Blog Post

Off Topic: Bear Stearns Bailout — It's the Prime Brokerage, Stupid

Stay on Top of Enterprise Technology Trends

Get updates impacting your industry from our GigaOm Research Community
Join the Community!

By now you all must be up on the news about Bear Stearns being sold for $2 a share to J.P. Morgan Chase. That’s roughly $236 million for an 85-year-old investment bank that was worth $20 billion only a few weeks ago. If you read the top dailies today — The Wall Street Journal, The New York Times and The Washington Post — you will get a 360-degree view of the crisis.

However, the big question is why did the Federal Reserve decide to underwrite $30 billion of its less liquid assets in order to get J.P. Morgan to buy Bear Stearns? It’s a big risk the Fed is taking, and I want to know why. After all, it’s the American taxpayer who would be left holding a bag of rocks if things go sour.

Given that the intricacies of Wall Street, the credit markets and other such big money topics isn’t something I write about on a day-to-day basis, I turned to Paul, who in a previous life was an investment banker. He pointed me to this article in the Money & Investing section of today’s Wall Street Journal that essentially said: prime brokerage.

Bear Stearns is the second-largest prime brokerage firm in the country, with a 21 percent market share. As part of the prime brokerage business, hedge funds would use their stock holdings and borrow money, many times the value of their stock from Bear Stearns, and then redeploy it in the markets. Bear Stearns, thanks to its stellar credit rating, could easily raise gobs of money that it in turn loaned to hedge funds. They had built up a portfolio of around $136 billion of these assets. (I am not sure how they are really assets, but maybe I am just way too skeptical.)

In the days leading up to the financial crisis, the hedge funds had started to get worried about the credit worthiness of Bear Stearns and decided to pull their money. Now had Bear Stearns gone bankrupt, there would be a lot of hedge funds out there being forced to dump their stocks into the market just to meet their obligations. In other words, the downward spiral that would have ensued would have become a vortex that would have sucked down entire financial markets.

And that would have put the confidence in the entire financial system at risk. Sooner or later that would start to impact Main Street, and then things would get ugly. Fears of a depression were trotted out just last week.

32 Responses to “Off Topic: Bear Stearns Bailout — It's the Prime Brokerage, Stupid”

  1. I could see bailing out thrifts and community banks, I could even see the argument in bailing out commercial banks…but an investment bank?!! crazy and corrupt..if the very definition of “free market capitalism” cannot stand up on its own, then why have the markets anyways? better yet what about the mom and pop shops who just need a cpl grand to keep operations going for several more years and provide a great amount of good for local and state communities.

  2. Mr. Dimon is mastering the art of the spin.

    JPMorgan’s CEO, James Dimon, is playing the markets, press and Bears Stearns investors perfectly. He knows exactly what he is doing and is executing with precision. Yesterday we learned that JPMorgan sweetened the deal now to $10 USD a share, up from a shocking $2 original bid. Dimon was quoted in the Wall Street Journal as saying, ‘We took another crack at it to get it just right.’

    Our theory is that Dimon knew all along that a $2 bid would have tremendous shock and awe value. In fact, he was counting on it. What better way to steal acquire Bear Stearns’ stock than to quintuple your original offer a week after the investors and the press couldn’t talk about it enough? Current Bear Stearns shareholders and investment bank employees had already calculated the fortune that got flushed down the toilet – now, hopeful again, they would be thrilled with any double digit stock price. A classic negotiating tactic is playing out before our eyes and, for most, the offer change comes as big news. We’re thinking this approach could go even further.

    In mid-March, a beaten up Bear Stearn’s stock was nearly $60 a share. To think that JPMorgan (or anyone else for that matter) could pick it up for even $20 a share was unfathomable at that point. Now, even if Dimon takes another “crack at it,” he’ll be pleased as punch to take the stock at $15 a share – especially with the aid of the Fed. Dimon knows the potential upside and he’s already protected JPMorgan from the downside.

    If JPMorgan’s target price for Bear Stearns was $12-15 a share all along, then anything less than that is simply icing on a very sweet cake.

    John
    Hedge Fund Jobs

  3. Just another example of the government being used as a tool of welfare for the rich fukers…oh they will kill the golden goose through sheer exhaustion…sad thing is even once the system bottoms out people will still owe all those debt and be able to declare bankruptcy just once in their small, tiny, measly, destitute lives…

  4. denbenenki

    thanks joe consumer for that illustration. i just happened on this site looking for an explanation of how the taxpayer is involved. most people in my class (low wages) do not know that their taxes will be used to help out the rich.

    joe consumer reminded a thought i have; all the extreme additions to the cost of living in the usa: littering is $1000. because a candy wrapper flew out of your hand while in a car? $400 for missing a stop light? $400 for speeding? and the many little no-cause-to-worry fees: $10 additional to buy a car battery, $10 to check if gas is evaporating from your gas tank, recycling fees on plastic and aluminum.

    a $400 fine would put me behind so bad it could dominoe affect me for months. i could learn my lesson just as well with an affordable fine, discomfort of court and humiliation. such unexpected costs destroy peoples lives down here.

    i quit my job bcz my landlord gave me 30 day notice to move and i could not find another house in two weeks that i could afford of a size to fit me and my furnishings. and i had to give two week notice that i would be quiting. unemployment denied me compensation bcz i took the offer from my sister to move with her– too far to keep my job– but i would be able to save my things and the family possessions i received– as my mother had just passed away. the agency said i should have just rented a room for myself. but as my landlord was also my employer, i had very little confidence i could keep my job much longer.

    i post this to illustrate one anecdote on how a person who makes up the basis of this economy has little recourse when “all hell breaks loose” in a low wage earners life. the only hope we have is unemployment and they are heartless. i thot i was doing the right thing to insure i at least had a place to stay so that i would not need to ask the taxpayer to give me food or voucher if i found a place to rent and lost my job as well.

    so it concerned me deeply to hear that people who have two homes might have to sell one bcz of BS going bust. its like those who watch deal no deal, while eating top ramen and cheering on a stranger who doesnt work, hoping they win 1000s of dollars.

    how could parents raise kids to be that stupid expect the family to progress into something better, as should be the goal of the gaurdian? (aka the govt)

  5. Joe Consumer

    You guys all live in a test tube. The economy is not DRIVEN by the investment and equity markets, they are merely barometers. The economy is DRIVEN by the consumer. And the consumer is completely tapped out. All income going to subsistence. There is only one solution. The insanely greedy that want to charge exhorbitant and usury interest rates and $60 late fees need to back off. The mortgage banks need to write down the value of upside down mortgages and pass that on to the consumer. i.e. if 1 formerly 200K home is now worth 170K then adjust the principle AND downsize the payment accordingly to put the differnce in the consumer’s pocket. If they don’t home values will continue to tank and more and more homeowners will just “walk away”. You idiots think you control the world. The consumers do, and basically your greed is killing your golden geese. What dumbchitz you all are.

  6. Michael Katcher

    @A.T. First of all it cannot be only beginning because it has been going on since June 22nd when BSC had to bail out its hedge funds. Furthermore, we know that it is the end because the Fed announcement on Sunday that it would extend TAF lending to brokerages will prevent what happened to Bear from happening to anyone else. The brokerages can now go anonymously to the Fed if they need cash and trade their illiquid securities for liquid Treasurys for short amounts of time. I’d hazard a guess that this is the end.

    As for those decrying this as a defeat of free market principles, I believe that is disingenuous. I am as much a proponent of free market principles as anyone here. However, the system was heavily regulated and disrupted by the government even before the crisis started. There are plenty of valid arguments that the government started the crisis in the first place. Some people feel that without a gold standard, the Federal Reserve is engaged in central planning, and thus Greenspan’s 1% interest rates in 2003 were to blame. Other people feel that state and municipal government pressure on lenders to offer loans to low-income, ethnically diverse neighborhoods was a cause. For me personally, I’d say that the existence of so much (useless) financial regulation provides investors with a false sense of security that undermines the operations of the free market.

    If in fact government regulation of and interference in free markets is to blame for the crisis, then to argue that government intervention to solve the crisis is anti-free-market is, in my opinion, intellectually dishonest.

  7. Re: hedge funds “pulling” their money, it’s actually the reverse. BSC extended credit (leverage) to hedge funds so they could make their myriad investments. When BSC faced its own liquidity crunch (30:1 leverage itself) from tanking mortgage backed securities, if the JP Morgan had not stepped in, BSC would have had to reel in all of its lending to hedge funds (i.e. margin calls) who then would have had to sell holdings to meet the calls, risking a downward spiral in markets.

  8. If you could take out one positive thing out this weekend’s events is that this was a watershed moment for BB and his team , he has finally ‘proven’ himself to the market as a creative and quick moving leader.

  9. I’ve heard they were up to 44 times levered. The problem was Bear Stearns holding were highly illiquid and since the fed HAD to get a deal in before asian trading began (or else risk a world wide economic melt down). JPMorgan and Mr. Dimon were able to have their way. They are one of the few institutions who could ‘stand behind’ Bear Stearns paper and they knew it. The Bear Stearns building is worth 1.2 billion alone, so assuming the rest of Bear Stearns holdings are not complete garbage ( the fed 30B should have covered most of the worst junk already) JPM stands to gain quite handsomely.

    The Fed had to do what they did , but unfortunately as a side effect maybe creating other systemic problems as they try to ease what is probably going to be one of the largest world wide market de-leveragings of our time.

  10. @ Sam,

    There were many hedge funds who did pull their money and move them to other prime brokerages. That was one of the reasons there was a “run” on the bank. However there were many more who have been leveraged up to the hilt thanks to generous lending from BS who didn’t have anywhere to run. Hence the bailout.

  11. Well, I agree, that it’s not a bail out when there are 14,000 employees all holding stock, many of who will be out of jobs soon.

    And low interest rate loans? That’s what the fed’s been doing with the lower interest rates — get it?

    My concerned is of the others who are having problems and not fessing up. That of course comes from the top — the Pres has his brain in a hole, not dealing with reality.

    Very sad indeed. Years ago, the mantra at Bear was that if you even thought you were loosing money, you told your boss, and pretty much took your losses right then and there, and moved on. No one part of the company would get so big as to take the whole down — it was all monitored. Sure one dept. or departments of the company could be doing poorly, but the others more than made up for it. And we all shared in the profits. That time ended when Ace Greenburg retired.

    Good-bye Bear Stearns. You will be missed.

  12. Matthew Brown

    RE: Jacob

    Unfortunately we aren’t going to get but a small cut to pacify us in the form of the $1,200.00 or so check that the fed will be sending out to some later this year. This will work well enough to avoid the obvious need for a complete overhaul of the economic system.

    You don’t matter to the fed = they are a private company masquerading as a public entity! As long as you keep taking out unnecessarily high loans (does anyone really need a 4,000 Sq Ft home when you only have 3 people living in it?) & credit cards (52″ plasma anyone?) you can’t expect them to tell you to stop do you? When greed is too easy to justify it becomes too hard to stop when all signs point in that direction.

    The day I paid off our credit card debt was the day I vowed to never live under that bondage again. We never needed anything we bought with them anyways. 5 years of freedom & counting! Have we gone with out cable & the latest dvd’s = yep. Are we better off financially than you? Yep. When the economy collapses we don’t have as many people to answer to = and it will collapse to be sure.

    But see that’s the trick – actually owning up to your mistakes & paying someone back. People “suffering with credit card debt” need to get a grip at some point & own up. We did – very liberating.

    Best,
    Matt

  13. Jacob Varghese

    I get it but if the govt can offer investment banks low interest rate loans like this then what about college students, home owners, and people suffering with credit card debt?

  14. michael

    I think Paul Krugman nails this story pretty well. This is just the first step in what will become a system bailoujt – redux of the savings and loan bailout of the 1980’s. This will be expensive.

  15. Matthew Brown

    Hi,
    If you want a better understanding of why the fed bailed out BS take a look at this site:

    http://www.bigeye.com/griffin.htm

    The book “The Creature from Jekyll Island” is fantastic & explains the reasoning behind all the financial issues we see taking place since 1913. To sum up:

    The Gold Standard was removed so that the banking systems could create something of value from nothing of value all the while taking a cut. If someone were to call them to the mat to prove their value what do you think would happen now?

    See Umair Haque’s stuff on the Macropocalypse for a tech related angle:

    http://www.bubblegeneration.com/

    Order out of chaos…that’s how banks dominate their niche.

    Best,
    Matt

  16. If hedge funds pulled their accounts from Bear Stearns and moved to other prime brokers, presumably they would return the money they borrowed and ask for their securities back. Assuming that Bear Stearns could return the securities, they would actually be getting cash at a time when there’s a liquidity crunch. Why would that lead to a crash at Bear Stearns ? After all, they were the lender not the borrower …

  17. American greed did what Muslim radical terrorists are unable to do. Bring down the US economy. All corporate executives who make reckless decisions based upon their self-greed should forfeit the ill-gotten gain. Corporations should reward executive who have the long-term interest of the company and the country as the priority for their decisions.

  18. It’s days like these when the “free marketeers” show their true colors.

    March 7 the feds announced the third straight month of job losses, plus more than half a million people losing hope and leaving the workforce permanently. Bush response? Cut $2 billion from federal employment and training programs.

    March 14 investment bank Bear Stearns threatens to collapse. Bush response? $30 billion bailout.

    They’ll jump into the market to manage risk and prevent a cataclysm when it’s their friends in the hot seat. The rest of us average bears have to get by on top ramen and cartoons: http://blog52.wordpress.com/2008/03/17/not-so-much-smarter-than-the-average-bear/

  19. Like Mark, I am discouraged by the government’s weakening of the risk/reward relationship. It is telling Morgan Stan that it can have any rewards it can wring from Bear, but that the risk will be borne by the taxpayer.
    ps of course that’s not the only discouraging thing…

  20. I totally get why the ripple effect of Bear, Stearns crashing and burning would have created a wake that could have done serious damage to our financial markets. This, in itself, is reason enough for the government to step in.

    Those who haven’t read, ‘When Genius Failed: The Rise and Fall of Long-Term Capital Management’ would be wise to do so, as it does a good job of connecting the dots on a complex topic.

    What I struggle with, however, is how to reconcile bailouts with the capitalist credo that ‘He who takes the risks, gets the rewards.’

    In this case, the American people take the risk by our tax dollars plugging in the preservation capital (or default guarantees). Shouldn’t there be some mechanism whereby they get real or phantom equity for when the tide inevitably turns?

    Mark
    My Blog: http://www.thenetworkgarden.com

  21. Excellent analysis! As far as I see it, bailing out Bear Stearns is simply staying off the inevitable, although – as you explain, it’s easy to see why the govt did it – its best to at least try to avoid a recession.

    Boom and bust scenarios like we are (or will be) experiencing are IMHO due to a massive mis-alignment of personal incentives in the financial world. High risk-takers are actually rewarded handsomely because huge bonuses are aligned to the profits made without taking into account the potential risk of the investment – thus the traders, bankers, mortgage brokers, IFAs etc are rewarded at bonus time each January simply by riding the bull market but consequently not penalised sufficiently when everything goes to shit. Sure they might lose their jobs but they probably would have done anyway even if they had managed their risk properly because of the cumulative effect of the greed of everyone else.

    Unfortunately the people affected the most are the common folk who screw up on their (mis-sold) mortgages and when the funds that their pensions are invested in tank.

  22. Om,

    The reasons for the bailout are clear (for me at least). However, it bugs me for several reasons:

    1. Using taxpayer money to bail out private enterprise goes against free market dynamics

    2. Bear Stearns and all of the rest of the investment banks reported record profits the past 2 to 3 years before the so called sub prime crisis

    3. Once again we’re seeing hypocritical policy from the party that claims it is for a smaller role for the federal government. Under the current administration, we’ve seen the taxpayer funded bailouts of United Airlines, American Airlines, and US Air, massive tax credits given to the oil companies (who also reported record profits), and now the bailout of Bear Stearns.

    I believe in free markets, which include corrections. The management of Bear Stearns is clearly incompetent, as is the management of the major airlines. In my opinion, the capital markets would be better off in the long run. The markets would have turmoil in the short run, but over the long run we don’t need Bear Stearns, United Airlines, American Airlines, or any other ‘ol boy companies being managed by brainless fat cats.

    I know my post is acidic, but hey, it’s an “off topic” response! :-)