Bear Stearns Meltdown
For anyone who follows the financial press, the meltdown at Bear Stearns shouldn’t be news. On Sunday, JPMorgan Chase stepped in and purchased the beleaguered investment bank for $2 a share, or $236 million, after acting as an intermediary to a Federal Reserve bailout on Friday. JPMorgan’s actions brought to mind the Banking Panic of 1907, when the real John Pierpont Morgan stepped in and calmed the financial markets after the collapse of the Knickerbocker Trust Company. The price paid for Bear Stearns was a bit of a shock to everyone, especially since their share price closed at $30 at the end of trading on Friday. In all honesty, when I first read the news I thought the reporter had accidentally left off a 0 and that the deal was actually $20 a share.
So how could a bank go from having a share price of $170 a share to $2 a share in the matter of a few months? Well, the answers are complicated. Bear had a lot of exposure to the mortgage market in a number of its businesses, and last summer the company bailed out two of its subprime mortgage hedge funds. The storm that followed grew, combined with some others, and eventually became the mortgage mess we have today.
What brought down Bear Stearns yesterday, however, was something else entirely. Bear frequently participates in a certain kind of transaction called a Repurchase Agreement or “repo” for short. This is essentially a type of short-term loan where two people (called a counterparties), one with cash and the other with assets, get together and swap. The asset holder takes the cash and extends their assets as collateral for the deal. These kinds of arrangements can be very short (overnight) or somewhat long (a couple of years), but by and large they are meant to be very liquid transactions. The cash holders are usually large money market funds, hedge funds, or corporations; while the asset holders can be just about everything from governments with bonds to other corporations to mortgage companies.
Bear Stearns was both a repo borrower and a repo lender, but they were more of one than the other. The difference between their borrowing and lending was $74.5 billion, with more borrowing than lending. That’s quite the substantial sum but not necessarily bad. Bear’s real problem was a lack of faith in their assets: mortgage securities. Over the past several weeks, the markets for these assets have simply stopped moving, meaning that in many cases buying and selling them is very difficult.
For Bear Stearns, the problem was simply that some of their creditors wanted repayment on their repos (they wanted their money they had lent to Bear back), but Bear was unable to find enough liquidity in the market using its large portfolio of mortgage securities. In other words, Bear couldn’t find enough money through additional repos and nobody would buy their mortgage securities outright. Other creditors, sensing trouble, began piling on and trying to get their money back as well. Since Bear Stearns had $75 billion more borrowed than lent, they were ultimately screwed without extra financing.
Obviously, this carries greater implications for the market than just mortgages. Repos are incredibly common, and a breakdown in that market would have created repercussions that extended all over the place. Ordinary investors would have seen their money market accounts mysteriously shrink while major corporations would begin running out of cash and face liquidity issues. When the Fed said it wanted to prevent financial panic from spreading, they damn well meant it.
A few other tidbits:
- During the JP Morgan conference call, an individual investor named Brian Firestone somehow managed to get through the screeners and ask a question. These calls are usually reserved for analysts who are well versed in the minutia of the deals, and Mr. Firestone’s question clearly demonstrates why. “I vote not to approve this sale,” he said after having his question about why a sale was preferable to bankruptcy rebuffed. He seemed to think that individual investors actually mattered here, but in reality he was rejecting a $2 a share deal in favor of Bear Stearns entering bankruptcy which would have netted him a whopping $0 a share.
- Go read that bail out article again that I mentioned above. Note the companies listed as helping Bear with their hedge fund mess: Merrill Lynch, Lehman Brothers, and JPMorgan Chase. Today, JPMorgan owns Bear while Merrill and Lehman are both suffering their own mortgage meltdowns. Lehman in particular may be the next to go (again), even though they claim otherwise.
Update: The Wall Street Journal has a nice run down of the events of the weekend.
Update 2: Brian Firestone responds and he has some great thoughts!
[...] I wrote about the Bear Stearns meltdown and I mentioned how they were felled by Repurchase Agreements or “repos.” I wanted to [...]
This is Brian Firestone. I read your silly tidbits regarding the Bear Stearns meltdown and I beg to differ that shareholders would get a wopping $0 per share in bankruptcy. As a broker dealer, the majority of the assets on Bear Stearn’s balance sheet are marked to market on a daily basis. JP Morgan even stated that they were comfortable with Bear Stearn’s market valuation of it’s assets. Through an orderly liquidation of these assets, maybe the recovery value would be less that the $84 book value but because the assets were marked to market on a daily basis, shareholders would be almost guaranteed substantially more that $2/share. Stay tuned. We may still see that this is the case.
As far as individual shareholders not mattering, I can tell you that my efforts have mattered significantly at several companies to include Healthsouth, Blockbuster and now Bear Stearns. Individual shareholders matter and will continue to matter more and more. The JPM/BSC deal is not a done deal. You have already seen and will continue to see that individual investors, especially activists like me, do matter. All that you have to do is open your mind.
Brian, first of all thank you for dropping by and sharing your thoughts! I appreciate your comment. I have two questions about your thinking:
What concerns me is that Bear literally had a run on the bank that was created by concerns over the real value of these securities. Repo holders may have been driven by fear, but they may have also been driven by a belief that the FMV of these assets were far less than claimed.
As for my comment on individual investors, my point here is that JPMorgan and the Fed had an obligation to keep the repo market functioning. It’s funny because I had a long conversation with a friend about this subject where we debated the rights of the shareholder here, but my belief is that in principle (though probably not law) the rights of the shareholder are no longer applicable in the face of a complete market collapse. Your thoughts here would be interesting.
Stanton,
I suggested that an orderly liquidation of the company’s assets may yield common stock investors more than $2 per share. Many question whether an orderly liquidation would be possible given the complexity and the many tangled weaves that Bear Stearn’s assets are woven into. But I believe that since there is little to no MBS market activity currently, BS may not have needed to sell their entire MBS portfolio all at once and now. If you believe Alan Schwartz, the run on the bank had stopped on Thursday once a deal with JP Morgan and the Fed was announced. But the Fed opened the discount window too late and the shorts kept the rumors flowing and counterparties were no longer willing to finance transactions with BS.
As far as the marks to market, JPM said during the conference call that they were comfortable with the company’s risk management and how the company marked their assets. We will find out more about the accuracy of Bear Stearn’s financial statements as a result of various investigations by the SEC and other regulators in the future.
Lastly, shareholders rights and their violation in this matter are a big concern of mine. JPM seems to think they have already knocked up Bear Stearns and marriage is inevitable. The cast has yet to vote.
One fine point here. Bankruptcy doesn’t necessarily mean the end of the world for the shareholders and the value doesn’t automatically drop to zero. This is a market bailout and not a Bear Stearns bailout. Those 2 bucks aren’t due to JPMorgan’s generosity, neither a result of efficient market. It is more of an arbitrary number arrived at after hasty negotiations. The last hasn’t been said or seen on this.
Brian and Pankaj:
Fair enough on the valuation point. I can see your arguments although I’m not convinced that liquidity is really possible here.
However, I’m still not convinced that a bankruptcy wouldn’t have had a chilling effect on the repo market and the broader economy as a whole. How could Bear have liquidated without damaging the repo market?
Brian: I’m also curious about your role as a shareholder activist. Is this something you do professionally?
[...] back, I wrote about the Bear Stearns collapse and why the government bailout was so important. Now the meltdown continues, and this [...]