Kass: Ready for the Bear Stearns Challenge?

Most of the time, it does not pay to invest on the basis of the view that "it's different this time" -- after all, multiple sigma events are just that, and, by definition, they occur infrequently. Victor Neiderhoffer, who I quoted at the start of this column, devotes his Web site, Daily Speculations, to applying historic reasoning in order to understand the current state of the market -- and how to respond tactically.

Unfortunately a 2-3 sigma event occurred in the housing market by 2005-2006, when housing affordability was stretched to unfathomable levels, and a "black swan" event is now in full force in the credit markets, thanks to many of the aforementioned secular developments.

The ultimate question is whether a small cabal of ne'er-do-wells at the banks and brokerages have infected the entire financial system with such large amounts of toxic paper so that traditional analysis of business/market cycles, the stock market's historical role of discounting an economic upturn after a recession and other factors lose their relevance as issues of liquidity, contagion and solvency gain center stage in a Shakespearean tragedy entitled "Avarice, Leverage and Hubris."

If so, the 1930s could be repeated -- and so could the Nasdaq's 75% swoon of 2000-2002.

But I doubt it.

Bear Stearns: The Failure of Not Diversifying

History might not repeat itself, but it sure rhymes. Or as Yogi Berra once said, "It's like déjà vu, all over again."

The decade of the 1980s gave birth (and death) to an upstart brokerage firm, Drexel Burnham, which created, sold and traded high-yield junk bonds -- the turbo debt and foundation of the previous "decade of greed." After the insider trading indictment of Drexel's Denis Levine was followed by Michael Milken's demise, junk bond liquidity dried up, recession befell the U.S. economy, and, by 1990, default rates on high-yield debt more than doubled to over 10%. Drexel, forced to buy the bonds of its junk bond clients, depleted its capital and filed bankruptcy.

In much the same manner as Drexel did in the junk bond market, Bear Stearns emerged as a leader in a parabolic growing market -- mortgages. As we are now witnessing at Bear Stearns (as we did during the Drexel era), a brokerage's well-being relies, in large measure, on the kindness and confidence of strangers to accept its collateral and accept counterparty risks. That confidence is impaired swiftly when price discovery unveils a diseased portfolio of assets, which is further exacerbated by a high degree of leverage employed. This is especially true when the brokerage's business is not diversified and is narrow in scope -- Drexel (junk bonds) and Bear Stearns (mortgages).

Following the Drexel bankruptcy and a real estate-led recession, the equity market regained its footing in late 1990. It didn't take much time - the same could hold true in 2008-09.

A One-Off Situation

The principal investment question at hand is whether Bear Stearns was a one-off situation -- whether its business was so levered and narrow in focus (mortgages) that, with its revenue base collapsing, operating losses would quickly have eaten up its $85-plus per share book value.