EYE ON AMERICA The trials of Bear Stearns
By Peter Morici
The near-meltdown of two Bear Stearns hedge funds invested in subprime
mortgages has focused attention on two critical questions. Will mortgage
financing dry up, throwing the economy into the great abyss? Will the rush of
private equity into publicly traded companies, aimed at reorganizing US
corporate assets, reverse and send stock prices tumbling?
If cooler heads prevail, the answer to both questions is no. However, if the US
Justice Department and the New York attorney
general are alert, senior management at Bear Stearns and other financial houses
should focus on a more compelling drama: the prospects for a public hanging.
The fundamentals under the US housing market remain strong. Although the volume
of existing-home sales has slowed, prices have remained remarkably resilient.
We are several months into the subprime debacle, and prices have recovered
since their January lows.
The housing bubble was not a bubble. Booming service economies in New York, San
Diego and many points in between drove up land values within reasonable
commuting distance of large employment centers.
The market for homes distant from city centers and suburban employment hubs has
softened, because rising gasoline prices and congestion are finally biting into
tolerance for long commutes. Those locations form the core of the new-home
market, and that market has not fared as well.
However, builders have written down land options and re-priced parcels, and
subcontractors have cut prices for construction services. The new-home
inventory overhang resembles more the glut of trucks as auto makers shift back
to cars than it does a permanent absence of demand. Home builders are adjusting
what they offer to lure buyers with lower prices and more amenities.
The big losers in the subprime market are not commercial banks, reputable
mortgage bankers and other financial institutions that provide the backbone of
mortgage finance but rather private hedge-funds investors and private
individuals who are widely distributed throughout the economy. Plenty of money
is available in the US capital markets to finance sound mortgages.
Mortgage rates are a bit higher lately, but the ratio of housing prices to
household income has declined over the past 12 months. The situation is
manageable.
Residential construction should subtract from gross domestic product growth in
the second quarter but less so than in the first, and it should add to growth
the second half of the year. Look for the US economy to expand at better than
2.5% as we race toward the new year.
The problems of hedge funds and private equity are not isolated to subprime
loans. Armed with borrowed money, these magical venues for investor avarice
have been buying up all kinds of illiquid, hard-to-value assets ranging from
toll roads to timber. Using models built by financial economists - the same
alchemists who gave us the 1998 Long-Term Capital Management debacle - fund
managers put values on those lightly traded assets.
Compensation for the managers of those funds is tied, in significant measure,
to the values those models spew out. As most economists not on the take will
tell you, the answers financial models give you depends on what assumptions and
data you put into them. With the pay levels of the "putters in" doing the
"putting in", and the process being naturally obfuscated by "professional
sophistication", you can see why public investigators should be examining the
goings on at Bears Stearns and other purveyors of lead-into-gold hedge funds.
Private equity still has a significant role to play in reorganizing hidebound
US companies like Chrysler and Motorola, if they can manage to penetrate their
firewalls. And the meltdown of hedge funds that invest in eccentric financial
instruments should only tend to drive endowments, pension-fund managers and
private individuals in the direction of profitable US stocks.
A flight to quality should favor stocks over peculiar securities whose
substance requires the combined expertise of a PhD in finance and the insight
into human nature of a bookmaker to appreciate fully.
Once the hysteria passes, the fundamentals that have been driving stock prices
upward - improved earnings - should trump the pessimists.
However, the recent goings-on at Bear Stearns and other sponsors of
private-equity funds call into question the competence of their senior
management or, sadly, whether competent financiers have been turning greed's
blind eye to how hedge funds value investments.
Peter Morici is a professor at the University of Maryland School of
Business and former chief economist at the US International Trade Commission.
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