A new fear has permeated conventional investment thinking: the massive leveraging-up of the recent past has gone too far and its unwinding will permanently hobble the global financial system. This view sees Bear Stearns as just one casualty in a gathering wave that has already claimed many U.S. subprime mortgage originators along with several non-U.S. financial institutions and will cause countless others to fail. And it sees the earnings power of those that survive as being permanently impaired.
The obvious question then is, which scenario is more logical: the extreme outlook described above, given the long period of easy credit extended to unqualiﬁed individuals? Or the scenario of a typical credit cycle that will work its way out as other post- excess crises have, and without impairing the long-term ROEs of the survivors? We believe the latter. Here’s why: