Bear Stearns...Not A Bailout

Unless you have been living under a rock for the past week, you have undoubtedly heard about the mess at Bear Stearns: their CEO proclaiming things were fine on CNBC, experiencing a liquidity crunch/good old-fashioned bank run on their assets, and finally the Fed-orchestrated JP Morgan Chase buyout for the princely sum of...$2...down from $170 a year ago and around $60 at Thursday's close. The important thing to understand here though is that, despite the non-recourse loan given to JPM by the Fed, this was not a "bailout."

Consider the following: Bear was counterparty to $13 trillion in various derivative contracts. To put this number into perspective, the GDP of the United States is approximately $13 trillion. So what does this mean? If you were a hedge fund, or really any kind of brokerage client of Bear Stearns, and you chose to to purchase/write some kind of derivative, Bear would take the other side of your desired trade as a service to you, and in attempt to make money. If Bear Stearns were to go bankrupt, any derivative trades that were held in your name would then no longer be valid. This would mean that $13 trillion in assets would be wiped to slightly below the stock price of Bear. This would undoubtedly lead to a wave of bankruptcies and destroyed wealth, as worthless investments on hundreds, even thousands, of leveraged balance sheets are wont to do.

But wouldn't SIPC (Securities Investment Protections Corporation) help? They only cover up to $500,000 worth of cash and investments in the case of a brokerage failure. Also, to my knowledge, this would not include the more exotic derivatives such as swaps. I'm not sure about more vanilla derivatives such as simple put/call options.

But how was Fed involvement, namely the $30 billion non-recourse financing to JPM, not a bailout of Bear Stearns? Because it was more like an orderly liquidation, whereby JPM was given an incentive to bring Bear's liabilities onto their own balance sheet, ensuring that a wave of panic and bankruptcies would not submerge Wall Street. Despite the objections by BSC shareholders that the company should go bankrupt so that they have a chance at more than the measly $2 of JPM stock, the reality is that preventing collapse of the U.S., perhaps even global, financial markets takes precedence, not to mention the fact that shareholders are last in a long line of creditors to receive anything in the event of a bankruptcy (read: be glad you are even getting $2).

While some might say that free market economics, of which I consider myself a follower, dictates that failures should be allowed to fail, and that the markets will deal with the aftermath, I believe that no one would benefit from the markets trying to deal with such a massive amount of vaporized assets. There are some occasions where the government, or a goverment entity, must act in order to prevent chaos. I believe this is one of those rare times. By orchestrating the takeover of Bear Stearns, I think the Fed has rightly avoided a potential catastrophe.

Stock Pick: Sun Hydraulics (SNHY)

The impetus for this post is the earnings release this past Tuesday, where SNHY reported a year over year increase in annual net income of 36% and a 34% increase for the 4th quarter yoy number. All that in a pretty poor market and overall economy too! I'll give a brief overview of the company before continuing on about why I like the company as an investment.

SNHY, based out of Sarasota, FL, designs and manufactures screw-in hydraulic cartridge valves and manifolds. These devices are used in control systems for various industrial applications. They fit comfortably into the small-cap category with a current market cap of $423 million and 2007 sales of $22 million. Only 52% of their sales for 2006 were generated in the Americas, giving them a fairly large international footprint, especially for such a small company. The cartrides that SNHY designs are currently around 1/3 of the $3.5 billion market for hydraulic valves. This is important because SNHY's products are such that several functions can be combined into one central manifold, rather than having the different valves and actuators spread throughout the system. The advantages SNHY's designs offer over the currently used technology should be readily apparent.


So, what else is there to like about the stock? Here are some metrics that I usually use to assess a potential investment:

• Trailing P/E.......................20.24


• Forward P/E.......................17.10


• PEG Ratio............................0.76


• Profit Margin......................12.93%


• ROA.................................20.40%


• ROE...................................27.03%


• % Insider Ownership................31%


• % Institutional Ownership.......44%

As you can see, their P/E is relatively low compared to the rest of the market. In fact, their forward P/E is around the historical P/E of the S&P 500. The PEG suggests that they will continue to see pretty significant growth in the future. Their margins, ROA, and ROE all are much better than the competitors listed by Yahoo! Finance, Parker Hannifin (PH) and Servotronics (SVT). The numbers are pretty great in their own right though. Finally, the % owned by insiders and institutions shows that there is definitely room to grow as far as interest from mutual funds, etc. Also, I love the fact that the management is so heavily invested in the company. That tells me that there will be great things to come in the future.

Looking at the chart (click for larger image), its not very pretty (especially when I see the point where I bought it). The stock is currently heading toward being overbought, as the RSI suggests, and the 50 and 200 day moving averages crossed in January, both sending a pretty bearish signal. However, the MACD shows a bullish trend beginning to emerge. In fact, the YTD chart is not that bad, especially since the beginning of February, where it has been stuck between support at 21 and resistance at 23. Even more interesting is that the earnings release signaled the 3rd test of the resistance, and the subsequent breakthrough to higher prices. Although it is too early to tell, it looks as if a new upward trend has begun since the bottom in January at around 18.

The financial statements continue to support my bullish thesis on SNHY. They have been paying down their long term debt consistently, from $11 million at the end of 2004 to a meager $292,000 at the end of 2007 Q3. They also have more than enough cash to pay off all current liabilities if necessary.

Even though I currently have a paper loss on this one, I remain convinced that they will do extremely well in the future. Once capital expenditures pick up again, I really expect SNHY to do great things. Until then, I'm just going to sit by and watch.

All data is from Yahoo! Finance as of end of day, March 6, 2008. Chart from StockCharts.com. Insert generic disclaimer about me not being an investment professional and not being able to make suggestions for your specific portfolio here.

Pfizer, MBIA, and the Ratings Agencies

This is a pretty thought-provoking article from Mish's Global Economic Trend Analysis blog: http://globaleconomicanalysis.blogspot.com/2008/02/mbia-maintains-highest-rating-pfizer.html.

The only reason I can see for not downgrading MBIA while Pfizer gets the axe is simply because of the fallout that would take place if MBIA, which truly relies on its credit rating to operate, was no longer able to insure bonds (ignoring the fact that they have so little cash that they probably couldn't cover many defaulting bonds at this point anyway). But is trying to forestall a potential blowup really the best thing for the economy or all those MBIA-insured bonds? After all the lack of insight/intelligence/due diligence on the part of the ratings agencies when it came to CDOs, I would think that it would behoove them to become ruthless in their ratings, to show that they really actually do what they claim to do.

Something drastic needs to happen with the way ratings agencies are currently run, since they seemed to have not learned anything from the whole CDO mess. If investment banks are required to have so-called "Chinese walls" in place to prevent improper conduct on the part of analysts and traders, maybe something similar should be instituted with the ratings agencies where those doing the actual analysis and rating are unaware of how much the agency has been paid by the company seeking the rating, or if they have paid at all. It may be hard to implement something, but since the ratings agencies seem unable to handle their responsibilities, as evidenced by the Pfizer/MBIA ratings, something should be done.

Misguided Derision of Black-Scholes

I just finished reading an article by Michael Lewis, of Liar's Poker fame, where he essentially blames Black-Scholes as the reason for catastrophic market failures, from 1987, to LTCM and even the current subprime debacle. I think he's gone a little far however.

Black-Scholes is a model which is supposed to give fairly accurate predictions of option prices. The problem that Lewis failed to understand is that the formula, in and of itself, is not necessarily faulty. The problem is that people have come to expect and use the model to actually price different securities instead of predicting the movements that result from dynamic variables.

This would not be the only time that traders/bankers/fund managers/etc. have used models as a means of pricing things in fact rather than in theory. Consider the write-downs from CDOs and other similar asset backed securities which presented themselves due to the inability to mark-to-market and the ensuing reliance on marking-to-model. In fact, I wrote the following for a research paper on CDOs, with regards to their pricing:

Interestingly, the Marshall-Olkin copula, the so-called “shock model” that accounted for successive catastrophic default events, was found to be a poor model of true market values of CDOs due to the fat-tails it created on the distributions of losses from defaults. This is interesting because the research was done in 2005, and the CDO market has actually trended toward fat-tail loss distributions and catastrophic default events in recent months. Obviously, such strict mathematical models should always be taken with a grain of salt, or at least with the understanding that such models should only be used as approximations for the price of an illiquid security. Instead, many investors (again, in the institutional sense) regarded the prices placed on the CDOs by their models to be the actual value, and in many cases felt that their models were still correct even in the face of a large divergence between the market prices and the model prices [1].

[1] X. Burtschell, J. Gregory, J.-P. Laurent. “A comparative analysis of CDO pricing models.”

It doesn't take college-level laboratory courses to see that theory does not always exactly match actuality or take into account the existence of outlying data points. For that reason, it seems that Lewis is misplacing the blame, at least to some degree. While Black-Scholes, or any market model, certainly comes with limitations and downfalls, it is the implementation of said models that determines their utlimate accuracy.

An Intersection of Engineering and Economics

In going through some of the stories posted on Abnormal Returns, I came across a story from the WSJ Economics Blog and found it interesting that Ben Bernanke and his ilk like to refer to what happened during the Great Depression as a form of a feedback loop. They apparently term the failing of one bank as a detrimental effect to other banks as a negative feedback loop. However, this is incorrect. The negative feedback is what the Fed would want to provide in the form of lower rates and increased liquidity while the compounding effect of cascading bank failures would be the positive feedback. That is, negative feedback causes attenuation of the input, eventually down to zero if it was a true feedback control loop. Conversely, positive feedback would result in the values taking off toward infinity.

This actually got me to thinking about what kind of system this bank data would actually look like, and if you could come up with some kind of control design (P, PI, PID, velocity-feedback, etc.) that would translate into how much to lower interest rates or what other actions should be taken in order to keep banks on their feet longer, thereby avoiding the calamitous outcomes of the Depression Era. Of course, this would require much more time than I would care to put into it. I guess the Fed will have to figure that one out without me.

Economic Stimulus: A Couple Months Late and a Couple Billion Short

President Bush just signed the surprisingly bipartisan stimulus package into effect today. I'll give the government an A for effort, and an A+ for actually doing something expeditiously for once, but I can only muster a D- for the actual package itself.

While I certainly won't send back the $600 check that's coming my way, I also don't plan on spending it the way so many other Americans will. What do you think that money will be spent on? Something like a new LCD TV that is made in Japan from Chinese parts. That is not exactly stimulating the overall economy here in the US. With the influx of foreign capital, especially into the battered banking system, Americans should do something really patriotic and either put that money in a high-yield savings account, invest it in a retirement account, or pay off the over $8,000 (on average) they have in credit card debt. In fact, the $150 billion dollar stimulus package would probably be better spent in reducing the national debt than giving it to consumers. Taking it a step further, for maximal benefit, the government would give all of the money to primarily small businesses as a means of encouraging expansion and capital expenditures, instead of just providing for equipment purchases. Such purchases do not really help businesses in the service sector that saw some awful numbers a few days ago.

Also, the checks won't even arrive until some time in May, meaning that the economy will already be in a recession, if that is indeed the future of our economy...something I'm not entirely conviced on yet.

The fact is, the stimulus package is only about 1% of GDP. That is a drop in the bucket. More than anything, this seems to be a political move in a year when a Presidential election and a slowing economy happen to be occurring.

Not So Super Tuesday

Well, unfortunately the Republican party seems to have been split. Huckabee, unsurprisingly, swept the Bible Belt states of Alabama, Arkansas, Georgia, Tennessee, and West Virginia, most likely stealing quite a bit of Mitt Romney's thunder. Of course, Romney did not turn out too poorly himself, garnering about 7 states to bring him to 269 delegates. Its going to be tough from here on out though, as McCain has about half of the delegates he needs to clinch the nomination.

I'm not really sure what happened. It seemed like most of the conservatives I've heard (personally and calling into talk radio) were ardently against McCain and tended toward Romney over Huckabee. It is disappointing because Americans seem to either be uninformed, apathetic, just plain stupid, or some combination of the three when it comes to voting. The economy has consistently been the key issue for the past few months, yet the candidate who has admitted to having fairly limited knowledge in the way of economics is poised to win the Republican nomination for President. That does not bode well for the Republican party or America.

Which is why I'm supporting Romney. He has the business experience, much of it in taking faltering companies and returning them to their prior glory, that "that other malfunctioning corporation called the USA" could use a healthy dose of. While I've always been of the opinion, unlike so many others out there, that the President and/or Congress have little to do with the performance of the economy, I do believe that they can create incentives to a certain degree that can stimulate businesses and consumers to do things that will make the economy grow. Bush's tax cuts are a good example of this. Businesses and consumers will almost always make better use of money than the government, whether that is measured in return on investment or utility.

Luckily, Romney's pockets are fairly deep, thanks again to his background in business. So, I'm not losing hope yet, despite how far Romney has to go after a fairly disappointing Super Tuesday.