Resolving The Crisis: Remembering What Makes Us Great

 |  Includes: AIG, BAC, C, GS, JPM, MS, SPY, WFC
by: Eric Parnell, CFA

"They have to do it. They have no other choice but to do it."

This is a refrain that I hear over and over again in the financial media. With the perpetually imminent Greek debt deal delayed day after day, many investors remain confident of the notion that in the end everything will all work out. Why? Well, they just have to do it. After all, the alternative for the global economy and the stock market (NYSEARCA:SPY) would just be disastrous. So for this reason, they'll definitely get it done because they have to get it done.

OK. But here's the thing. They really don't have to get it done. As a matter of fact, they don't have to do anything. Sure, many certainly hope that they will get something done. And perhaps it is highly probable that they will. But hope does not imply absolute certainty. And acting on hope under the belief that it is certainty is simply a tenuous approach to risk management.

It is worthwhile to dissect what's going on around the world to understand the true risks associated not only with the situation in Europe currently fixated on Greece but also the financial crisis that has been ongoing over the last several years.

It is first worthwhile to consider who the "they" is that have to get a deal done. "They" are policy leaders, but "they" are also people who are human. "They" are individuals that are acting ideally on rationale, but also sometimes on emotion. As we know all to well as we look back throughout history, people make mistakes. And it is often the consequences of these mistakes that creates the most notable history.

It is also worthwhile to understand the priorities of the people "they" represent. The various leaders struggling to keep the global financial system afloat represent a variety of different constituencies. Not everyone is necessarily on the same page when it comes to what "they" are trying to achieve or what "they" even believe.

A fundamental truth about people is that everyone wants something different depending on their priorities. Investors want a deal because they want global stock markets to keep going up. The Germans want a deal with conditions because they want to continue to benefit from all that the Eurozone offers for their economy. But how long will the German people approve more rescue plans at the expense of having their own financial security undermined by their struggling sovereign neighbors? And the Greeks want a deal with as little conditions as possible because they want to try to stay in the Eurozone. But how much longer and at what additional cost will struggling Greeks (and Portuguese, Irish, Spanish and Italian) be willing to endure before they decide that the "unthinkable" alternative might actually be the better path?

This is where the "done" comes into play. What we as investors perceive how the crisis needs to be resolved is very different than how German leaders may view the situation. Of course, this is different still from what Greek leaders may believe are the best solutions. And none of this even begins to consider the perspectives of other sovereigns, hedge funds and CDS holders that all are directly involved and have a totally different set of priorities as well.

There is a reason why the Greek deal is perpetually imminent but never actually gets done. It's the same reason why the Eurozone has been in a full-blown crisis for several years and continues to fester. It is because no clear solution exists to the problem. Each participant has his or her own unique perspectives and priorities. It's also not as though these leaders have quantitative models that crank out the most disciplined decisions to make as circumstances evolve. Instead, most participants are individuals, many of whom are politicians are outside of their core area of expertise in dealing with a financial crisis and all of which are prone to making unintentionally bad decisions and emotional mistakes at times that could lead to shocking outcomes. And unfortunately, all roads taken in dealing with the crisis lead to messy conclusions.

The Peril of Relying On "They Have To Do It"

Thus, the risk management approach of relying on "they have to do it" is lined with catastrophic potholes. After all, this certainly isn't the first time that we've heard this notion, and it certainly won't be the last. And the times when the belief of "they have to do it" met with the reality of the "unthinkable" has resulted in some of the most turbulent points in our market history.

One has to look back no further than 2008 to see the most recent example of the "unthinkable" coming to pass. As the trading day came to a close on Friday, September 12, it was well known that Lehman Brothers, Merrill Lynch and AIG were quickly heading toward a financial flat line, with Lehman Brothers being the sickest patient in the ward. But as the latest round of Long-Term Capital Management (LTCM) style emergency banker negotiations got underway over the weekend of September 13-14, it was widely presumed that they would work something out.

Of course, they rescued LTCM back in 1998 and they worked something out for Bear Stearns back in March 2008, so they'll certainly do the same for Lehman Brothers this time around. After all, "they have to do it", right? But as we all know, things didn't necessarily work out that way. Lehman failed, and while we all know the end result of what followed, I am often surprised at how the events that unfolded along the way to this end are overlooked. More on this in a moment.

It's not as though the Lehman collapse was the first time in history that the notion of "they have to do it" was refuted with unsettling consequences. Many also assumed that European leaders would never allow a major financial institution like Credit-Anstalt fail back in 1931 during the Great Depression. But they did, in part because the resources to do otherwise were simply gone at that point. Most every policy alternative had been exhausted. And it was this "unthinkable" outcome, not the stock market crash that preceded it in 1929 that led to the most severe phase of the crisis at that time.

So when relying on the notion "they have to do it", remember that history has shown many cases where they didn't. And shocking results often followed.

It's Not About Failure. It's About Confidence.

It's worthwhile to return to the Lehman point for some added perspective. When reflecting on the outbreak of the financial crisis back in late 2008, many over simplify the situation by suggesting a basic cause and effect. The widespread recollection is that Lehman Brothers was allowed to fail and the global economy and stock market immediately plunged into crisis. But it was not that simple. Far more was going on beneath the surface.

While Lehman may have been a contributor to the crisis, it certainly wasn't the only cause. When Lehman Brothers collapsed back in mid-September 2008, the stock market held steady for over two weeks. Thus, it wasn't as though the market descended into peril upon the news that Lehman was bankrupt. Instead, Lehman was just one among a series of events that occurred along the way that led to a far more profound result. What was occurring at the time of the Lehman collapse was a policy decision to handle at risk financial institutions on a case-by-case basis, which resulted in confusion.

Lehman failed, but Merrill Lynch was placed into the arms of Bank of America (NYSE:BAC) in a shotgun wedding during the same weekend. The government effectively nationalized AIG while Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) were given fast track waivers to convert to commercial banks. Washington Mutual was seized by the FDIC and sold off to JP Morgan Chase (NYSE:JPM) all without the knowledge or participation of Washington Mutual's senior management or board of directors. And Wachovia cut a deal to be acquired by Citigroup (NYSE:C) only to have the government step in and push the suffocating bank toward Wells Fargo (NYSE:WFC) instead.

While all of these actions were undertaken with the best of intentions to try and rescue the financial system, the resulting chaos sparked a dramatic loss of confidence in the same financial system, as many institutions were left to wonder the following: will I be spared, will I be allowed to fail, or will I get off a plane only to discover that my firm is now owned by someone else. With confidence shattered and uncertainty running high, financial institutions were left with no choice but to frantically race to raise capital for survival.

And the resulting massive asset liquidations were the primary force behind the major market selloffs that followed in October 2008, November 2008 and February/March 2009. It was only after repeated reassurances by the Federal government that no additional major financial institutions would be allowed to fail, the recapitalization of the banks through TARP, the initiation of QE1 (nee QE) by the U.S. Federal Reserve and the suspension of mark-to-market accounting for financial institutions that confidence finally started to return again. And once confidence returned, the liquidations finally stopped and the markets stabilized.

The Peril of Doing It Too Much

The knee jerk reaction from policy makers more than three years after Lehman is to prevent crisis at all cost. But this is not the answer.

The system can handle the failure of a financial institution. They can even handle the failure of a sovereign like Greece. Why? Because the resources are still available to help guide the financial system through the mending process. And as long as the rules are clearly stated as to what sovereigns will be allowed to fail and under what conditions, and what financial institutions that are adversely affected will be allowed to fail and under what conditions, the global economy and its markets will be able to withstand it.

I'm not saying it's going to be pretty. I'm also not saying that we won't see some sharp market corrections along the way. But it's worth it if allowing the system to cleanse itself will help finally bring us toward a final resolution to the crisis.

The alternative of endlessly propping up the system driven by fear is actually far more perilous. This is because with each bailout, more precious resources are deployed. At the same time, the magnitude of the problem becomes greater. Think of all of the capital that has been spent and all of the money that has been printed since the Greece problem first reared its head back in the spring of 2010.

Yet now two years later we not only have a Greece problem that is much worse, we also have a Portugal, Ireland, Spain, Italy, Belgium, France, etc. problem. Thus, at this rate we will eventually reach a point where we no longer have the resources or the capacity to guide the financial system through the mending process. And instead of uncomfortable corrections on the path to resolution, we could ultimately see a full-blown financial calamity. This is where a Lehman moment evolves into a Credit-Anstalt moment, and it is certainly an outcome we would all like to avoid.

Recall What Makes Us Great

The free world is founded on the principles of perseverance, innovation and personal responsibility. It was not built on a flimsy base of bailouts, rescue packages and moral hazard. We have faced a variety of challenges in the past and will face more in the future. This is what the notion of risk is all about, and we accept these risks with the understanding that it can lead us to great rewards.

So instead of relying on a steady stream of artificial financial support to try and fix problems that have no resolution, its time to begin accepting the necessary adjustments so that we can finally move past the current crisis. It's no longer about buying time.

That was the point of the initial bailouts over three years ago. It's now about taking the bold action to finally fix the problem once and for all. It won't be easy. But instead of fearing the consequences of failure, we should take these consequences head on with the confidence that the spirit of perseverance and innovation will help drive us to a final solution that is far better than the conditions we have today. Now is the time to act, for if we wait too much longer, it may eventually be too late.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.