Insights
In the News - The Recent "Bear" Market
Since mid-2007 the investment community has been mired in negative news … and now, roughly 8 months later, the plot has thickened, as news of the near collapse of Bear Stearns added a new dimension to the current financial crisis! Recently, on March 16th, the Federal Reserve took unprecedented and unconventional steps to restore investor confidence in order to avoid what some suggest could have resulted in an economic meltdown in the US financial markets with widespread global ramifications. It all happened so fast, leaving investors with so many questions. We hope the following explanations clear up some of the most frequently asked questions that we’ve been asked:
- What happened at Bear Stearns?
- How does this event affect other financial institutions?
- Will it affect individual investors?
- How are individual investors protected in such circumstances?
- What’s an investor to do?
What happened at Bear Stearns?
To start with, of all the investment banks on Wall Street, Bear Stearns was known as the most aggressive player in the mortgage backed underwriting arena and one of the largest underwriters of complex investments, including collateralized debt obligations (CDOs) and other fixed income products linked to mortgages. In fact, you may recall that two of its internal hedge funds, which were among the most heavily leveraged with sub-prime mortgages, failed back in July of 2007.
According to individuals on Wall Street, Bear Stearn’s management exercised poor judgment, in that they had an obvious lack of risk controls, exceptionally high leverage, a lack of liquidity and reserves, and an apparently poor corporate reputation on Wall Street. (The story goes, that back in 1998, when Long Term Capital Management was going under, the major banks were brought together by the President of the New York Fed. The only party who refused to participate in the $3 billion bailout was Bear Stearns -- Long Term's prime broker!). Despite the Company's recent assurances that it had plenty of cash on hand to continue operations, Bear Stearns (the country’s fifth largest investment bank) failed because its investors no longer believed it could repay its loans.
On Sunday (March 16th), in a Fed-mediated sale to keep Bear Stearns from having to declare bankruptcy (which would have meant a long, drawn out process and would likely have precipitated a crisis of unimaginable proportions), JP Morgan agreed to acquire Bear Stearns via a share exchange for a mere $2 per share, a dramatic decline from a high of roughly $171 per share in January 2007, and $80 at the end of February 2008! (FYI, in addition to the NY Federal Reserve, both President Bush and Secretary Paulson signed off on the deal).
Bear Stearns Stock Chart
Source: MSN
We’ve included an interesting account of the details that led up to the Bear Stearns collapse which was taken from the Angry Bear BlogSpot.
Last week starting late Wednesday and through Friday, Bear Stearns (BSC) experienced a run on the bank when several European banks stopped acting as Repo counter parties. This resulted in numerous institutions beginning to add a premium charge for anyone else who was going to use BSC as part of a transaction that the institution was going to be a counter party in, which resulted in more counter party agreements being canceled, withdrawal of credit lines and hedge funds who used BSC's prime brokerage business drawing down their balances.
BSC had the weakest liquidity position of the major brokers and couldn't raise cash fast enough and was rapidly approaching the point where counter parties would likely seize and fire sale collateral, which would have resulted in a massive unwind as others became forced sellers or faced margin calls due to mark to market. Probably the biggest fear of the Fed was what would happen from the massive forced unwind from hedge funds due to the size of BSC's prime brokerage business.
So the Fed stepped in to try to insure an orderly liquidation rather than a meltdown and an unwind that would have spilled over. JP Morgan and JC Flowers showed up, looked at the books. JC walked away and JP told the Fed it needed to do something about $30B of assets that JP didn't want. As no surprise to many, apparently a Bear doesn't just sh*t in the woods it also has a balance sheet for that.
So the agreement they came to was that the Fed would take the $30B in assets at a 50% hair cut and make it non-recourse. So there isn't a $30B bail out. The Fed gave JP a $15B loan for the assets, which was about the fair market value of the assets, for which only the Fed has downside. Thus the max bail out is $15B and could end up being $0 in the end. The more probably max down side is a $9B bail out since the estimated fire sale/liquidation value of these assets was $6B. However, JP does have the option to pay off the loan and take the assets back in the future, meaning JP has all the upside on the assets as well.
As to the $2 price that many are claiming is a pittance, it’s essentially the equity holders being offered the option to collect the saving on legal costs from bankruptcy instead of going through bankruptcy and likely getting $0 down the road. If shareholders reject the deal we go back to fire sale of seized collateral that will in the end leave equity holders underwater.
But Bear's building is worth $1.8B, and it's free and clear. Bear has $81B in unsecured debt outstanding, and in a bankruptcy proceeding a long list of counter parties and clients it would likely owe even more. In the end, this was the Fed doing a good job of ensuring the orderly functioning of financial markets instead of a massive meltdown on technical factors. While not truly bailing anyone out, the Fed made sure BSC was liquidated in an orderly manner and offered some protection to the bank willing to take on the risk on short notice.”
How does this event affect other financial institutions?
In reality, the consequences from the existing sub-prime mess has affected almost every investment bank to some degree or another in the past year, so it's not surprising if there were to be other similar situations waiting in the wings.
While commercial banks are routinely required to disclose troubled investments to the regulators, there is considerably less scrutiny required of hedge funds and investment banks, most of which are public companies. In essence, Bear Stearns was rescued to help curtail the potential that a domino effect would occur, given Bear Stearn’s link with many other financial institutions through both its mortgage backed and its derivative securities.
The collapse of any large financial institution undoubtedly creates uncertainty. As such, if there's any chance, perceived or real, that borrowers will default, lenders would refuse to make loans, ultimately causing the entire economy and the financial system to just shut down. The Fed’s unprecedented arrangement last week to allow financial (non-deposit taking) institutions other than banks (in essence, the 20 large securities dealers and investment banks that sell Treasury securities) to borrow directly from the discount window (over the next six months), was a major step in reassuring the marketplace that these institutions would be able to get money quickly when and if they needed to. While rumors of difficulty at Lehman Brothers has been prevalent, arguments have been made that the recent Fed decisions, combined with further reductions in interest rates, have eased these concerns…at least for now.
Once again, we quote from the AngryBear Blog, noting that "the rumors and speculations of Lehman Brother’s imminent demise seem to be greatly exaggerated". They acknowledge that Lehman is twice the size of Bear Stearns, has twice the liquidity as a percentage, is significantly less dependent on Repo financing ($19B vs $74B outstanding) and has been a better risk manager. Also, Lehman now has access to the new lending arrangements at the discount window that the Fed has extended to primary broker dealers in the event that liquidity is needed to elude the possibility of a run on the broker.
How will it affect individual investors?
Clients with brokerage accounts at Bear Stearns will eventually have their accounts and assets transferred to J.P. Morgan, with some assurance that their money should, overall, be safe. That said, the average investor at most any other brokerage company should feel confident, after the Fed’s recent plan, that they will not likely experience any direct impact or loss of capital (aside from general market fluctuations, etc.) due to the recent debacle. Interestingly, the sale of Bear Stearns differs from the Long Term Capital Management rescue a decade ago when investors were left substantially intact. Regrettably, however, Bear Stearns employees, including the rank and file, will likely see their savings associated with Bear Stearns stock all but disappear. How investors will be affected, is indirectly, particularly if yields on money market mutual funds and other bank deposits move lower as the Fed continues to cut interest rates. Stock prices will likely continue to be extremely volatile, while the value of the U.S. dollar is expected to continue its decline, as global investors sell their dollar holdings in search of higher interest rates elsewhere. As a result, American’s will undobtedly pay more for all that is imported.
How are individual investors protected in such circumstances?
The situation at Bear Stearns has raised concerns about what could happen to individual investors if a major brokerage firm goes under. Fortunately, there are regulatory rules in place which should protect most investors. Under the Securities and Exchange Commission's customer-protection rule, broker dealers are required to hold client assets in "segregated accounts," which means the firm cannot use those assets for their own business purposes. To the extent that the firm doesn't have the funds and securities to cover those claims -- either because of misappropriation or negligence -- the Securities Investor Protection Corp. (SIPC) will step in to cover losses up to $500,000 per account, including $100,000 for claims for cash. Beyond the SIPC coverage, most brokerage firms offer additional insurance. Remember, neither SIPC nor FDIC covers losses due to market fluctuations!
According to SIPC, while there have been occasional situations where brokerage-firm customers didn't get their money back, those have been mainly limited to small broker-dealer firms, some of which may have dealt in lightly regulated penny stocks. In the past five years, there have been seven brokerage firms, mostly small ones that were liquidated. As stated on the SIPC website: “Customers of a failed brokerage firm get back all securities (such as stocks and bonds) that are registered in their name. The firm's remaining customer assets (including cash or assets not covered by SIPC) are then divided, with the funds shared in proportion to the size of claims. SIPC will attempt to return all of a customer's stocks, bonds and options. The failed broker's other assets (including cash or assets like futures, currencies and commodities not covered by SIPC) are then divvied up among clients in proportion to their claims.
If that still doesn't cover the losses, then SIPC reserve funds are used, up to the $500,000 per-customer ceiling, which includes as much as $100,000 for claims of cash that were held in the client's account. (Many brokerage-firm clients also have their uninvested cash automatically swept to a bank-deposit account or other cash alternative. If cash is swept to a bank savings accounts, the funds have up to $100,000 in coverage from the Federal Deposit Insurance Corp. Cash that is swept into a money-market mutual fund is covered by the SIPC. Also, exchange-traded funds that have underlying investments in commodities such as gold or currencies are treated as securities regardless of the underlying investments). As for options accounts in a failed firm: All of them are closed out at the date of a bankruptcy, with the cash returned to their customers. The exception: short positions, which result in a debit to the customer’s account.
It should also be noted that the majority of brokers have a relationship with a clearing firm, which is where your assets are actually held. These firms work with the securities exchanges to confirm, deliver and settle trades. They're also responsible for seeing that transactions are settled correctly in a reasonable amount of time.
Most brokerage executives said that it would be difficult for a clearing firm to go bankrupt. If one of their member firms did something crazy, such as overextending margin or allowing a customer to trade a product he or she didn't understand, it could affect the clearing corporation. But there would have to be a huge drop in the market, combined with a lot of trading on margin. In other words, a perfect storm would likely have to occur to cause a bankruptcy at a clearing firm”. SIPC, is not a federal entity like the Federal Deposit Insurance Corp., which protects bank accounts. They publish a brochure on the subject, entitled "The Investor's Guide to Brokerage Firm Liquidations: What You Need To Know...And Do." The brochure is at http:// www.sipc.org/pdf/SIPC_brochure_Investors_Guide_To_BD_Liquidations.pdf.
Also, additional information on FDIC insurance may be found on its website http://www.fdic.gov/consumers/consumer/information/fdiciorn.html.
So what’s an investor to do now?
Here’s an interesting fact taken from the LA Times….over the last 10 years 75% of the best days for the Standard & Poors 500 Index have come within 2 weeks of the worst days! While we run the risk of sounding like a broken record, the biggest mistake people make is rash decisions.
Based on one’s investment objective, ones age, risk tolerance, expected date to retirement, life circumstances, etc. are discussed and an appropriate time horizon is determined whereupon an investment portfolio is created. The various percentage allocations between stocks, bonds and cash take into consideration that the markets will, in all likelihood, experience volatility. The amount of risk you were willing to assume typically determines the price volatility you would be likely to experience…both up and down.
So, unless you absolutely need money in the next 3-6 months, now’s probably not the best time to sell based on the old adage “buy low, sell high”. Can the market value of your portfolio go lower….absolutely. Whether it will go lower, however, is a question that can’t be answered with any certainty. Based on consensus thinking, the probability is that it is likely to go a bit lower before it bottoms out. Historical evidence suggests that every financial crisis results in some sort of major failure. Looking at the decade of the 90’s, in 1998, it was the collapse of hedge fund Long-Term Capital Management, and in 1990, it was the savings-and-loan crisis.
Each time, the market fell about 20% before rebounding. With the market down more than 21% on March 10th from its October 2007 high, some on Wall Street suggest that the worst of the current decline could now be priced in. Just when things seem that they can’t get any worse is usually a pretty good sign that the market may turn around soon. Also, the fact that the market remained orderly and the bottom didn’t fall out after the Bear Stearns announcement clearly reflected investor sentiment of the “glass is half full” versus “glass is half empty” perspective. If your portfolio is well diversified, and your allocations reflect your longer term investment plan…it just might be a good time to sit tight!
As always, we’re here for you and welcome your thoughts and comments. If you’ve got other questions that you’d like us to comment on, please feel free to let us know.
