Monday, March 17, 2008
Whoa No Shoot
I don't know if anyone else is interested, but I'm kind of fascinated by Bear Sterns - they had been the # 5 Investment Bank on Wall Street until quite recently - going under.
Their stock had peaked at, like, $170 a share in 2007 and yesterday, it was sold for $2 per share. Having been going, very part time, to business school for four months I can tell you that that's a lot less.
So what happened?
I don't profess to have a deep understanding of the financial markets, by any means but I'm going to take a shot at what happened, as I understand it - albeit in overly simplified terms - and anyone that understands it, please jump in.
Bear Sterns is an Investment Bank and basically what that means is they have a shitload of other people's money (billions) and they take that money, invest it and try to make more.
One of their investments was in the the subprime mortgage market. When Fannie Mae or Countrywide or whoever, sell all those mortgages, they are owed billions of dollars by home owners/mortgagees (collectively). They're taking a risk people can't pay them back - the higher the risk you won't pay them back, the higher the interest you pay because it's more of a risk. And when you're a pretty high risk, they call you subprime and charge you a very high rate.
All of this debt is amassed by the mortgage companies and because they don't want to take all the risk themselves, they sell it off to investors and pay them a percentage in order to take the risk from them (if people start defaulting, they lose the money too.)
With all this debt, they essentially made towers of debt and I-Banks bought the debt at some level on the tower, accepting the risk of the people defaulting on the loans, picture this:
If you have the blue layer, you may get paid, say 10% interest on your level and there is a 3% risk of people in your section defaulting, you reflect that on your balance sheet as a 7% profit margin (as long as people don't default); if you're red it may be 8% and and 2% for 6% profit, etc.
Basically what happens is even if these banks weren't in the blue, where losses due to defaulted mortgages were actually paid out, they still took a balance sheet loss because they were getting paid as if there risk was the red level but the risk was actually in the blue level now because after part of the blue level was eroded the red had to drop down - closer to the actual risk of mortgage defaults - which is less of a profit than they said they were making, and now they have to write that down on their balance sheet as a loss.
Multiply that by four kajillion, and that's a big loss and because Bear Sterns had put too many of their proverbial eggs in the proverbial subprime basket, when people started defaulting due to the slumping housing market, BS had to write down like a trillion dollars (it may be in the billions but I'm not going back to look it up and, anyway, the point is it was a lot of money).
Investors started freaking out and were no longer trying to invest with Bear Sterns as well as pulling money out and, with their funds in jeopardy, their stock price plummeted.
All this led to the choice of going bankrupt or being bought out.
They went with terrible option B, which is how JP Morgan was able to purchase the decades-old former Wall Street giant for 1.2% of it's peak value in 2007.