Mar 23, 2008

bear stearns

I have had a few people ask me exactly what happened with Bear Stearns, so I thought I would write a post explaining what happened in plain English. There have been quite a few articles written lately trying to explain the event and also place blame. I don't feel like any of them actually got to the truth of the matter so hopefully I can do better here. It is a long post however.

The first thing to understand is the infratructure of Wall Street and how it ties to Main Street. While people mainly think of stocks when they think of Wall Street, debt is probably a more core part of Wall Street. Stocks are a claim against a company. If you own 1 share of Exxon you own a part of the company and any future earnings. Debt is a claim against a stream of cash flows. If you own a bond that Exxon 'sold', you own a set of cash payments against that bond from Exxon. Bond owners get paid first, stock holders get paid what is left. Stocks are therefore higher risk. If Exxon goes insolvent, the bondholders will get paid first and stockholders may get paid nothing.

Debt can arise from many places. A company may want to raise debt to buy a company that costs more money than the cash the company has on hand. A homeowner may want to raise debt so they can buy a home that costs more money than the cash the homeowner has on hand. A family may want to raise debt so they can buy a new car that costs more money than the cash the family has on hand. And so on.

The other type of Wall Street instrument is a derivative. A contract that bases its value off of some other type of instrument; typically a stock or a bond. A better way to think of derivatives is as an insurance policy. You pay some premium - the price of the derivative - and that entitles you to some future guarantee. For example you can buy an Exxon option to sell the stock at a future time at a fixed price. If you own Exxon stock this can be a way to insure your investment against losses. If the stock goes down your derivative contract will be worth more, offsetting your loss on the stock. A derivative is much more volatile than the underlying instrument it derives its value from. As a result a derivative is more risky than stocks or bonds. Another important point is that it can be used for insurance but it can also be used to speculate. To take large risks.

Wall Street is where these 3 assets classes get traded. If you bought your home with a loan from Countrywide, that debt will make its way to Wall Street to be packaged and sold off to investors. This is a good thing. It provides liquidity or a means for cash to flow to people and companies that need it. This is the primary value Wall Street brings to our economy. Without it our economy would be very inefficient.

Now let's looks at how debt travels around. It's a bit simplified but you can extend this example to credit card debt, auto loans, commercial debt, a company's accounts receivables, etc. The family above buys a home and gets a mortgage from Countrywide. Countrywide will use a consumer rating agency like Experian to assess the family's creditworthiness through things like FICO scores. Countrywide then sends the mortgage to a investment bank, like Bear Stearns. Bear Stearns packages these mortgages up into baskets of mortgages and slices them into chunks of debt which have different claims to the money that is coming in from homeowners as they pay off their monthly mortgages. At the 'top' is a safe tranche. At the 'bottom' is a unsafe trance or equity tranche. When homeowners pay their mortgage bills the top tranche gets first claim to that cash. Each tranche down gets paid next. The equity tranche gets paid last. This is why it's called the equity tranche - it's like a stock which is called an equity.

The ratings agencies, like Moody's or S&P then grade these tranches with labels like AAA or BBB. These labels are supposed to describe the amount of risk inherent in the tranches. Then someone buys these tranches. Sometimes Bear Stearns keeps them or a pension fund buys them or a hedge fund buys them or a bond fund buys them. Anyone who has cash might be interested in buying these tranches. And then they might get resold again. If a hedge fund buys the tranche, a pension fund might put its money into the hedge fund. It then effectively owns that tranche.

The other part of this that I've left off is the Fed. Which effectively injects money into the economic system. When the Fed lowers interest rates it doesn't actually change a dial or anything. It's just a target. It then tightens up or loosens up their cash lending to banks. If it lends a lot of money to banks, there is oversupply of money and the rate drops. It will lend until the market rate drops to their target. The Fed is actually opening or closing a spigot on money that gets lent out to banks. When it lets too much money out a lower Fed rate means banks can get access to money at a low rate, which means it can lend it to others at a low rate and this stimulates economic activity. When it lets too little money out it does the opposite. Why not let a whole bunch of money out if it stimulates the economy? Well too much money and you get inflation. Or a devaluation of what a dollar is worth. Again it is supply and demand. Too much dollar bills running around (supply) and the value of the dollar drops or the price of things goes up. Inflation is very bad because it rewards people who take on debt and punishes people who save. Whatever they saved becomes worth less.

So to recap this is all just a way to connect people who have money and want to invest it for a return with those people who need money. The homeowner is sending payments to Countrywide, then Bear Stearns, then the hedge fund, then the pension fund. And the pension fund is sending an initial investment to the hedge fund, then to Bear Stearns, then to Countrywide, then to the homeowner, then to who ever is selling the home.

The upside of this is that money can flow freely. It's a nice system to funnel money to where it is needed. The downside is that the assessment of risk - how likely it is that the future cash flows from the debt holders will come in is quite removed. The pension fund does not know the homeowner and their situation beyond FICO scores and some other metrics and the rating the ratings agency put on the tranche. They may not even know that. This is part 1 of the problem.

One last piece about the Wall Street infrastructure. This is very important to understand how everything works. People invovled with investing money make money based on some measure their performance. A hedge fund for example gets paid 2/20. That means they get paid 2% of the assets they are managing and 20% of the performance or outperformance (depending on the fund). If I manage $1M dollars and my fund goes up 30% this year. Then I get paid 2% of $1M or $20K plus 20% of the $300K the fund went up. The key thing to notice here is that if my fund does terrible I get paid 2% at the very least. If my fund does very well then I get paid 2% and 20% of the performance. This is assymetric. It ENCOURAGES risk taking. It encourages shooting for the moon. Most of Wall Stret is encouraged to take risks. While this can bankrupt your fund, it also means you could retire in 2 years if things go right. This is part 2 of the problem.

There are a number of ways to take more risk. If I'm a hedge fund and I have $1M to invest, I could go buy some bonds or stocks and try to earn a return. If I buy stocks or bonds and they go up 10% in value then I've made $100K. I could alternatively, believe it or not, also go to someone like Bear Stearns and raise another $10M. After I have done this I have essentially $11M in cash and $10M in debt. If I invest that $11M in the same bonds or stocks and they go up 10%, I've now earned $1.1M on the $1M capital I started with. A pretty awesome return. I have to pay the interest on the $10M I've loaned from Bear Stearns but this will be at a lower rate than 10% so I will have come out way ahead. This increasing of the money you can invest is called leveraging. Leverage comes with a downside. Increased risk. If my $11M of stocks and bonds goes down 10% and I need to pay Bear Stearns interest on the $10M I can also lose a lot of money. But remember it's not the hedge fund owners money. It's the investors money who put money into the fund. The hedge fund owners get paid on performance.

Now not all hedge funds operate this way. Our fund is leveraged 1.3X meaning we borrowed 30% more than the actual capital we have from investors. Some hedge funds are leveraged 30X or 100X. Long Term Capital Management which blew up in 1998 was leveraged something like 100X.

Now here's the kicker. Bear Stearns and the rest of their ilk are basically hedge funds. The type that are massively leveraged. If you go look at their balance sheet, you can take the Assets and divide by the Equity to understand how leveraged they are. Goldman Sachs for example, had $1,112 billion in assets and $43 billion in equity. That's 26X. They argue they are 'hedged'. This means they have balanced the risk. This could be through opposing positions or through derivatives (insurance). And to some extent this is true. But come on. 26X! They are seriously leveraged anyway you cut it.

So what happened with Bear Stearns? Very simply if we think of them as a hedge fund that is massively leveraged then all you need to go wrong is for their assets to go down in value enough that some bad things start to happen. Those assests that went bad started with the securitized mortgages above. Instead of selling all their mortgage tranches off to hedge funds and pension funds Bear Stearns kept some of them. These are called residuals. All the primary investment banks kept some of these tranches. Why? Well, they had good returns. Often the tranches they kept were the worst - the equity tranche. Sometimes they kept them because they couldn't sell them to anyone. They should have known better but again you have people shooting for the moon. They could lose their job but they could also be retired by next year.

When the mortgage payments started going bad, the underlying value of the mortgage tranches went down. Realistically Bear Stearns had to mark down the value of these mortgage tranches that were on their asset line. When you heard UBS or Credit Suisse writing down $2B this is what happened. But many of the banks tried to not write them down. Why would they do this? Because they are leveraged. They didn't want people who had loaned them money to know their assets were worth less. This is similar to when a retail investor buys stock on margin and the stock goes down and they get a margin call. Bear didn't want a margin call.

Let's say you lent money to a hedge fund. You give them $10M on their $1M. I don't recommend this. If their assets go down so their $11M becomes $10M you would likely say, 'Hey wait a minute. If this goes down any more you won't have the $10M I gave you! Give me my money back.' Well there is only one way they can give you the money back and that is to sell the $10M in assets they have left and convert it into cash. On a normal day this might be fine. But what if everyone else out there - the banks, the hedge funds... - are all in a similar position? Then everyone is selling and no one is buying.

Two things can happen. First everyone could transact in which case the value of the $10M could be much less. After all there are too many people selling and not enough buying. Second the transactions don't happen. The credit market freezes in effect. The hedge fund in that case might say, 'Look. If I sell now you won't get your $10M back. You'll get $5M. Give me some more time until the markets lighten up.' And you might be okay with this because some of the stuff that the hedge fund has to sell is stuff you own and you don't want the value to go down because you are leveraged too. You might get a margin call. This second thing is what happened. And it spread to all kinds of debt. Even very safe debt like municipal debt. There were just too many sellers and not enough buyers. Lots of people were trying to sell or deleverage and no one was really buying. And lots of people just sat there waiting for the transactions to take on a more realistic level of pricing. But it never really came. Maybe those low prices were realistic to begin with.

The Fed tried to open things up by lowering the Fed rate and encouraging additional lending through other windows. Remember this adds money to the system. Money which can be used to buy things and offset all the selling that wants to occur. But even with all this money, many didn't want to buy. Why not?

This goes back to our mortgage example above. People realized they didn't know what they were buying. The ratings agencies ratings were called into question. Was a AAA tranche really high grade? Just because you had money now did you really want to go out and buy some of this stuff? Some people have called this the repricing of risk. People were buying this debt before and not truly understanding how much risk was involved. Why? Because they didn't really care. I'm sure most people involved with all this knew this was going to happen. But so what. Why not make my millions now? I might be retired by the time it collapses.

So Bear Stearns was put into a tough spot by this repricing of their assets. That in and of itself is not enough to bankrupt the company. But at some point no one is willing to lend Bear Stearns any more money and others will start asking for their money back. Then you get a liquidity crunch. A run on the bank. In A Wonderful Life the bank has a run. People wanted to take heir money out of the bank while the bank had lent out money to people and companies. It didn't have all their money. It was locked up in other loans. Most of these 'runs on the bank' start because of rumors. We were actually short Bear Stearns going into this collapse. Clearly one of my best shorts since I got in this game. We heard some of the rumors. If you have money tied up in Bear and you hear rumors you may shoot first and ask later. At some point Bear realized they had more money going out than their assets would cover and they would be insolvent. The deal with JP Morgan where they bought them for $2 a share was really a great deal for JP Morgan. Not because it got sold for $2. That $2 is meaningless. What JP Morgan got was a Fed deal that said we, the Fed, will take $30B worth of Bears crappy assets off their books. In effect they bought $30B worth of stuff that was probably worth nothing. The Fed can do this because the Fed can't go bankrupt. Well sort of. They get to print this stuff. They have the copiers. There are downsides to this though.

But the Fed said something much more amazing that's been somewhat overlooked. They basically said they would lend money to the investment banks. And the investment banks have obviously been borrowing. Normally the Fed only lends to banks. True banks. And the reason it only lends to them is that they are regulated. They aren't as levered. The investment banks aren't regulated by the Fed in the same way. So this is a dangerous precedent set by the Fed. They will have to turn this off at some point or start regulating the investment banks. I think both will happen.

So who is to blame? I think you can pass the blame around to everyone. The homeowners who bought homes way too large for their financial means are to blame. They are acting like hedge funds. Will little equity and savings they took out debt and bought huge homes. The Countrywide's who gave loans to people with no money down and little documentation of their finances are to blame. They took advantage of a securitization scheme that allowed them to fund mortgages to homeowners and now that that is shut down they have no financing. Go look at Countrywide's stock. The ratings agencies who rated this debt with little understanding of what they were rating are to blame. Their trustworthiness as raters is now gone. Go look at their stocks. The investment banks securitized these loans and kept some of them on their balance sheets while being highly levered are to blame. They are all sitting on lots of bad assets and now have a Fed hanging over their shoulders ready to institute new regulations. Go look at their stocks. And the hedge funds with all their leveraging and getting 30% returns on assets that generally return 4-7% are to blame. You can't look at their stocks but many are going out of business and other will find it hard to raise money to invest.

And finally the pension funds who invested in hedge funds that were highly leveraged are to blame. This is the last piece of the puzzle that I think we'll see in the news going forward. They ultimately are the final buyers of all this debt and when their returns suck going forward you are going to see lots of underfunded pensions. They will have to be funded through the earnings of the company if it is a company pension and taxes if it is a state pension. I fully expect to see stories of this nature going forward.

But the most blame goes to the Fed and Alan Greenspan in general. This is a man who had set interest rates so low for so long that we had asset inflation after asset inflation. Money was so cheap that it made sense to take out debt and leverage. Whether it was a home owner or a hedge fund manager, it paid to lever up. Bubble after bubble. First came the internet bubble. When it broke, he dropped rates and then we had a housing bubble. It just broke and now his successor, Ben Bernanke, has dropped rates and now we have a commodity bubble (wheat, corn, oil...). This is the worst bubble because we don't all need to run internet companies or buy homes. But we all need to eat and drive cars. And because foreign countries generally produce these commodities we have been shipping a lot of money overseas to pay for this stuff. That's why you here about foreign investment funds and companies trying to buy or invest in US companies. It's our own doing. We can't blame them for having a crap load of dollars that they want to get rid of.

At some point here the inflation will be so bad that the Fed will not be able to ignore it. And it will raise rates. This means lowering the amount of money lent out which increases the value of the dollar. And if we aren't already in a recession/depression this will cause us to head that way. But that's how capitalism works. There's a business cycle. Ups and downs. You can't avoid the downs. They are actually very healthy for the economy. They sound bad. People get fired and companies shut down. But it wrings out excess capacity. Capacity that has been built on cheap Fed money that has caused an oversupply. A recession forces companies and people to become more efficient and less wasteful. By being efficient companies can grow. And maybe this will help us be a little less frivilous with the resources at our disposal and help us save more so that we aren't effectively financing the growth of every other country. For more reading on this I highly recommend reading Warren Buffet's Squanderville v Thriftville.

I'm okay with greed. I agree with Gordon Gecko that greed is good. It's a great way to distribute resources. But having the Fed both set up these asset bubbles which led to increased risk taking and then bailing out those who lost is so uncapitalist I can't believe more people aren't pointing this out. If you take risk, great. If you want to buy a big home that is worth more than you can afford in the hopes that the price will double and you'll make a lot of money, then fine. Go for it. If you want to run your investment bank or hedge fund leveraged to the hilt, go for it. Just don't ask for a bailout when it doesn't come true.

Update: Here's one such article that tries to lay out the situation. The main problem with this article is that it focuses on derivatives being the problem. Again the problem is always leverage; borrowing more assets to invest in an attempt to create better performance. Derivatives are a way to get that but that isn't really the issue here. It was straight leverage. Most of the derivatives were actually trying to create some insurance against downside. But derivatives (insurance) don't work when everything goes to hell. If everyone crashed their car, Allstate would go bankrupt. That doesn't make insurance bad.

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