Economic Ebola – Part 1

Last week, in "People versus Partners," we opened by saying, "In this decade, we have witnessed two of the most major collapses in the history of the US economy, rivaling in scope to the Great Depression but luckily not rivaling the Depression’s impact on the employment index and run on banks, among other things. In the past two weeks alone, we have witnessed the government takeover of the two firms responsible for backing more than half of all domestic mortgages, the last minute buyout of one of the top five largest banks, the bankruptcy of 150 year old also top five bank, and the $80+ billion dollar injection of public funds for the largest insurance carrier. Add to that the collapse of one of the largest mortgage banks just a month ago and the fire sale of yet another top ten bank just a few months back, and the crisis hitting the financial markets far exceeds anything witnessed during the burst of the dot-com era. Perhaps worst of all, for as much as it feels like the denouement, we might have just hit the beginning of the end, not the end of the end. There is no bigger story right now than the implosions as a result of the mortgage mess and credit crunch, but for all of its significance, as a story, it simply is too great to grasp. Everything we have witnessed to date is simply a warm-up for the mess that we will have to work through, one brought upon not by impropriety and fraud such as that from Enron in Collapse 1.0 but one brought on from folly not too dissimilar from the Dutch Tulip Bulb mania of the 1600’s. This round involved more complicated financial instruments but arbitrary ones nonetheless."

Each week for the past six week’s, we’ve wanted to do a piece on the forever changing and changed face of the US economy, and each week, we wait wondering what bombshell will happen the following week. We will begin with a trip down memory lane, going back to March of this year when we watched the markets deal with the first of now many banking causalities in Bear Stearns. On Friday, March 14, Bear Stearn’s stock closed around $26 per share, valuing the company a little north of $3.3 billion. While that might sound like a like of money, it represents half of what Microsoft paid for Avenue A, but even that amount was a scant 15% of the value the company had at the beginning of 2007. In typical Wall Street fashion, or perhaps typical public company on the brink of disaster fashion, Bear Stearns had, less than two days prior to its implosion, assured investors of the companies financial health. They must have thought the company had a mild virus as opposed to the fiscal Ebola virus. The next day, the company didn’t look so healthy as news surfaced of a bailout by JPMorgan with help and urging from the Federal Reserve to make sure the company had adequate resources to survive. The bailout turned into a fire sale instead, as on Sunday, March 16 the announcement came that JP Morgan would acquire the troubled Bear Stearns for a mere $236 million, a price that included their New York City headquarters. For as phenomenally abrupt as the devastation unfolded, the writing was on the wall and in the press well before the stock began its journey into the abyss. And, as we will see not just with Bear Stearns but the financial casualties that follow, their undoing came from gambles on the mortgage market and a fundamental flaw in their business models – using other people’s money to make their risky bets.

A news search of Bear Stearns brings up not just articles of the companies hurried sale to JPMorgan and bad debt absorption by the Federal Reserve of roughly $30 billion but one piece from June of 2007 involving a Bear backed hedge fund. The company "pledged up to $3.2 billion in loans to bail out one of its hedge funds that was collapsing because of bad bets on subprime mortgages," the biggest rescue of a hedge fund since 1998 when more than a dozen lenders provided $3.6 billion to save Long-Term Capital Management, of which Bear was not one. In the Bear incident, the company had to step in because many of its customers wanted their money back after learning of huge losses suffered by this and a related fund. Beginning in 2004, the impressive sounding Bear Stearns High-Grade Structured Credit Fund had done well, posting 41 months of consecutive positive returns, and despite its high reliance on outside capital for placing bets and the warning signs related to its core drive, subprime mortgages, the company began the second related fund in August 2006. Illustrating the concept of leverage, the second fund, began with $600 million in investments, mostly from wealthy individual clients of Bear Stearns, and at least $6 billion in money borrowed from banks and brokerage firms. Meanwhile, the company itself, including top executives contributed a mere $40 million to the close to $7 billion fund. Interesting, on June 23, 2007 after the announcement of the bailout by Bear for its fund, Bear’s stock, by the way, closed down $2.06 at $143.75. 

In July, the funds went bankrupt, and as documents later revealed, and reported in Business Week, more than 60% of their net worth was tied up in exotic securities whose reported value was estimated by the team running the fund. That practice of having money managers estimate the values of securities for which they can’t find true market prices, known as "fair value" accounting, makes as much sense to the lay person as allowing people to declare their income and provide no proof of income when asking to borrow hundreds of thousands of dollars from a bank with no money down. Unlike Enron and WorldCom, though, the actions were those of just plain stupidity as opposed to fraud. To be fair it didn’t seem like stupidity at the time, just ballsy risk taking, but those who have read The Undercover Economist will know better. It was the market not the risks. Bear Stearns was not a superstar firm; instead they were on the margin, and when times get difficult, those on the margin face the impact of competition, or in this case the economy, faster than those not on the margin. When Bear’s issues surfaced, it put pressure on the next most leveraged firm, the firm next closest to the margin, Lehman Brothers, who looked like they might fall just days later in March. Instead, they didn’t fall then, and by the end of March, things looked shaky but steady. Oh how wrong we were, as we see in Part 2.