Four Musings on this Manic Market

 |  Includes: ALY, BRNC, RGA
by: David Merkel, CFA

1) Two Positive Surprises; Two Things I Don't Do 1/24/2008 [From my post at RealMoney]:

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Two more news bits. I don’t buy for takeovers, but today Bronco Drilling (NASDAQ:BRNC) got bought out by Allis-Chalmers Energy (ALY). (Now I have three open slots in the portfolio.) I also don’t buy to bet on earnings. But I will ignore earnings if I feel it is time to buy a cheap stock. With yesterday’s purchase of Reinsurance Group of America (NYSE:RGA), I did not even know that earnings were coming today. What I did know was that they are the best at life reinsurance, and that it is a constricted field with one big (in coverage written) damaged competitor, Scottish Re (NYSE:SCT). So, today’s good earnings are a surprise, but the quality of RGA is not.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Scottish Re to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: long RGA BRNC

2) There’s a lot of commentary going around on the Financial Guarantors and bailouts, whether to profit-seeking individuals like Wilbur Ross, or a consortium of investment banks who will not do so well without them. For a good summary of what will make a consortium bailout of the industry as a whole tough, read this piece at Naked Capitalism. I will say that Sean Egan’s estimate of $200 billion is too high (maybe he is talking his book). Just on a back of the envelope basis, the whole FG industry earned about $2 billion per year. If they needed $200 billion more capital to be solvent, their pricing would have to expand about 5-10 times to allow them to earn an acceptable ROE. No one would pay that. So, if the $200 billion is right, it is just another way of saying that the FG industry should not exist. (Well, the Bible warns us of the dangers of being a third-party guarantor…)

Then again, there are many risks that Wall Street takes on where the probability of ruin is high enough to happen at least once in a lifetime, but adequate capital is not held because protecting against the meltdown scenario would make the return on equity unacceptable. The risk managers bow to pressure so that the businesses can make money, and hope that the markets will stay stable.

3) There’s been even more musing about the Fed 75 basis point cut, with a hint of more to come. No surprise that I agree with Caroline Baum that the Greenspan Put is alive and well, or with Tony Crescenzi that we could call it the Bernanke Pacifier. But Bill Gross leaves me cold here. He and Paul McCulley consistently argued against raising rates during the recent up cycle, and in the prior down cycle cheered the lowering of the Fed funds rate down to 1%. These policies, which overstimulated housing, helped lead to the situation that Mr. Gross now laments.

I also think that David Wessel and many others let the Fed off too easily on their misforecasting. Who has more Ph.D. economists than they do? I’m not saying that the Fed should read my writings, but there is a significant body of opinion in the financial blogosphere that saw this coming. Also, they basked in their aura of invincibility when it suited them, particularly in the Greenspan era.

As I have already commented, Bernanke is a bright guy who will not let his name go down in the history books as the guy who allowed Great Depression #2 to emerge. So as the bubble bursts, the Fed eases aggressively. Even Paul Krugman points to the writings of Bernanke on the topic.

One last note on the Fed: Eddy Elfenbein points out the basic mandate of the Fed. I’m not sure why he cites this, but it is not a full statement of the Fed mandate, unless one interprets it to mean that the Fed has to promote the continuing growth of the credit markets (I hate that thought). Since the Fed is a regulator of banking solvency, and must be, because money and credit are similar, the Fed also has a mandate to preserve the banking system under its purview. That’s difficult to do without overseeing the capital markets, post Glass-Steagall. Unfortunately, that is what creates at least the appearance of the “Greenspan Put.” And now the market relies on its existence.

4) But maybe the Fed overreacted to equity markets getting slammed by SocGen (OTCPK:SCGLY) exiting a bunch of rogue trades. Perhaps it’s not all that much different than 2002, when the European banks and insurers put in the bottom of the U.S. equity markets but being forced to sell by their regulators. If so, maybe the current lift in the markets will persist.
As for SocGen, leaving aside their chaotic conference call, I would simply point out that it is a pretty colossal failure of risk control to allow anyone that much power inside their firm. Risk control begins with personnel control, starting with separating the profit and accounting functions. Second, the larger the amounts of money in play, the greater the scrutiny should be from internal audit, external audit, and management. I have experienced these audits in my life, and it is a normal part of good business.

Because of that, I fault SocGen management most of all. For something that large, if they didn’t put the controls in place, then the CEO, CFO, division head, etc. should resign. There is no excuse for not having proper controls in place for an error that large.

Full disclosure: long RGA BRNC