Tuesday, September 2, 2008

From Bailout to Bailout - The Prelude to Bear Stearns Collapse

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Our video on the material in this post is 'The Bear Stearns Bailout'. It can be found at: http://www.youtube.com/watch?v=G8Mn67rNCFQ

The New York Investing meetup first mentioned in August 2007 that Bear Stearns was likely to fail. Two of Bear's hedge funds had gone under in late July and this helped t0 precipitate a sell off in the U.S. stock market by bringing media attention to the subprime crisis. Even though the subprime crisis had begun by at least December 2006 with the sudden failure of mid-sized mortgage lending company, the financial media failed to recognize its importance until the forced closure of the Bear Stearns funds. The precarious state of Bear Stearns finances that this failure indicated was in turn also missed by the U.S media. As usual, the media took its cues from Wall Street, which remained bullish on Bear Stearns right up to the very end (as was the case for Enron and a number of other major corporate failures).

Furthermore, the September 20, 2007 earnings report indicated everything was fine. Despite the failure of the two hedge funds, Bear Stearns claimed to have earned $1.16 a share. A write off of only $200 million (an insignificant amount for a Wall Street firm) was taken as a charge for closing the funds. Another $700 million of mortgage assets were also written down, also not that great an amount. In the earnings conference call, the CFO stated that he “expect[ed] a return to more favorable conditions next year”, stressed the underlying business was sound, and market dislocations tended to run a quarter or two. The only thing he was correct about was that the market dislocations would only last two more quarters - although he certainly didn't imply that this would be because Bear Stearns would no longer exist after that time.

While the September earnings report was reassuring, Bear Stearns December 20th earnings report was an indication of serious and possibly fatal problems. Suddenly, the company lost $6.90 a share, the first loss in its history (Bear was even profitable in every quarter during the Great Depression). Wall Street analysts were expecting a loss of only $1.79 a share, missing the actual loss by over $5.00 a share. The loss included only $1.9 billion of write downs in subprime mortgage exposure. Despite the indication that analysts had completely missed the extent of Bear Stearns problems, the stock actually went up after the earnings report, instead of sharply falling as it should have. The CEO subsequently 'resigned' - something that usually only takes place when a company is in trouble.

By December 2007, Bear Stearns was hardly unique in suffering losses because of the ever expanding credit crisis. The Federal Reserve attempted to address these system wide problems by creating its first new lending facility, the TAF (term auction facility), which gave it an additional conduit for its money pumping operations. In January 2008, reacting to the further deterioration in the financial system, the Fed cut its funds rate by an additional 1.25%. Bear Stearns, however, could not benefit directly from any of these moves since it was not a commercial bank and was therefore not allowed to borrow money from the Fed, so its situation continued to deteriorate.

Nevertheless, even as late as early March 2008, neither Wall Street, nor the media were ringing any alarm bells that Bear Stearns was about to implode. No Wall Street analyst had a sell recommendation on Bear Stearns stock even though it was about to lose almost all of its value. It apparently didn't bother them that the balance sheet indicated 33 times leverage, an amount that can only be described as enormous and which was greater than any other broker dealer or commercial bank. While the public facade that everything was fine was being maintained by Wall Street, rumors were circulating behind the scenes that Bear Stearns might go under. The big players were quietly getting their money out in what was basically a secret run on the bank.

NEXT: Bailout to Bailout - The Collapse and Rescue of Bear Stearns

Daryl Montgomery
Organizer, New York Investing meetup

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