Crossing the Rubicon - Bob Rodriguez, FPA

These past two weeks have been extraordinary in that the Federal Reserve has had to take actions that have not been used since the Great Depression and a few that heretofore have never been used. There have been several crises in the capital markets that lead us to comment on what they appear to mean. During the last year, we have conveyed a growing concern, through several prior commentaries, as to the dangers and implications of an absence of fear toward various types of increasing risks in our financial system. We believe the culmination of these risks forced the Federal Reserve to take the recent extraordinary actions of creating two new lending facilities for primary dealers and facilitating a merger of Bear Stearns with JPMorganChase to prevent a liquidity and solvency crisis from potentially toppling the U.S. capital markets. The partners of First Pacific Advisors, LLC (FPA) discussed these events on March 21 and came to several conclusions about what the long-term implications of these actions might be and we will share them with you in this commentary. Fortunately, over the last two years, our preparations for potential financial market disruptions have meant that FPA and most of our product areas have essentially avoided the calamitous effects of this credit crisis.

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The Federal Reserve did not regulate broker/dealers since this was the responsibility of the SEC. Now it appears the Fed has become the lender of last resort to a borrower that had not been regulated or subject to review by the Fed. In essence, the balance sheet of the Fed, and potentially U.S. taxpayers, is being placed at risk for institutions that increased their balance sheet leverage and risk, during good times, so as to enhance their firm’s profitability but now, during a time of difficulty, they are looking to the Fed to be the savior, despite their previous business mismanagement practices. In our opinion, this is a strategy of heads they win, tails the U.S. taxpayer loses.

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In an earlier era, Bear Stearns would have been left to fail. This is not the case today since there was apparently a deep fear on the part of the Fed that a failure of Bear Stearns could create a domino-like crisis infecting a wide array of financial institutions, thereby accelerating and deepening the current credit contagion. As Steven Romick said in our FPA partner meeting on March 21, “I’m more concerned about what I don’t see. Why is it that we are not being told about or seeing another bidder for Bear Stearns other than JPMorganChase? Might JPMorganChase be playing defense so as to protect its $91.7 trillion dollar derivative exposure (according to September 2007 Office of the Comptroller of the Currency data) that is supported by just $123 billion of equity? How much counter party exposure did JPMorganChase have to Bear Stearns?” In our opinion, the Bear Stearns transaction looks very suspicious. If the situation were so precarious, why shouldn’t shareholder ownership have been entirely wiped out because of the excesses and mismanagement by their firm? Why should the Fed’s balance sheet be placed at risk while shareholders are receiving some type of compensation? A week later, the bid was raised from $2 to $10 per share, increasing the value conveyed by approximately $1 billion. Again, why should there be any compensation to shareholders? This compensation is being conveyed to owners of a firm that had derivative positions, with notional amounts as of November 30, 2007, totaling $13.4 trillion. Warren Buffett has, on several occasions, described derivatives as potential “weapons of mass destruction.” Apparently, the collapse of Bear Stearns might have triggered a financial market nuclear meltdown and this potential outcome forced the Fed to intervene.

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Apparently, the risk of a CDS contagion helped to force the Fed’s hand to create a bailout of Bear Stearns. The lack of supervision and control by the SEC that allowed this expansion in risk to develop, and the Fed’s bailout of Bear Stearns, are highly disturbing to all of the partners at FPA.

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In light of the above comments, the partners of FPA came to a unanimous conclusion that the recent Federal Reserve actions and the potential new Congressional policies under consideration are likely to lead to a significantly higher level of long-term inflation in the U.S. We are more than disappointed in the substandard decision making that has taken place within the Federal Reserve and other governmental entities these last several years. The misguided monetary policies of the former Chairman of the Federal Reserve, Alan Greenspan, created an era of “too big to fail” that has led to two major asset bubbles. With each successive bubble, the policy actions available to the Federal Reserve to reduce financial system risk have been systematically reduced. The extraordinary actions taken by the Bernanke Federal Reserve reflect acts of desperation rather than long-term policy solutions. The rapidly changing events within the capital markets are forcing the Fed to adopt policies that have the potential of long-term negative consequences. These recent events, and their fundamental changes to the U.S. financial system, are forcing the leaders of FPA’s product areas to reassess their present portfolio allocations. In essence, we believe we have “Crossed the Rubicon” into a new financial era.

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