Ok, so it was either this title, or "Lions, Tigers, and Bear Stearns (oh my)". I couldn't really figure out what I'd do with the Lions and Tigers bit though. Regardless, the subject of this post won't change - the mammoth collapse of the 5th-largest U.S. bank. Before I start however, I wanted to point out that there is only 1 week left in the competition. With the unbelievable swings in the markets in the last couple weeks, a large bet one one or two stocks could catapult you to victory or decimate your hard work over the last several months. Be very (beary?) weary.
So what the heck happened to Bear Stearns? Well, to sum it up in a few words: it took on way too much risk, and got hammered in the subprime fiasco. It was so highly exposed to subprime that it's bottom-line was negative for the first time in 83 years. It's credit rating dropped from AA to A. Investors sold it off en-masse. From a trading high of near $160, to around $5 today. A startling drop of Titanic proportions. Here was a firm that survived the Depression and WW2, and all of a sudden a few bad bets and a souring market leads to its collapse. How this happened is a fascinating story.
Last Friday, Bear Stearns stock dropped 47%, from around $60 to around $28 bucks. The collapse was preceded by that of its close affiliate Carlyle Capital (the mortgage investment fund of Carlyle Group). There was basically a run on this fund after investors started asking for their money back. This really unnerved the market, and raised questions about Bear Stearns. Rumours began circulating that Bear was facing a cash crunch, which newly-minted CEO Alan Schwartz decried as ridiculous. He noted Bear's strong balance sheet and abundance of cash - investors didn't believe him. From Wednesday to Friday, Bear's clients and lenders (a.k.a Bear's counterparties - counterparties are just the parties a financial firm trades with) began moving their money out of the firm. Essentially, it was a classic run on the bank (Jimmy Stewart was nowhere to be found - if you don't know what I'm talking about, you probably haven't seen the 2nd best Christmas movie ever... Alastair Sim in the 1951 version of Scrooge takes the cake). So , there was a liquidity crisis at the bank. Securities firms were demanding cash from Bear, as opposed to accepting collateral. This required, in a rather extraordinary step, the Fed to step in with J.P. Morgan (JPM) to keep Bear afloat. The Fed acted in order to preserve the confidence of the financial markets. Basically, if Bear had completely collapsed, the shit would have hit the fan (excuse the crudeness).
Basically, Bear got access to cash for 28 days. The way it works is as follows: JPM borrows money from the Fed and relends this money to Bear, providing it with liquidity. The amount that Bear could borrow was limited by the amount of collateral that Bear could supply. The Fed was to assume all the risk here. The Wall Street Journal pointed out that, "it was the first time since the Great Depression that the Fed has lent in this fashion to any entity other than a bank".
So why did Bear collapse? Well, Bear has historically had a reputation of being a strong risk manager. However, in recent years, its mortgage business grew rapidly. It became basically the highlight of Bear Stearns recent success; that is, until a bunch of subprime mortgages went sour and home prices started falling. You'll remember from our first meeting the discussion of the two Bear hedge funds that collapsed in July. This was essentially the first major trigger in the subprime disaster. It all built up into last weeks loss of confidence in Bear Stearns. Investors wanted their money back, Bear had to give it to them.
So why did the Fed act? Well, that's an excellent question with a very interesting answer. Here's how the WSJ put it (paraphrased): The Fed had to act because Bear risked defaulting on its "repo" loans (short-term loans from the government - usually overnight - that influence the level of interest rates). In order to get these loans, Bear (and the other 20 "primary" dealers) had to pledge high-quality collateral, which was in short supply. If Bear defaulted, the other dealers would see access to repo loans become more restrictive. As a result, the pledged securities behind these loans could be sold in what amounts to a fire sale. This would aggravate the drop in securities prices.
On Sunday, J.P. Morgan announced in what some might term a bombshell (only because of its terms) announcement that it would buy Bear Stearns for $2 per share. That was the value hundreds of investment bankers working on basically no sleep for the weekend determined was fair. The market seems to disagree, with Bear trading at around $5 per share currently. This disparity is due to the fact that the market feels there could be a higher bidder, and that shareholders won't accept the deal.
There are other reasons for the stocks higher price. First off, bondholders are eager to get the deal done, because upon completion of the deal, Bear bonds will be converted into JPM bonds. There creditors are buying shares so they can vote. Other investors are shorting Bear bonds and CDS's (credit-default swaps). They are buying shares to vote "no", hoping that Bear goes into bankruptcy.
So, this has been a pretty fascinating story, and I hope this entry has been enough to get you up to speed on what's gone on in case you were enjoying St. Patty's Day a little too much. There is so, so much more to talk about and so many interesting subplots to this story. One really interesting one: billionaire investor Joseph Lewis, who has lost $1 billion on his investment in BSC is going to try to challenge JPM's $2 per share offer. This will develop over the coming days and weeks.
Just a final reminder the competition ends March 28th. Here's a tip, if you want to make or lose your shirt in one day, buy or short one of the financials. With volatility like we've witnessed in the last week (some days up 15%, some days down 30%), you could make a big move in the competition, and win the prize.
Happy Easter to all!
