Bear troubles and fears

18 March 2008

The Bear Stearns collapse has shaken up Wall Street and may signal a prolonged and painful crisis for financial markets. By Vivek Sharma

If you have survived the worst economic crisis in recorded history, you would consider yourself strong enough to take anything that is thrown at you. You have seen the heights of exuberance giving way to the depths of despair within weeks. Besides, you have a successful track record running to many decades which has imparted superior survival skills and, you believe, wisdom. You might occasionally get carried away and play with fire, but you are confident that you are more or less immune to fatal failures. Even if you stumble, enough people have confidence in you to give you a helping hand.

The top management of Wall Street investment bank Bear Stearns must have harboured similar confidence. Bear Stearns began life before the Great Depression and was a closely held boutique firm until it went public in the '70s. Over many decades, the firm had done reasonably well and became one of the top-5 investment banks on Wall Street – even if it was the midget in that elite group. At its peak, the firm was valued at over $30 billion and was managed from a steel and glass tower – itself worth over $1 billion – in Manhattan. 

Until Sunday, that is. Faced with bankruptcy and liquidation, Bear Stearns allowed itself to be acquired by JPMorgan Chase for just $236 million - less than a hundredth of its peak value! (See: JPMorgan Chase acquires Bear Stearns for $2 per share)

First to hit trouble and first to go under
It was the collapse last year of two hedge funds promoted by Bear Stearns which alerted the world to the impending sub-prime crisis. Until then, everything was well in the world of financial markets - except for the minor distraction of falling US housing prices. The housing weakness was believed to be well 'contained' with no or little impact on other sectors or the overall economy. The financial instruments that were backed by the wobbly housing assets and home mortgages were believed to be so well structured that they were hardly considered risky. Big investors who had loaded up on such securities had no reason to loose their sleep.

Wall Street banks like Bear Stearns were making a pile of money by selling these 'mortgage-backed' securities to eager investors flush with funds. It was so profitable that the investment banks were actively searching for mortgage assets to be sliced, diced and sold as asset backed securities. They earned hefty fees for devising these 'innovative' instruments, but were not directly exposed to the underlying risks. Then things slowed down a bit and some of these investment banks had to keep large quantities of such securities with themselves. They did not hesitate to hold them as the housing downturn was supposed to be a short and mild one, in the hope of selling them at even higher prices when the market recovers.

But, the market did not recover. Instead, it slipped and slid down a steep incline – leaving behind a trail of wreckage. The mortgage-backed securities that were supposedly as risk free as the best quality corporate bonds suddenly became 'toxic'. Investors panicked and rushed to exit their positions. To their dismay, they found that there was no market for these 'damn things' – as  Fed chairman Bernanke called them.