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08/13/2009

Seriously Pete, how did Bear Stearns collapse so quickly?

 

I get this question a lot in my speeches.  How could a giant, multi-billion dollar company, run by smart people, with $18 billion in cash suddenly fall apart?  I mean who can burn through that kind of money (besides Elliot Spitzer at ½ price night at the Bunny Ranch?)

Permit me to reveal one of Wall Street’s dirty little secrets (and there are many.)  For the past 30 or so years, investment banks have been funding many of their operations with short term loans.  One such form of financing is the overnight “repo” market.  Here loans are backed by the firm’s own assets (it stocks, investments and cash.)  This overnight borrowing practice was huge, with firms like Bear Stearns borrowing $75 billion a day and borrowing it for only one day.  Literally Wall Street suits would hit the phones at 6:30 in the morning.  They’d ask big companies, like Fidelity Investments, to borrow say $6 billion, for just 24 hours.  They’d negotiate a daily rate and perhaps on one particular day, Bear Stearns would have to pledge more assets or pay a higher rate if the markets were down.  But for 30 years this worked just fine.

Until…

Well you can already see the danger.  Suppose a firm like Fidelity said, after 30 years of straight lending, “we’ll like to hold off for today.”  (Perhaps cause they heard a rumor two about Bear Stearns.  No proof, just rumors.)  Now it’s just one day, but it has a catastrophic effect.  The Bear Stearns dude who usually gets his $6 billion from Fidelity now has to call one of his other lenders, say maybe Federated Investors, and try to get an extra $6 billion from them.  Now if you answered the phone at Federated Investors and a Bear Stearns dude asked for an extra $6 billion, what’s the first question that would pop into your mind?  “Hmmmm…why does this guy need more money from me today?  It must mean that he couldn’t get it from someone else, which means someone might know something I don’t.  Which means I better be extra careful.  I’ll hold my funding for a day too just to investigate this a little more.”

Now if these were not overnight loans it really wouldn’t be a problem.  If the Fidelity dude said, “I can’t lend you the money,” then the Bear Stearns dude could say, “Let’s meet for $18 martinis, I’ll bring over our balance sheet and I can address all your concerns.”  But because it is overnight there is no time. 

Indeed Bear Stearns was a leader in underwriting mortgage backed securities.  These securities and their dwindling reputation may have been the match, but I’d argue it was the overnight lending that was the gasoline that lit the house on fire. 

 

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