My last blog post dealt with the untimely death of Michael Jackson. Today I’m musing over another untimely demise – that of Bear Stearns, one of the largest investment banks around until 16 months ago. So how did an 85-year-old company with 15,000 employees and $16 billion in revenue disappear in a heartbeat? I decided to look into this when a friend gave me William D. Cohan’s book, “House of Cards – A Tale of Hubris and Wretched Excess on Wall Street.” If you don’t feel like spending a few afternoons on this book yourself, read on.
In a nutshell, the Bear Stearns collapse involved a confluence of issues – some internal, some external – that contributed to what amounted to a “run on the bank.” Yet unlike the run on The Bailey Building and Loan Association in the classic film, “It’s a Wonderful Life,” there was no chance of Bear Stearns having enough liquidity to fulfill customer requirements at the end of the day.
What happened? For one thing, unlike banks, there are no regulations regarding debt to equity ratios for securities dealers like Bear Stearns. The company was leveraged at times to the tune of 50 to 1. (In comparison, Bank of America’s average total debt to equity ratio for the last 5 years was a little over 2.5 to 1.) Amazingly, Bear Stearns was financing their operating capital needs with very short-term paper, routinely raising as much as $75 billion in short-term financing, usually on the overnight “repo” market.
Secondly, Bear Stearns was heavily invested in, and made the market in, many of the securities that ultimately became toxic. They were a big originator of prime and subprime mortgage-backed securities and had a large investment in those securities. What killed them was the “mark to market” rule. Simply put, the SEC required securities dealers to price these types of securities on their balance sheet to their daily market value. As such securities traded down in a spiral, their inventory of asset-backed securities became less valuable. Conversely, their lenders required more collateral and would lend less. Eventually, it became almost impossible for Bear Stearns to borrow money against these toxic securities.
These and other issues finally led to a crisis of confidence. Once rumors received traction in the media, lenders became afraid to do business with the company. At the same time, Bear’s customers stampeded to get their money out of the firm. Even the firm’s $18 billion in cash was not enough to cover the outflow. And since many of the securities they owned were in a free fall -they could no longer use them as collateral to borrow operating capital – it took only a few weeks for the firm to become insolvent.
When they were ultimately purchased by JPMorgan Chase, Bear Stearns’ stock price was $10 per share, compared to $172 per share a year earlier. It was said that Bear’s real estate holdings were worth more than its purchase price.
An interesting epilogue is that soon after the demise of Bear Stearns, the Federal Reserve Bank opened their discount window to the securities industry, allowing securities dealers to better withstand the loss in value of toxic assets. Later, the SEC also repealed the “mark to market” rule for thinly traded securities. Had either of these changes come sooner, Bear Stearns might have weathered the storm.
