Introduction
Well before the week Bear finally fell in March 2008, most mortgage-backed securities (including securities backed by subprime, alt-A and prime residential mortgages) already were toxic. With the housing market in shambles, nobody was willing to buy residential MBS for more than a fraction of what already were drastically "written down" book values. Mortgage backed securities and CDO's that held MBS were, for all practical purposes, totally illiquid. Therefore, while Bear Stearns purportedly held somewhere between $30 billion and $50billion of MBS and other mortgage related assets in late 2007 and early 2008, there was the not so small technicality that Bear Stearns had no way to sell the junk. This state of affairs is, by the way, the very definition of a liquidity crisis.
LIQUIDITY AND THE GARAGE SALE
Explain? No problem. Imagine that you are an economist. Further imagine that your neighbor has been bragging to you for years that his collection of miniature French horns is worth thousands of dollars. He says he brought the tiny instruments on Antiques Road Show and and a tall, well groomed woman told him on TV that the collection showedexquisite craftsmanship were worth somewhere in the five to seven thousand dollar range. You know a little something about supply and demand, so you have your doubts. You decide to keep them to yourself. Anyay, In the midst of the financial crisis, your neighbor is suddenly laid off from his cushy investment banking at Citigroup.
Soon your neighbor is short of cash, so he decides to hold a two day garage sale. Besides the very valuable French horns, he has lots of other great collections. On the first day of the garage sale, your neighbor does well. He sells his baseball cards, his stamp collection, even his mother's diverse array of Limoges. To his shock, there is no buyer for the mini French horns. On day two, your neighbor makes a sign to tell shoppers that the horns are the featured item of the day. He lowers the price from $5,000 to $3,500. There is a huge turnout. Almost everything goes - even a Tiffany lamp for five grand. Still, there no bids for the French horns.
Your neighbor comes over to have a beer that night. He is happy with the sale, but you can tell that something is bothering him. "What's wrong?" you ask. "I don't know - the French horns. I know they're worth way more than I was asking. I just can't believe people weren't fighting over them." You try not to laugh, but it is impossible. You ask when he expects the horns to sell. He just shrugs his shoulders. "Who knows? But if I can't sell them at least I'll have an asset worth thousands of dollars." You, the economist, finish your beer, look up, and tell him this: "That's not exactly true." He pops open another can of Schlitz. "So, what are you saying - what about Antiques Roadshow?" You ask your neighbor if he really wants to hear your explanation. He nods. "As long as you're supplying the beer, I'm interested in anything you have to say." You clear your throat. "OK. Well, at the most basic level, the value of any asset available in the general marketplace is set by how easy or hard it is to sell." Your neighbor, the investment banker, interrupts - "Right, right... Supply and demand." You continue. "Exactly, if it is easy to liquidate an item - to sell it for cash - that is a good indication that that demand for the item is high. And - as you were saying - as a pretty reliable rule, high demand will translate to high price." Your neighbor smiles at you. "So?" You smile right back. "So, since there apparently is no demand for your little French horns, they lack liquidity. Which is my fancy way of saying that you can't turn something into cash if there aren't any willing buyers. And if you have no way to convert an asset to cash - if you can't sell it - then its true value, at the moment anyway, is zero."
In late 2007 and early 2008, the true value of Bear Stearns' "multi-billion dollar"mortgage portfolio was the same as a fictional $7,000 collection of mminiature French horns. Without investors willing to buy MBS, Bear's mortgage holdings were illiquid and, therefore, virtually worthless.
CREDITORS, CONFIDENCE, AND COLLATERAL
Wall Street investment banks like Bear Stearns constantly needed on-demand access to tens of billions in short-term credit. For several years - especially after the SEC removed caps on leverage for the largest investment banks in 2004 - an uninterrupted flood of loans, lines of credit, overnight repos, and other financing vehicles produced reliable profits for lenders, and allowed investment banks to expand their businesses with borrowed funds rather than their own capital. From 2004 on, many creditors functioned as virtual ATMs for Wall Street, dispensing unlimited cash to finance the investment banks' constantly growing balance sheets.
By the end of 2007 - as Bear Stearns marched toward its destiny - credit markets around the world were tightening. The end of the housing boom, and the start of the housing disaster, was more than a year old. The effects were seeping into the broader economy. Creditors, from the few remaining small town banks to international financiers, were on the front lines of a deepening credit crisis. Lenders, many of which had been severely burned by loan defaults, had no choice but to adopt a more cautious approach to risk management. The big creditors that financed major investment banks now had to consider a doomsday scenario that previously had been unthinkable: The economic tide had turned against Wall Steet. The massive profits of previous years were history. Was it possible that one of the big Wall Street firms - Bear Stearns or Lehman Brothers or Merrill Lynch or Morgan Stanley, or JP Morgan, or Goldman Sachs - could be suddenly find itself without sufficient liquidity to replace the revolving mountain of short-term debt upon which all of Wall Street was dependent to one degree or another? Many lenders concluded that, yes, there was a risk that one or more investment banks were vulnerable. It was a risk that needed to be managed carefully, because massive credit was Wall Street's gasoline. Without access to money, the investment banks could quickly die.
The collateral Bear offeredincluded the firm's giant inventory of illiquid MBS, CDO's, and related products. For a while - when the thought of an institution like Bear Stearns defaulting on its obligations seemed too farfetched to take seriously (Bear was more than 80 years old and had survived the depression) still impossible - lenders were willing to play a game of make believe with Bear Stearns. Bear pretended that the multi-billion dollar valuation it had stuck on the firm's toxic mortgage portfolio was real, and lenders went along with a wink and a nod. Certain that their funds were not in jeopardy, many creditors permitted Bear Stearns to pledge its cache of MBS and related products as collateral to secure massive short-term borrowings. However, in the slumping economy, Bear's business strategy seemed to at least a handful of creditors to be out of touch with reality. By late February, lenders speaking in hushed tones began to state that Bear Stearns was a credit risk. It now seemed like bad business to make loans to Bear Stearns that, as a practical matter, were virtually unsecured. No creditor wanted to own Bear's mortgage securities.
By early 2008, creditors were concerned that Bear Stearns might be a candidate for the doomsday scenario. In 2007, bad business practices had devastated Bear's finances and its reputation.The firm had taken a huge loss in the fourth quarter of 2008, and it ran its businesses almost entirely on borrowed money. Instead of slowly adjusting its business model to slash its bloated balance sheet, of unloading toxic or near toxic assets that clogged Bear's balance sheet, reducing leverage, and raising capital (a mission that Bear had pursued unsuccessfully for the better part of six months), Bear Stearns seemed to be more or less maintaining the business model that could not be sustained in the long-term. Bear Stearns had a huge portfolio of toxic mortgage securities. It had the highest leverage on Wall Street at 33:1. It had an under-diversified business model that put far to much responsibility for the firm's success in a handful of business units (several of which would not perform well if the credit crisis deepened). The conventional wisdom was that Bear Stearns' struggles would get worse as the economy continued to slide.
On a day to day basis, Bear Stearns was able keep the credit merry-go-round going with enough short-term borrowing to keep current on loan payment obligations and fund daily operations. This cycle of constant borrowing can create an illusion of stability. After all, Bear Stearns was doing business and it was paying its creditors. However, this day to day dependence on massive leverage is very dangerous. Asudden unavailability of credit for any reason (and there were numerous reasons why Bear was vulnerable to a sudden evaporation of short-term credit) would break the cycle. If enough creditors stopped lending to Bear Stearns, the firm would face a liquidity crisis of epic proportions. Without daily access to billions of dollars, Bear would be unable to keep current on credit payments. Moreover, the cash shortage and would almost immediately for Bear to eat through its reserves and quickly leave Bear Stearns with insufficient funds to operate its business and pay its employees.
In the beginning and the end, Bear's creditors lost confidence in the once-venerable investment bank. When Bear did face huge liquidity issues. But what the conspiracy theorists overlook is that the whole downward spiral - the reason the lenders lost confidence - was the sorry state of Bear's own grossly mismanaged business.
Excerpt, below, from Stanton Champion website, Bear Stearns Meltdown, March 18, 2008.
"Bear's real problem was a lack of faith in their assets: mortgage securities. Over the past several weeks, the markets for these assets have simply stopped moving, meaning that in many cases buying and selling them is very difficult."
"For Bear Stearns, the problem was simply that some of their creditors wanted repayment on their repos (they wanted their money they had lent to Bear back), but Bear was unable to find enough liquidity in the market using its large portfolio of mortgage securities. In other words, Bear couldn't find enough money through additional repos and nobody would buy their mortgage securities outright. Other creditors, sensing trouble, began piling on and trying to get their money back as well. Since Bear Stearns had $75 billion more borrowed than lent, they were ultimately screwed without extra financing."
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