Bear, Stearns & Co. Inc., until two weeks ago, was the fifth-largest investment bank in New York. The bank was renowned for its trading house and brokerage and it enjoyed successful advisory and asset management businesses. Former employees include Sandy Weill, former CEO of Citi, and Chris Gardner, entrepreneur, author and subject of the recent Will Smith movie "The Pursuit of Happyness" (sic). Former investment bankers Jerome Kohlberg, Jr., Henry Kravis and George R. Roberts went on to found Kohlberg Kravis Roberts Co., one of the most successful and influential buyout firms ever. Until late 2007, Bear Stearns hadn't posted a loss in 83 years. But with a few misplaced bets, that all changed. Now this company's misfortune has chilling implications for the rest of the economy.
This summer, an invisible hurricane brewed as financial firms created and traded high-risk collateralized debt obligations. The storm finally landed on the shores of two of Bear Stearns' hedge funds: the High-Grade Structured Credit Fund and the High-Grade Structured Credit Enhanced Leveraged Fund, ?which concern the complex debt instruments in which the funds were invested and the extra money borrowed to invest in those products, respectively. As the housing market collapsed and bankers started to realize the CDOs were losing some of their net worth, the two hedge funds lost all their value by the middle of July. In the disaster recovery effort that followed, Co-President Warren Spector resigned from his post during August and Standard & Poor's, a company that essentially ranks companies' financial health, downgraded the Bear from AA to A just three months later.
By December, the company's stock price had taken a hit, dropping from its high at more than $170 a year down to just under $100. $100 per share, however, is still respectable.After all, the market was going through some trouble, and financial stocks were already risky business. Investors were concerned, but even when it seemed like more write-downs were on the way, the confidence that had assured people housing prices would never fall instilled a sense of reserved optimism. Bear's prices continued to drop, but so did everyone else's.
Thursday, March 13, rumors that Bear Stearns was running out of money started to circulate, and many investors woke up to the shocking news that the stock had declined 10 percent or more since the markets had opened that morning. Options traders following the unfolding story quickly bet that a larger plunge was likely.
At noon that day, Bear Stearns stock was worth about $553. Put options -- contracts giving the right to sell the stock -- with a strike price of $25 expiring at the end of March increased in price by 500 percent, indicating that many investors thought Bear Stearns stock would be worth less than half its then-current value in fewer than two weeks. Most shareholders, however, remained unmoved. In a Bloomberg article, Prof. Roy Smith of New York University's Stern School of Business said, "These guys are very smart. If there's any group on Wall Street that's known for being good money-makers through thick and thin, it's Bear Stearns."
The morning of Friday, March 14, Bear's stock dropped more than 47 percent to $30 per share, losing $5.7 billion in market value in only a few minutes. The rumor mill that had started days earlier had continued to churn away, and investors were starting to get scared. Fearful for any sort of connection to the company, traders at other banks who regularly engaged in long-term trades with Bear Stearns decided to hold off. Companies seeking advisory roles decided to call a different investment bank. Worst of all, banks that provide routine short-term loans -- necessary for securities firms' day-to-day operations -- thought even those would be too risky. Over the course of five days beginning March 10, Bear Stearns' liquidity pool -- the amount of cash the company had on hand to pay for things -- decreased from $18.1 billion to $2 billion. According to Reuters, CEO Alan Schwartz announced, "Our liquidity position in the last 24 hours had significantly deteriorated." To help, JPMorgan and the Federal Reserve Bank of New York joined together to offer Bear short-term financing to get back on its feet, and Schwartz foreshadowed that the bailout was "a bridge to a more permanent solution," according to an article in Business Week.
Sunday, March 16, JPMorgan shockingly announced it would buy Bear Stearns in stock for a price equivalent to $2 per share, or $236 million total. Not including any of Bear's actual businesses, the company's Manhattan headquarters alone was valued at about $1.2 billion. Essentially, JPMorgan was getting Bear Stearns' solid businesses -- notably its prime brokerage, a JPM target -- for free. In an unprecedented move, the Federal Reserve Bank of New York agreed to take on $30 billion of mortgage-backed and other under-performing securities to help the deal go through.
Shareholders -- one-third of them employees -- were incensed. Bear had a history of paying its people with stock. So, when the stock lost 99 percent of its value, some executives lost a majority of their net worth. JPMorgan upped its bid Monday five times to $10 per share, likely to avoid impending lawsuits or even a shareholder veto of the deal. Additionally, the company acquired 39.5 percent of Bear's stock, making a full acquisition by a rival bidder nearly impossible. But, the stock still traded around $11 per share Tuesday, indicating some investors still think a higher offer may be on the way.
The implications of such a quick death spiral are huge. First, the Federal Reserve has not helped in a bailout of such a scale since the collapse of massive hedge fund Long-Term Capital Management nearly 10 years ago, which yielded a slew of non-fiction works. So, its level of involvement here points to the fact that had Bear Stearns been allowed to collapse on itself, the entire financial system could have fallen with it. With the endless web of contracts among firms, one major player's downfall could entangle tens of others.
"The fear is," University Bank Management Prof. Richard DeMong explained, "if Bear Stearns liquidated, the creditors have first claim before bankruptcy. Everything would get dumped on the market all at once. If all the [debt] gets put on at the same time, it will depress prices."
Bear Stearns survived the Great Depression; the current economic crisis destroyed the firm in a matter of hours.
The scary part is that rumors were enough to bring Bear down. The company's capital ratio, an overall measure of the amount of money Bear had, stayed level around 13.7 percent from January through March -- well above the Federal Reserve's standard of 10 percent for a "well-capitalized" firm. This means that in all of its assets, Bear had more than enough money to keep running. If someone had been willing to lend enough money to keep the company liquid, business could have continued in relatively normal fashion. But exaggerated fears drove any help away. After betting too heavily on mortgages and paying for it, bankers could now treat any sort of risk like the plague. The day after the Bear Stearns collapse, Lehman Brothers narrowly escaped a similar fate for the same reasons in reaction to their brief 15-percent dip in stock price.
Wall Street is a plane ride away from Charlottesville, but if implosions like Bear's were to continue, it would seem a lot closer to home. Overall confidence in the economy is tied directly to what people can observe in the stock market. Seeing tumult like this, investors would rather hold their money in low-yield bonds or even in cash. Earning less and fearing for future returns, people spend less, slowing the economy as a whole. DeMong warned that now "the confidence indexes are as low as they were in 1973 during the oil embargo."
Charlottesville's plethora of restaurants and shops could struggle under the slowing pace. Alternatively, investors could choose to buy foreign investments, one effect of which would be a further decrease in the value of the dollar. Students traveling in Europe already get 40 percent less for their money overseas than they would in the United States. On the other hand, DeMong offered hope.
"Charlottesville is perhaps better protected than most cities," he said. "We have U.Va., which is very stable and [is a] very little manufacturing base. The city is also attracting a lot of retirees, who will collect their social security no matter what the economy does."
Employees, however, might be more pessimistic. JPMorgan has publicly stated it will probably fire more than half of Bear's 14,000-strong workforce. Students here on Grounds with internships or full-time offers lined up with Bear basically have to cross their fingers and wait. In Fortune magazine, JPMorgan spokesman Brian Marchiony said, "We're still in early stages of assessing businesses, but we are committed to building a great pipeline of people and intend to keep students updated as much as possible."
Overall, the demise of Bear Stearns supported views that the country is headed into a recession. Though similar patterns have emerged in the past, the drama that has unfolded over the past two weeks is truly unprecedented in scale and scope, and it likely will be talked about for years to come. As Bear and JPMorgan work towards finalizing a deal, it will be interesting -- albeit nerve-racking -- to see what waves form in their wake.
David Victor-Smith is the president of the McIntire Investment Institute, a student-run equity fund.
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