bear market, mind you (no pun intended), but a severe correction. When Bear went out, the S&P 500 was down 18% from the October highs and down 12% from the Jan. 1 year start.

You can see here how Bear was highly correlated with the S&P 500 from May 31, 2007 onwards, which makes sense given Bear’s poster child status for that market on the way up … and the way down.

Bear Stearns and the Narratives of Systemic Risk

And then we had the Bear Stearns Bounce.

The overall market came roaring back over the next 8 weeks, so that by May 19 the S&P was only off 1% for the year. Still down 8% or something like that from the highs of 2007, but no one cared about that. Long or short, you get paid in this business on the calendar year, and every January 1 is a clean slate. Shorts like me who were feeling pretty pleased with themselves on March 17 were enduring a crisis of confidence on May 19, and the longs who were despondent in March were feeling prettay, prettay good in May.

Why did the market come roaring back from mid-March to mid-May? Because narrative.

Because according to every market media Missionary, Bear Stearns was the bad Wall Street apple in an otherwise reasonably decent Wall Street barrel. Oh sure, there were still problems here and there in mortgage portfolios, and sure we were in a recession, but there was no longer a risk of the system falling down. Eliminating Bear didn’t mean that the tough times were over for the financial system, but it did mean that the crisis was over.

Sacrificing Bear Stearns to the regulatory gods meant that – and I’ll never forget this phrase – “systemic risk was off the table.”

LOL.

From May 31, 2008 to March 9, 2009, the S&P 500 fell by more than 50%. Because, of course, systemic risk was NOT off the table with the execution of Bear Stearns. Because, of course, the Wall Street banks were ALL bad apples.

And so here we are in 2020. Nice bounce!

Bear Stearns and the Narratives of Systemic Risk

What’s the Bear Stearns equivalent in this morality play? What’s the bad apple? What’s the singular source of systemic risk that we are now hearing is “off the table”, so that investors can enjoy a well-deserved V-shaped rally?

It’s the New York/New Jersey surge.

It’s the fact that we really and truly flattened the curve and we really and truly avoided a healthcare disaster in San Francisco and Kansas City and Nashville and Los Angeles and Birmingham. It’s the fact that New Orleans and Houston did not become New York City. It’s the fact that NO city in the United States suffered an overwhelmed medical system except New York City.

And now that the worst is over even in the uniquely hard-hit area of New York/New Jersey … now that our daily death rate has peaked at 2,000+ Americans dying every freakin’ day from this disease, so that improvement to “only” 1,000+ Americans dying every freakin’ day becomes the “good news” that allows markets to climb a wall of worry …

“Yay, systemic risk is off the table!”

That’s the narrative you’re going to hear from every market media Missionary, that New York was the bad COVID-19 American apple in an otherwise reasonably decent COVID-19 American barrel. Oh sure, there are still problems here and there in clusters of cases in this state and that, and sure we are in a recession, but there is no longer a risk of the system falling down. Blaming New York (and make no mistake, that IS the thinly veiled subtext here) doesn’t mean that the tough times are over for the rest of the country, but it does mean that the crisis is over.

It’s already starting. Here’s Bret Stephens in the New York Times last Friday.


No wonder so much of America has dwindling sympathy with the idea of prolonging lockdown conditions much further. The curves are flattening; hospital systems haven’t come close to being overwhelmed; Americans have adapted to new etiquettes of social distancing. Many of the worst Covid outbreaks outside New York (such as at Chicago’s Cook County Jail or the Smithfield Foods processing plant in Sioux Falls, S.D.) have specific causes that can be addressed without population-wide lockdowns.

Yet Americans are being told they must still play by New York rules — with all the hardships they entail — despite having neither New York’s living conditions nor New York’s health outcomes. This is bad medicine, misguided public policy, and horrible politics.


And so we’re going to start reopening local and state economies. And so because of the biology of this virus and the nature of exponential functions, I think we’re going to have at least a solid month of still more “good news” from states like Georgia in regards to their re-opening “data” before you have any resurgence of clusters. And so even then, I expect the new clusters will be explained away, lost in the shuffle of 500 to 1,000 Americans dead from COVID-19. Every freakin’ day.

See, that’s the thing about narrative-world, both for markets and politics. People can get used to ANYTHING in narrative-world. As the COVID-19 narrative becomes that of a chronic and excusably lethal event for the United States, as opposed to an acute and unforgivably lethal event, we WILL get used to it.

I’m not saying this is good or bad. I’m just saying it is. And it’s constructive for things that are driven by narrative. Things like markets. Things like this White House.

And that constructive narrative will last until something acute and unforgivably lethal happens again in real-world, until real-world events give the lie to narrative-world complacency. Which they will. Because of the real-world severity of this virus and the entwining of TRILLIONS of dollars worth of assets in business models that are not just damaged but obliterated by that severity.

Just like real-world events gave the lie to narrative-world complacency in the summer of 2008. Which they did. Because of the real-world severity of nationwide housing price declines and the entwining of TRILLIONS of dollars worth of assets in business models that were not just damaged but obliterated by that severity.

The systemic risk question you need to ask yourself today is the same question you needed to ask in 2008:

What is the micro-level truth of the potential real-world shock (home price appreciation then, virus biology today), and does that micro-level truth threaten the common knowledge surrounding a levered business model and securitized asset class of enormous size (mortgage-backed securities then, global trade finance and collateralized loan obligations and similar debt securitizations today)?

I know that last sentence was a mouthful. But it’s worth parsing.

History doesn’t repeat when it comes to outcomes. it doesn’t even rhyme. But the PROCESS of history never changes. That’s what I’m describing here … the historical process of systemic risk manifestation in social systems like markets and elections.

I’m not here to sell you an Answer. I’m here to show you a Process.


About Ben Hunt
Ben Hunt
He is the chief investment strategist at Salient, a $14 billion asset manager based in Houston and San Francisco, and the author of Epsilon Theory, a newsletter and website that examines markets through the lenses of game theory and history. Over 100,000 professional investors and allocators read Epsilon Theory for its fresh perspective into market dynamics.

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