“If a tree falls in a forest and no one is around to hear it, does it make a sound?” is a legendary philosophical thought experiment that raises questions regarding observation and knowledge of reality. Can something exist without being perceived? Is sound only a sound if a person hears it? The most immediate philosophical topic that the riddle introduces involves the existence of the tree (and the sound it produces) outside of human perception. If no one is around to; see, hear, touch or smell the tree, how could it be said to exist? What is it to say that it exists when such an existence is unknown?
The experiment is often discussed in this manner; If a tree were to fall on an island, where there were no human beings, would there be any sound? The answer is no given that sound is the sensation excited in the ear when the air, or other medium is set in motion. This poses the question not from a philosophical viewpoint, but from a purely scientific one. Sound is vibration, transmitted to our senses through the mechanism of the ear, and recognised as sound only at our nerve centres. The falling of the tree or any other disturbance will produce vibration of the air. If there are no ears to hear, there will be no sound. Within the crowded forest of market information we’re continually bombarded with on a daily basis could there be sounds of falling trees that we’re not hearing?
The references to the market crash of 2008-2009 have been over done during the past few months; the PIIGS, the Eurozone debt crisis and its contagion possibilities, the downgrading of the USA credit rating, continual bank failures in the USA, (fifteen since August 2011), Soc Gen’s rogue trader, French banks’ credit rating downgrades, unemployment staying stubbornly high, the UK BoE’s MPC engaging in a further round of QE..The list is endless with regards to the current economic malaise and yet despite this barrage of negativity the markets, particularly the equity markets, have deflected the issues and remained at levels that (whilst still subdued) are nowhere close to the lows of March 9th 2009 when the Dow Jones industrial average (INDU) closed down at 6547.05, its lowest point since April 25, 1997.
The classic position trade V shaped price action ‘recovery’ thereafter was stunning. Using our classic rear view mirror it was obvious that the fear had been overdone and most global markets were oversold, the rally thereafter was equally spectacular. Without a doubt zirp, bailouts, assisted bankruptcies in the USA, (called pre-packaged rescues in the UK) and rounds of QE to “rescue the system” assisted the Dow Jones recovery to over 11,000 by early 2010. The global crash of 2008-2009 was precipitated by the Lehman Bros. collapse, revisionist and selective memory indicates that Lehman was the cause. However, that ignores the shock the market suffered the year previous with Bear Stearns.
I experienced a strange event when Bear Stearns began its decline. I was on holiday with my family in Kefalonia Greece at the time of its heart attack, as if the ancient Greek gods had ‘rumbled’ the system, the ATM system on the island went down. The reason given in the evening was that close to the island, or the mainland, there’d been a minor earth tremor. Later that evening, whilst reading about the Bear Stearns situation at an Internet cafe I did wonder, in some coincidental twist, if we’d reached an ‘inflection point’ of sorts. Had ‘we’ simplistically run out of money? For those of you now expecting a neat link up between: trees, forest, bears and woods I’m sorry to disappoint, but before we get to the punchline of this musing here’s a snapshot of how it all went wrong with Bear Stearns..
On June 22, 2007, Bear Stearns pledged a collateralized loan of up to $3.2 billion to “bail out” one of its funds, the Bear Stearns High-Grade Structured Credit Fund, whilst negotiating with other banks to loan money against collateral for another fund, the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund. The incident sparked concern of contagion as Bear Stearns might be forced to liquidate its CDOs, prompting a mark-down of similar assets in other portfolios. During the week of July 16, 2007, Bear Stearns disclosed that the two subprime hedge funds had lost nearly all of their value amid a rapid decline in the market for subprime mortgages.
At the time Bear Stearns was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession. Bear Stearns was involved in securitisation and issued large amounts of asset-backed securities, which in the case of mortgages were pioneered by Lewis Ranieri, “the father of mortgage securities”. As investor losses mounted in those markets in 2006 and 2007, the company actually increased its exposure, especially the mortgage-backed assets that were central to the subprime mortgage crisis. In March 2008, the Federal Reserve Bank of New York provided an emergency loan to try to avert a sudden collapse of the company. The company could not be saved and was sold to JP Morgan Chase for $10 per share, a price far below its pre-crisis 52-week high of $133.20 per share, but not as low as the $2 per share originally agreed upon by Bear Stearns and JP Morgan Chase. The collapse of the company was a prelude to the risk management meltdown of the Wall Street investment bank industry in September 2008, and the subsequent global financial crisis and recession. In January 2010, JPMorgan ceased using the Bear Stearns name.
Bear Stearns was the seventh-largest securities firm in terms of total capital. As of November 30, 2007, Bear Stearns had notional contract amounts of approximately $13.40 trillion in derivative financial instruments, of which $1.85 trillion were listed futures and option contracts. In addition, Bear Stearns was carrying more than $28 billion in ‘level 3’ assets on its books at the end of fiscal 2007 versus a net equity position of only $11.1 billion. This $11.1 billion supported $395 billion in assets, meaning a leverage ratio of 35.5 to 1. This highly leveraged balance sheet, consisting of many illiquid and potentially worthless assets, led to the rapid diminution of investor and lender confidence, which finally evaporated as they were forced to call the New York Federal Reserve to stave off the looming cascade of counter-party risk which would ensue from forced liquidation.
The fact that Bear Stearns had caused a massive heart attack to the system in 2007, that should have resulted in questions being asked with regards the solvency and investment methods of all banks, but those questions as to the overall solvency and working mechanics of the global financial system didn’t truly manifest until 2008, should be a cautionary warning sign and portent of what may be in play now under the surface. This latest market heart attack suffered in August-September could prove to be the start of far worse crises than the subprime crisis suffered in 2008-2009. Yet similarly this could be the start of an unravelling of events that may take some time to thoroughly haemorrhage through the system. But in terms of direct comparisons we are at Bear Stearns stage now and not Lehman bros.
So where is our ‘Bear Stearns’? Well it’s not quite that simple and as proven they were simply the canary in the coal mine that was muffled before it’s chirpy song became too loud. However, if we regard our banking system as the liver of global financial operations; an organ which has a multitude of important and complex functions: to synthesise, metabolise, form and secrete bile, secrete potentially harmful products and generally purify the system, then there are plenty of warning signals coming from the banking system suggesting a few trees in the forest are about to fall. Moving aside the questions of solvency of the French banks we’ve recently experienced Dexia which, like a circus freak show act in a by gone Victorian age, has been quickly re-packaged, shuttered and moved along to the next town before the children of the parish get too scared. But to imagine that Dexia is an isolated case is stretching the credibility of the banking system and the credibility of those bodies who found it stood up to recent stress tests, to tensile limits. Not withstanding Dexia nervous markets have recently experienced short selling bans on financial stocks, another ‘back to the future’ ointment that failed to work in 2008-2009.
Today we learn UniCredit, the Italian bank, has had its shares suspended after only a 7.5% fall. It’s not the fall that’s of concern to the markets, nor the contagion or domino effect, as unlike Bear Stearns this is not the banking system that is in question, this is a sovereign debt crises that is bringing into question the solvency of nations, not individual banks and that’s were this situation is radically different to 2008-2009. However, if Bear Stearns was the portent for Lehman, could Greece be the herald for bigger sovereign defaults? Is Greece the sapling being felled on the edge of the forest whilst deeper into the forest a large tree has already fallen but we can’t hear it?