n + 1 has a published a sequel to their much-beloved-by-us anonymous interview with a hedge fund manager. In this episode, HFM explains what went wrong with Bear Stearns:
n+1: So can you tell me what happened with Bear Stearns? What were the steps?
HFM: Bear was a bank that was very involved in the asset-backed and sub-prime market. Both as a principal and as an agent.
What happened this summer was funds managed by Bear Stearns–not things on their own books, other people’s funds that they manage, other people’s capital–those funds were heavily leveraged and invested in asset-backed securities. Those funds blew up–they went into uncontrolled combustion. They failed very quickly. One day they were there, the next all the assets were marked down, then they were insolvent and folded up. Now that’s not Bear Stearns’ capital, but there were guys sitting in the Bear Stearns office.
n+1: Which is where?
HFM: On, uh, 47th and Madison. Just down the street.
n+1: And they were sitting there; they had a little hedge fund–
HFM: Which means they raised money form outside investors–they get paid based on how the fund does, they get a percentage of the profits. And they traded in sub-prime assets where the capital was given to them by outside investors.
n+1: These were 10 guys?
HFM: I don’t know the size of the team, but they were sitting there, buying asset-backed securities backed by sub-prime mortgages, they were borrowing a lot of money, they used the capital they had, they borrowed outside money, they bought sub-prime mortgages. They were highly, highly leveraged. 50:1 leverage.
n+1: Why was Bear Stearns in particular doing this?
HFM: Bear Stearns supposedly had an expertise in sub-prime and asset-backed securities; it is an expertise of theirs. They’re still alive.
HFM: You know when somebody falls off a motorcycle, and they want to harvest their organs, they’re still alive until they harvest the organs. Right now Bear Stearns, there’s an EKG, it is pinging, they’re technically still alive and JPMorgan is waiting for the healthcare proxy to sign and say they can start harvesting the organs. This is where Bear is right now. They had an expertise.
n+1: So it was 100 billion dollars? How much money?
HFM: I don’t know. It was not huge. 1-2 billion dollars each. In that range. Which doesn’t make them huge funds. Modest funds.
But from that moment forth, people on the market speculated as to how many similar kinds of assets Bear Stearns must own on its own books. There was a cloud of suspicion over Bear Stearns. As it turns out, I don’t know that they were in that much trouble. They were probably much more careful with their own money than outside money, but once there’s a cloud of suspicion the information asymmetry that exists between people outside the firm who don’t know what’s going on, and inside the firm, can create a crisis of confidence.
n+1: Can’t the firm say, “Look, we have this, we have that…”?
HFM: What are they going to do, are they going to show you every instrument they have on their books? People don’t know what these instruments are worth. Like an asset-backed bond–what’s it worth? Nobody knows what’s it worth, there isn’t a market for this anymore. It’s not like there are three bond issues, and that’s it, there are thousands, and each one is backed by thousands of mortgages, it just becomes an information-processing problem. You simply can’t prove to me in a reasonable amount of time that everything’s fine.
n+1: They don’t have other instruments besides mortgages?
HFM: They do, they have their building, that’s one of the things that is probably worth the most. But Bear was involved in a lot of the asset classes that had problems. First it’s sub-prime mortgages, then it’s leveraged loans–they’re exposed to all these things, 30 times levered, so a very small diminution of the value of these assets could mean that their equity is worth nothing. And it’s just going to be impossible for these guys to prove to everyone’s satisfaction in a short period of time with a high degree of precision that their assets are worth what they say they’re worth. There’s been a cloud over Bear Stearns for 8 months and in retrospect people were critical of their management for being insufficiently aggressive in trying to persuade people that everything was fine. They simply asserted that everything was fine.
And the question everyone is wondering:
n+1: Wouldn’t it have been better to let them go bankrupt?
HFM: And let their counterparties face the music? Maybe, but the parlous condition of the financial system as a whole I think persuaded the Fed that this is not the time to experiment and see how interconnected the system has become.
If we were in a calm economic environment and Bear, for non-systematic reasons, failed–say they put all their money into cheesesandwich.com or something, and they failed for that reason, then it might be appropriate to let them go bankrupt because the rest of the financial system would be stable. Even if it inflicts losses on the rest of the financial system and causes a lot of brain damage for me, it won’t be a risk to the system as a whole.
But every bank out there to some degree or another is suffering the same problems that led to the cloud of suspicion over Bear. So this is not a great time to test a proposition that the financial system can cope with disorderly unwinding of all these contracts.
Lots more good stuff over there.