I know it's painful, but days like this are what makes America so great. Our willingness to allow Lehman (LEH) to go bankrupt makes us great. Our short selling attacks on AIG (NYSE:AIG), Washington Mutual (NYSE:WM), and Citigroup (NYSE:C) make us great. Dropping 500 points on the Dow is difficult to swallow but consider the alternative of artificially propping up a company like Lehman so they can flounder on for another five years. That wouldn't be great.
The capitulation to come this week is required to form a bottom in the financial sector. I count ten times this year that analysts have prematurely called for a bottom in the financials and each time buyers have been bitten. We at Lone Peak Asset Management have refrained from making any such calls but it must be noted that this action is different. History shows us that forced consolidation is the sure way to end a crisis.
A similar panic in financial stocks happened during the Gulf Crisis, in August of 1990. Banks, S&Ls, insurance companies and other financial stocks, already down sharply because of real estate problems, went into a free fall. Fears were being voiced about the viability of the banking system itself, and doubts were expressed as to whether it could withstand the shock of a substantial real estate downturn. From the beginning of the year to the end of September, regional banks dropped 50%. Some financial stocks fell by as much as 80% from their previous highs. Sound familiar?
Jim Cramer remembers this about that time period:
I had made almost all of my money shorting the financials that year. I didn't want to leave the thesis; it was too lucrative. And then it changed. Citigroup got a sheik savior. I saw institutions, insolvent institutions, rise from the dead and get bought at a premium. I remember fighting it. I remember digging in my heels. I remember being smarter than the average bear. I remember saying that the bulls were a bunch of bozos and lightweights and didn't know anything. I remember the scorn I had for them. And what happened? The financials rallied 200%. Oil prices plummeted. Inflation went away. The market took off huge. A new president eliminated the budget deficit and created tons of new jobs. The remaining banks prospered beyond belief.
The bottom of the 1990 crisis was formed once the mergers began. The current bottom is upon us as Washington Mutual, AIG and Citigroup join the others who have found resolution: Merrill Lynch (MER), Lehman, Fannie (FNM), Freddie (FRE), Indymac, Countrywide, and Bear Stearns. As a result of these resolutions, our financial system will emerge stronger than before and the broad market will finally be able to sustain a rally. Those banking institutions that remain will be buoyed up by the Federal Government as soon as this necessary consolidation is finished.
Vince Farrell is the latest to suggest that the government suspend mark-to-market disclosure requirements, the same argument that we at Lone Peak Asset Management offered up back in July. Mr. Farrell said:
In addition to the exotic debt obligations, companies like Lehman have billions in commercial real estate on their balance sheets, and how are you supposed to mark to market a long-lived asset like an office building every quarter?! David Malpass of Encima Capital, a first-rate economist, writes in the current issue of Forbes that the government should suspend this accounting provision and rethink its application. Asset deterioration needs to be accounted for, but probably not quarterly and definitely not marked to a chaotic and unreliable market level. It seems to me that Treasury and the Fed are kind of making up the rules to this one as they go along. That is not a criticism. But since there is no guideline or precedent, I think they should try to calm the situation down with an accounting adjustment. I don't want to see any more government bailouts. In a free enterprise system, there is risk as well as reward, and now is as good a time as any to remind us all of that. An accounting accommodation could act as a time out while we figure out how best to apply the principle without putting more taxpayer money at risk.
Maintaining a clear perspective during a 500 point down day is difficult but rest assured, the system is not falling apart, it is fixing itself. None of us can escape the anxiety and doubt that permeates a crisis. Crisis investing opens the door to large profits but they don't come without discipline and an ability to stomach the temporary reverses. To make the big gains you have to buy while overreaction surrounds you.
In closing, Bank of America (NYSE:BAC) CEO, Ken Lewis had an interesting response to the question of why he didn't wait longer to buy Merrill Lynch:
We don't think many people, if any, can ever call the bottom...as we weighed everything, we said it is better to seize on this opportunity as we see it at the moment, as opposed to trying to catch the very bottom and possibly not catching it at all. This is the strategic deal of a lifetime.