Posted on March 17th, 2008
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!
