Financial firms from Citigroup to Lehman are raising money at a breakneck pace, convincing investors that the worst is over. They couldn't be more wrong.
No sooner had the credit crisis been declared the "worst since the Great Depression" than, pffft, it was winding down. Epic poems will be written about the terrible weekend in March when Bear Stearns sort of almost nearly went under but then was actually just sold to another bank. You'll regale your kids with the story of where you were when that hedge fund in London had to close down.
What a relief it's over. The financial sector has raised tens of billions of dollars in new money-some of it literally overnight. A.I.G., Bank of America, Citigroup, Lehman, Merrill, UBS, and dozens of others have held out their hands and been rewarded with cash. That money-raising has been offered up as evidence that the economic tide has turned. It seems almost unnecessary to go through a recession, though it promises to be short and shallow if it happens at all, Wall Street economists assure us.
Somehow it all seems too easy. Something nags. Why did Federal Reserve chairman Ben Bernanke strongly urge banks in mid-May to continue raising capital, arguing that it would help the economy, if everything was okay? The rampant optimism, which has bolstered financial stocks, makes little sense. We are in deep denial. This loose-lending house party won't end with just a vase smashed and a scratch on the dining-room table.
Think the investors who are pouring money into financial institutions know something special? They don't. Since the banks and insurers don't really know the value of their own books, neither do outside investors. These financial institutions are sitting on huge piles of assets for which there is no market. There is still no good outside gauge of prices for many of these holdings, so banks must rely on internal calculations of value. Sure, accountants vet these assessments. But one doesn't have to be a cynic to think that they're guesses. Clearly, these investors aren't acting on carefully calibrated, unique insights. They're guessing, hoping, and praying. Some will be right; some will be wrong. I don't know, you don't know, and they don't know.
These hearty rounds of capital bingeing shouldn't make investors happy. Because of them, the banks' per-share profit will be spread more thinly. That the banks mostly opted to raise money by selling more stock rather than by selling off assets suggests that nobody wants their dodgy loans and mortgage-backed securities.
Everyone who invests in these banking companies knows this. We like to think that professional investors do prodigious amounts of due diligence before they make their moves. In reality, their research largely boils down to a set of simple assumptions: that the economy will recover sooner rather than later, that the brands of the banks are strong, that the price is right, and that regulators won't let financial institutions fail.
They're buying because they see an opportunity. They're buying because their buddies are. And they're buying because people have the money. Many banks first turned to sovereign wealth funds, the equivalent of the rube tourists who think they can win a game of three-card monte in Times Square. Citigroup hit up the Abu Dhabi Investment Authority. The government of Singapore invested in UBS. Kuwait and Korea sent billions to Merrill Lynch. Since then, the situation has deteriorated in spite of the insistence by the new management at all three banks that things are turning around.
These investments came too early. In a fashion, it was bad that the sovereign funds were such obvious suckers. That meant that the institutional investors who waited a few extra months and have just bought in can wrap themselves in the illusion that they demonstrated prudence and patience. After all, they weren't the first to the trough-but, by God, they won't be the last.
On a Monday in April, Colonial BancGroup, a tiny Alabama bank, announced a stock offering in the morning and closed the $333 million sale by evening. A hedge fund manager familiar with this market described how these deals work. The brokers call you up on Friday morning and ask you to sign a confidentiality agreement. By Friday afternoon, your lawyers have had enough time to work through it, and you sign it. The investment bank involved in the deal sends you a "book," laying out the company's numbers. You work all weekend and set up a conference call with managers to ask them whatever questions you can think of. The deal is announced on Monday. What about due diligence? "They aren't doing any," the hedge funder says.
As everyone knows, the defining rescue of the credit crisis (so far) happened at light speed. J.P. Morgan's bailout of Bear Stearns took only a weekend. Warren Buffett would later say that doing the deal so quickly "took some guts I didn't want to match." The Street spent the next several weeks dead certain that J.P. Morgan had fleeced the Fed. Jamie Dimon's C.S.I. team spent that time poring over the balance sheet of what it had just bought. In May, Dimon raised his estimate for the costs of the deal from $6 billion to $9 billion as, lo and behold, more bodies than expected were buried at the Bear estate.
We're still at the beginning of this crisis. We haven't had the expected recession yet (and even if we never do, the economy is likely to be slow for a while). The U.S. hasn't been hit with serious job losses or business bankruptcies, even though house prices continue to fall. We've merely had the anticipation of these things, followed by worry that morphed briefly into a flash of panic. As a culture, we've gotten so good at disseminating and assimilating an idea and then moving on, that we can no longer grasp a slow-moving phenomenon like a �housing-market crash.
Sometimes it pays not to follow the money. The sophisticated Warburg Pincus made a boneheaded bet on MBIA. And let us recall the private equity boom that happened last year. Wherever one looked, private equity firms were lecturing us about the superiority of taking companies private and letting them thrive out of the glare of the public markets. They told us that they entered into deals willing to hold on to their purchases for years, for better or for worse, in sickness and in health, for richer and, well, richerer.
Then, after the credit markets hiccuped, we were treated to the spectacle of the best and brightest acting like Hollywood stars, announcing their engagements and then backing out in Us Weekly time. Goldman Sachs and Kohlberg Kravis Roberts' offer for Harman International Industries, an electronics maker, was notable for how fast the firms' feet went cold. In April 2007, Goldman and K.K.R. had spring fever, offering $120 a share, but then they backed out by September. They were hardly alone. J.C. Flowers reversed itself on its Sallie Mae deal. Cerberus had second thoughts about United Rentals.
It's certainly the case that the financial sector needs to recapitalize after spending the past decade lending madly, putting aside smaller and smaller amounts to cover bad loans, and running with thin cushions of capital. Eventually, the sector's healing will help the economy. Some of these investors will end up making a killing. But most will wind up like Singapore and Abu Dhabi-so early to the party that they're stuck doing the extra beer run, hauling the ice from the supermarket down the block, and wondering why the house is still trashed from the night before.Visit Portfolio.com for the latest business news and opinion, executive profiles and careers. Portfolio.com© 2007 Condé Nast Inc. All rights reserved.
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