Lessons For Everyone
From Bear Stearns
Jim Prevor’s Perishable Pundit, March 25, 2008
With the collapse of Bear Stearns there will be many questions to be addressed. One valuable one is for all business people to understand how such a dramatic collapse could occur.
When The New York Times did a piece on March 20 entitled, At Bear Stearns, Meet the New Boss, it covered the visit of James Dimon, the CEO of JP Morgan Chase, to visit the executives at Bear Stearns. He made a point of not blaming Bear’s top executives:
“I don’t think Bear did anything to deserve this,” Mr. Dimon said. “Our hearts go out to you.”
“No one on Wall Street could have anticipated this,” he continued.
That may have been a politic thing for James Dimon to say. After all, Bear Stearns employees hold about 30% of Bear Stearns stock, and he needs their votes to complete his acquisition.
But it is not true.
What happened was unpredictable as to timing but highly predictable as to likelihood.
There are two timeless business lessons that the collapse of Bear Stearns should remind all business people of:
1. Leverage is a two-edged sword.
Bear Stearns’ assets were 33 times greater than its equity capital. In other words for every dollar Bear had, it borrowed 32 dollars to buy investments. Among other things, this means its vaunted great investors were not so great. Tiny advances in the market price of assets it bought would translate into enormous returns because the equity base was so small.
Conversely, Bear Stearns was always at great risk because tiny decreases in market value could leave the company insolvent.
In other words, if Bear had a billion dollars in equity, it would then borrow $32 billion and wind up owning $33 billion of assets. If the value of the assets went up 5%, Bear made $1.65 billion, or a 165% return on the one billion in equity.
Conversely, if the value of the assets dropped by 5%, the $33 billion in assets would be worth only $31.35 billion, and since Bear borrowed $32 billion, the company would have negative equity of $650 million — in other words, Bear would be insolvent.
Bear supposedly engaged in sophisticated risk management techniques so it could diversify its risk and hedge its positions and thus not be as much of a house of cards as its thin equity position would imply. However, as we learned from the collapse of Long Term Capital Management (LTCM), whose Board of Directors included Nobel Prize winners Myron Scholes and Robert C. Merton — Scholes being the father of the Black-Scholes option pricing model — even brilliant minds cannot account for future changes in relationships between different asset classes.
The Wikipedia entry for LTCM describes what happened this way:
… if the fund had been less leveraged, it would have weathered the spike in volatility and credit risk: In the end, the idea of LTCM’s directional bets was correct, in that the values of government bonds did eventually converge. Due to the high leverage, however, this only happened after the firm’s capital was wiped out. Thus, the incident confirms an insight often (though perhaps apocryphally) attributed to the economist John Maynard Keynes, who is said to have warned investors that although markets do tend toward rational positions in the long run, “the market can stay irrational longer than you can stay solvent.”
2. Borrowing short and lending or investing long is a big problem.
Even Bear’s high leverage might not have proven its undoing — if the maturity of the leverage matched or exceeded the holding period for the assets. In other words, even if you over-leverage your house, as long as you can make the payments, over long periods of time the market may come back and save you.
Many of the problems in the market today, of Bear Stearns, but also companies such as Peloton and Carlyle Capital, are not due to investments in subprime mortgages that turned out to be worthless. Many of the problems are due to changing valuation for assets such as the bonds issued by Fannie Mae and Freddie Mac. These are referred to as “Government Sponsored Entities” and occupy a kind of nether land between “full faith and credit” bonds issued by the federal government and corporate bonds for which the government is not responsible.
If an entity sells 30-year zero coupon bonds and thus becomes highly leveraged but then uses the money to buy Fannie Mae 29-year-and-11-month zero coupon bonds, if market valuations shift and the Fannie Mae bonds drop in value, the entity may be technically insolvent, it couldn’t liquidate its assets and repay its debts — but that doesn’t matter. The entity doesn’t have to liquidate its assets, it can hold to maturity and as long as Fannie Mae pays its bonds upon maturity, the entity will have enough money to pay its obligations.
The problem here is that all kinds of financial institutions were attempting to make the differential between long and short term rates by borrowing on very short maturities, such as overnight, and investing in long term bonds and other long term investments, many of which had Triple A ratings.
But all that had to happen is that for any reason people and organizations didn’t want to roll over those 24-hour loans, and hedge funds and investment banks were forced to start selling their better holdings to raise cash. This put pressure on the market price for these higher quality holdings and turned a liquidity difficulty into an insolvency problem.
It is worth noting that just as Long Term Capital Management was correct, if it had been able to hold onto its investments, everything would have turned out all right, so too, if Bear Stearns had been less leveraged or had leverage with maturities tied to the maturity of its holdings, it is very possible that it would have come out of the current economic situation in very good financial shape.
The dangers of leverage and its timing are not confined to Wall Street. Produce companies have filed for Chapter 11 never having missed one payment, but just because a bank decided not to roll over a loan — the value of land and changes in banking made it impossible to find someone to take over the loan — and that was the beginning of the end.
Had these produce companies raised equity to lessen their leverage or acted to keep the maturity of their loans always far in the future, it was unlikely they would have had to file.
The government’s efforts to manage the situation may or may not work. Although stepping up to save Bear Stearns may have avoided panic, it reduced the transparency of the market. In some ways, the best thing would have been to auction of Bear Stearns assets so clear values could be assigned. This would make people confident in doing business with other holders of the same assets.
Herbert Hoover disagreed with Andrew Mellon, his Secretary of the Treasury, who had served three presidents and was widely seen as the greatest treasury secretary since Alexander Hamilton. When the stock market collapsed, Mellon famously argued that the government should “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate” — in that era before Stalin’s Great Purge, he didn’t mean to kill anyone, just to not stand in the way of bankruptcy laws and markets for that would require debitors to liquidte assets to pay lenders whatever they could.
In economic terms, he was arguing that the prices of assets had to be allowed to fall in order to clear the market for each asset. He felt this would “purge the rottenness out of the system” and that once this was done, a recovery would be swift.
The bail out of Bear Stearns — the Treasury has agreed to basically guarantee the asset value of $30 billion in assets although a change in the agreement now calls for JP Morgan Chase to take the first billion dollar hit itself — can best be seen as the government resisting Secretary Mellon’s advice from the grave.
We will know soon enough if the government’s efforts will work.
Clearly for an individual business looking to avoid liquidation, decreasing leverage and ensuring the maturity of any debt is far in the future is a consideration of prime importance.