Understanding The Downfall of Bear Stearns
Oct 5, 2008
Posted by Jody Eisenman | Filed under crisis
Bear Stearns was one of the largest global investment houses, having started in 1923. The company employed over 15,000 people throughout the world, and stock traded over $130 per share in 2007. As mentioned previously, Bear used lots of leverage in their balance sheet in order to increase their profits. In July of 2007, after pledging $3.2 billion Bear announced that 2 of it’s hedge funds were effectively worthless. This was the first real sign that Bear was heavily involved in the sub prime mess. In December, they announced a $1.9 billion loss, which, amazingly, was the first quarterly loss the company ever had. In March of 2008, as rumors swirled that the company was facing severe liquidity issues, Alan Schwartz (the head of the company) said “Bear Stearns’ balance sheet, liquidity and capital remain strong.” He assured Wall Street that there no problems, despite the fact that the stock had plunged to around 60. Five days later, JP Morgan announced that they were buying Bear for an incredible 2 dollars per share! (This was later raised to $10)
What happened?
First of all, Bear had leveraged it’s balance sheet to incredibly risky levels. To understand this, just imagine how a margin account works. Lets say at the beginning of 2008, you had $100,000 to invest and you were bullish on the stock market. Lets say you were so bullish, that you decided to buy on margin. Your broker would allow you to buy up to $200,000 worth of marginable securities. Unfortunately, as the market fell, your stocks fell as well, leading your broker to tell you that you either had to come up with more capital, or they would be forced to sell some of your securities. Not good. Now lets assume that instead of starting with $100,000, you started with $11 billion. Then lets assume that instead of purchasing double that, you actually were able to purchase almost $400 billion dollars worth of securities! Then, lets assume that not only did some of these securities decline, but many were essentially illiquid and couldn’t be readily sold. Impossible you say? Welcome to Bear Stearns.
By mid-March, rumors were rampant that Bear was in deep trouble. In fact, many of Bear’s counter parties were refusing to trade with them. What does that mean? Whenever you buy or sell a security, there is another side to the transaction, also known as a contra. When institutions felt Bear wasn’t safe, they started to avoid trading with them. Bear knew the end was near. The Feds got frantic. Besides trading securities, Bear was perhaps the largest Prime Broker on Wall Street. Prime Brokers basically act as clearing houses for hedge funds, which are large pools of capital managed for wealthy individuals and institutions. These hedge funds were themselves heavily leveraged, as Bear was known on Wall Street as being very aggressive lenders. Lets take a hedge fund that manages 1 billion dollars. Lets say Bear gave them 6 to 1 leverage. Effectively, this meant the fund could purchase up to 7 billion dollars worth of securities. Should Bear go under, this would effectively mean that this credit was cut off. This left the fund with a choice of either finding another prime broker immediately, or being forced to massively liquidate it’s holdings. When you consider that hedge funds made up as much as 16% of Bear Stearns revenues, you’re talking a major potential liquidation that could have led to an incredible market decline. This, combined with the fact that Bear was the first potential major bankruptcy in the financial sector, led the Feds to hastily arrange a merger with JP Morgan Chase, another financial supermarket. The markets rallied for weeks on this news, and it seemed like the worst was over. However, this was just the tip of the iceberg……
