Kass: Ready for the Bear Stearns Challenge?

Updated from 12:00 p.m. EDT

This blog post originally appeared on RealMoney Silver on March 17 at 8:37 a.m. EDT.

"But these waves we are battling, caused by the biggest hurricane in 20 years, had been pounding the shore relentlessly. Although I wouldn't admit it to George (Soros), it was very clear to me that something unusual was going on."

-- Victor Niederhoffer, The Education of a Speculator

The sale of Bear Stearns (BSC) at a price of $2 per share to JPMorgan Chase (JPM) will have short-term negative reverberations around the world as the credit quality of the leading financial institutions will come into question. While it was an illiquid balance sheet and the lack of institutional confidence that brought Bear Stearns down (as panic and margin clerks are today's voting machines), the price tag of $2 per share could raise more questions than it answers. After all, the general impression was that the company's headquarters were worth over $1 billion and that the prime brokerage business was worth at least $2 billion, or 4 times last year's cash flow of $550 million. These factors suggest that there must be more to the story.

Nearing a Bottom?

Last Thursday, I argued that "it's different this time." Stated simply, the housing and credit bubbles have been unprecedented in scope and duration -- and so has the novel and astonishingly large increase in debt (especially of a consumer kind) as all elements of risk control and due diligence were abandoned in the quest for yield enhancement. Meanwhile, amidst these bent secular influences, the reckless proliferation of unregulated and unwieldy derivatives continued, seemingly limited only by the imagination of man (or mad men).

And as I wrote on Wednesday, there is no single policy that will politely eradicate the egregious and out-of-control buildup in debt and the proliferation of unregulated derivatives in our shadow banking system. And as I said that night on "Kudlow & Company," the natural forces of a business downturn seem the only solution to what ails the equity and credit markets.

Piecemeal and oldfangled policy responses to newfangled problems will no longer work and, in many cases, will lead to adverse and unintended consequences. Deleveraging out of the most recent cycle will be a rabid bitch. There will be many more currency, economic and hedge fund casualties. The Fed can only do so much -- any more could jeopardize the world's view of its creditworthiness, which would serve to put even more pressure on our currency.

The market is now catching up to my above views as stocks tumble back toward the lows established in mid-January.

"Charlie (Munger) and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both with the parties that deal with them and the economic system."

-- Warren Buffett, 2002 Berkshire Hathaway letter

At the core of the equity market's and economy's problems are:

1. the derivative issue; and

2. the increased role that leverage and credit have had on worldwide economic growth and on speculative activity in all corners of our financial system.

To get some sense of the complexity of the derivative threat, I strongly suggest that subscribers consider reading pages 12-14 of Warren Buffett's 2002 letter to shareholders of Berkshire Hathaway (BRK.A) for a fuller understanding. I may continue to be short his stock, but, once again, his wisdom and insights run true -- well before the issue became au courant.

Back in the summer of 2007, I suggested that, based on the degradation of the credit markets, a 25% decline in equities from the high might be anticipated. At today's opening, we will be close to that decline in percentage points, which has historically coincided with a bear market low.