The Rise and Fall of Bear Sterns

I’ve decided to focus this week more on the actual events of the crisis then the continued leadup, mainly because the nitty gritty of why, for instance, Bear Sterns went down, I feel is much more interesting and much more relatable then the events of the seven years between the development of Li’s function and the beginning of the end. The main thing to take away from those seven years is that the algorithm became a readily used tool in the financial industry, originally used simply to ‘check the work,’ then to make sure original calculations proved accurate, but then more and more became the cornerstone of calculations. And it was used by the investment banks, the rating agencies, and the risk assessment groups. It was judge, jury, and executioner.

Essentially what happened was that once it became absolutely ubiquitius it no longer became accurate. I’m reminded personally of one of Asimov’s short stories  called “Alexander the God,” from his short story collection Gold. It told of a computer which its creator augmented until it could understand the grand flow of money and investment across the globe. The creator augmented it so much that the machine itself became a pivotal player in markets. Finally, he was financially ruined when the machine’s calculations collapsed because it could not predict the role that the computer’s actions themselves played, thus rendering its advice useless and inaccurate. The Copula Function did this same thing; a combination of inaccurate risk assessment and Wall Street bravado caused investment banks to leverage too much on very  risky investment. It would be like a gambler putting all of his money on Red on a roulette wheel, while being assured that there was a Seventy Five percent chance  that he would win. This inaccurate assessment of risk led to some of the largest financial forces on the planet failing.

The sun rises in the morning, the moon revolves around the earth, and the price of the American Home has never gone down since the Great Depression. The last ‘fact’ has been something that investors have always had faith in. Whenever the market was fluctuating, whenever the dot-coms were busting, whenever pork bellies were worth nothing, American investors took stock in the fact that real estate would never, ever decrease in value. Until 2007. That’s when homes in the United States began to decrease in value. To Wall Street, this was as if the sun just decided not to rise one morning, or if the moon decided to retire to warmer climates and take a summer off in Florida. It was absolutely unheard of. What had happened from 2004 to 2007 was that Wall Street investment banks had gone to war with Fannie Mae and Freddie Mac, attempted to take some bites out of their marketshare. Fannie Mae and Freddie Mac responded by lowering their standards for mortgage lending, by giving out mortgages to people who were less likely to, you know, pay them back.

Bear Sterns was known on Wall Street for reliable risk management. They were a relatively safe bet, they took risks to pay the bills but the consensus was that Bear was a bank that took care of your money. In late June 2007, two of Bear Sterns’ Triple- A (The lowest possible risk) Credit rated hedge funds went bust. They ran out of money. And people went absolutely nuts. 1.6 Billion dollars has evaporated from a AAA- Rated Hedge Fund. Triple A rating means a supremely low risk. Like, Government Savings bonds type of low risk. And two of these hedge funds evaporating cause a huge tightening of markets, especially ones associated with Bear Sterns. This was a problem because Bear Sterns made their money by having a continuous in flow of investments to pay their outflow. This brings to mind the unfortunate Bernie Madoff scheme, however the basic premise is actually the cornerstone of the banking business model. Continuous inflow, continuous outflow, take a little off the top to keep the lights on and the bills paid. So Bear’s business constricting had major impacts further down the line.

Generally speaking, Banks lending to other Banks for a period of three months is a safe investment, if not the safest investment, probably only second to the United States government lending money for a period of three months. The term in the Financial industry used to relate the difference between the risk of a three month loan from the US Government and a identical loan from one of  the major banks is “The TED Spread.” In an ideal economy with strong consumer confidence, the TED spread is very low. Three months after Bear’s two Hedge funds went bust, the TED Spread was at an all time high. People were seriously frightened.

March 2008 was a rough month for Bear. On March 10, there was a panic caused by rumors that Bear was running out of money. The rumors were totally unfounded because Bear had a 17 billion dollar war chest at the time, but rumors have killed companies before. By 3 PM the stock dropped seven points until a veritable deus ex machine happened: The Governor of New York was revealed to have had affairs with $8,000 prostitutes. The panic stopped, and Bear lived to see another day. All thanks to Elliot Spitzer. But Bear’s troubles weren’t over. The next day, March 11, investors in Bear are still jittered enough by a crappy TED spread and bad memories from last June to start jumping ship. Novation requests start pouring in, and people sell their stakes to third parties for nickels. That Wednesday, March 12, CEO Alan Schwartz goes on CNBC to tell the world that everything is okay, that Cash reserves are still up, and they should not take their money out of Bear. But it’s too late. By Thursday, March 13, Bear’s cash reserves are down to 3.5 Billion. They’re trying to assure Goldman Sachs, their largest customer,  that everything is going to be okay. But at the same time, they’re shopping around for someone to buy their company.

That Thursday night, Bear Sterns CEO Alan Schwartz called JPMorgan CEO Jamie Dimon asking for $30 Billion in capital. Schwartz also mentions that, if he doesn’t get this capital, Bear is for Sale. Dimon tells Schwartz he’s sending over people to look at Bear’s books. He also recommends that Schwartz calls Tim Geithner at the NY Fed and to call Paulson at the Treasury. He does, and Geithener also sends over a team to look at Bear’s books. At two in the morning the Fed, JP Morgan, and the SEC all have people reading Bear’s books in horror as they realize how toxic the assets are, due to the miscalculation of risk. Geithner, Paulson, and  Bernake decide at Five o’clock on that Friday morning that the Fed will essentially loan $30 Billion dollars to Dimon’s JP Morgan, Dimon will them lend the $30 Million to Bear, and Bear will have its head above water long enough to guarantee consumer confidence and get it’s money back. All Bear needs is a good showing on the trading floor that Friday.

But Friday is a terrifically bad day for Bear. Friday murders them. Without government intervention from the Fed and JP Morgan, Bear Sterns would have gone bankrupt on Friday, March 14. Paulson informs Schwartz that he needs a plan in place by the time the Asian markets open on Sunday evening. Because that’s when the government money stops moving. The loan was only good for that weekend. Paulson was uncomfortable with an open ended government money loan. So Schwartz is back in hot water.

That Saturday, Bear’s competitors are all looking at its books. It is clear that Bear Sterns is done for, ready to be sold off to the highest bidder. JPMorgan executives alert Bear that they intend to bid $8-12 per share. For perspective, Bear Sterns stock closed at $32 per share on that Friday. The New York Times publishes an article called “Why Save Bear?” that Sunday. Still uneasy, JPMorgan withdraws the offer. Bernake sees that a deal needs to happen by 6PM, when the Asian markets open, so he guarantees $30 billion to cover Bear’s toxic loans. Paulson has JPMorgan drive their new offer from $4 a share to $2 a share, in order to, in Paulson’s opinion, reduce the ripples through the economy. The deal is approved that night. JP Morgan bought Bear for $2 a share, when in early 2007 it was worth $130 a share. Eight days later, the deal is raised to $10 a share, in order to get past the shareholder vote.

I realize this post has gotten supremely long… I think I’ll end it here for now then pick up where I left off in another blog, if that’s alright. There’s still so much to go through, like AIG, Fannie, Freddie, Lehmen, and my personal favorite, September 18th.  Keep up that consumer confidence!

Comments

  1. The nice people in the Charles Center applaud your diligence.