Call the Plumbers!
Anyone who has ever owned a house has experienced the
need of a good plumber. A toilet backs up and makes a
stink. We all know that there are pipes but don’t have
any idea where they are or how to clear them. Call the
Plumbing is an apt metaphor for the hidden conduits
of the financial system through which capital flows from
lenders to borrowers. Driven by the housing boom,
financial institutions innovated, stuffing the pipes
with complex securities inadequately tested for risk
should the housing market run out of steam. Call it
Voodoo Finance 101. As the housing bubble burst,
investors refused to buy these securities, leaving the
banks holding the bag with impaired capital. Stock
prices collapsed. That forced the banks to go to foreign
investors, hat in hand, to raise equity to stave off
insolvency. With so much waste stuffed into the pipes -
sub-prime mortgages, SIVs, CDOs, CMBS, leveraged buyout
bridge loans - there was bound to be a backup when the
music stopped. In retrospect, as always, it seems so
And what a backup there has been. Lenders won’t lend;
some borrowers can’t borrow at any price. The financial
system has frozen up and is threatening the “real
economy,” the one that provides mortgages, car loans and
inventory financing for business. Wall Street’s folly is
threatening Main Street’s pocketbook.
Call the plumbers!
Federal Reserve Chairman, Ben Bernanke, and Secretary
of the Treasury, Henry Paulson, donned their overalls,
plungers in hand, and set out to clear the blockages.
They acted expeditiously and with imagination. I wish my
plumber were as responsive.
Over four days in March, the Fed injected $200
billion into the financial system, cut interest rates,
and arranged for the sale of Bear Stearns, a major
investment bank that the Street decided was not
creditworthy enough to do business with because of its
aggressive investments in low-quality securities.
The bailout of Bear Stearns was a watershed event.
Wall Street operates on the notion that “my word is my
bond,” the ability to honor and settle a trade, and the
confidence that the firm on the other side of the trade,
the counter-party, will honor the commitment. If
confidence in that “bond” disappears, as it did in the
case of Bear Stearns, confidence in the system is
undermined. Since everyone to varying degrees was
playing the same game as Bear, the question became,
“who’s next?” Rumormongers targeted Lehman Brothers. By
stepping in to guarantee the assets of Bear Stearns and
by implication, just about anyone else, the Fed signaled
that it would do whatever necessary to stand behind the
financial system…another blockage plumbed.
The Fed seems to have gotten it right for now…but
Bear Stearns shareholders, including employees who owned
30% of the company, were devastated; they received $10
from JP Morgan for their stock that had sold for over
$170 a share only a year earlier…so much for moral
hazard, the notion that the government will bail out
Despite vigorous efforts by the Fed, financial
markets remain vulnerable. Large write-offs of bad debt
remain to be taken by financial institutions and that
may yet unsettle confidence and the markets. Numerous
financial companies continue under stress; they will
need to raise capital or sell out to stronger partners.
The Fed and Treasury will remain matchmakers,
shepherding the weak into the arms of the strong.
Though full confidence has yet to return to the
markets, we sense that there is a large pool of
opportunistic capital waiting to buy up distressed
assets. However, it is still unclear what the risks are,
so the recovery unfolds slowly. Cautious stock market
rallies reflect uncertainty as to the length and depth
of the current downturn in business activity.
Our strategy is to test the investment waters
incrementally. Over the last seven months we have made
small purchases at what have seemed like attractive
entry points. Some of those investments have been
premature. We feel like explorers descending a series of
cataracts along an uncharted river. After each set of
rapids, there is a period of calm. We wonder whether we
are through the worst (should we buy?) …or are more
We continue to emphasize investments with good
dividend yields when we can find them. Dividends, often
unappreciated, have contributed a surprisingly large
part of the long-term returns of common stocks. We
believe that many distressed securities today will
continue to pay their dividends, resulting in above
average returns as confidence returns to the financial
As fiduciaries of many of our clients’ investments,
we are acutely aware of our responsibilities to preserve
capital during difficult times. This, however, has to be
balanced by the need to do the right thing by buying
depressed securities during periods of low confidence in
order to benefit from the eventual return to growth that
has characterized the stock market over the long-term.
In crisis there is opportunity. It is our challenge to
sift through short-term problems to identify eventual
We thank clients for their patience and confidence
during this unsettled period.
Please read our important notice
about these letters and the securities they mention.