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Please Do Not Feed BearHey, how come that hedge fund got bailed out and I didn't?

By Daniel Gross
Posted Tuesday, July 3, 2007, at 5:24 PM ET
Illustration by Mark Alan Stamaty. Click image to expand.

Illustration by Mark Alan Stamaty. Click image to expand.Bear Stearns has always been the pesky, streetwise, kid brother in the Wall Street family—smaller, younger (it was founded in 1923), and less polished. Bear lacks Goldman Sachs' tradition of public-minded financiers, the brand name of Merrill Lynch, the proud WASP lineage of Morgan Stanley, or the overwhelming size of Citigroup and Chase. Bear Stearns' market capitalization is a measly $21 billion, less than one-tenth that of Citigroup. CEO Jimmy Cayne isn't a Harvard MBA; he's a former scrap-iron salesman who didn't complete his studies at Purdue. Bear Stearns confirmed its outsider status in 1998 by refusing to participate in the Wall Street-orchestrated bailout of faltering hedge fund Long Term Capital Management.

But now Bear Stearns has finally joined the club. Last month, facing a crisis at two large hedge funds run by its asset management unit, Bear Stearns agreed to bail out one of the funds (and its many creditors) by providing a $1.6 billion line of credit. The move, intended to spare Bear Stearns embarrassment and protect the reputation of its asset management business, also had a take-one-for-the-team result. It insulated fellow Wall Street firms from losses and prevented widespread damage to similar hedge funds.

The details of the Bear Stearns rescue may fascinate only those who devour the Money & Investing section of the Wall Street Journal. But because it reinforces the notion that the big boys get pampered when their investments go bad, the bailout should resonate.

The two Bear Stearns hedge funds ran into trouble by borrowing heavily to invest in CDOs (collateralized debt obligations), investment vehicles that hold bits and pieces of subprime mortgages. (Wall Street's Jungle-esque food-processing machinery chops and dices mortgages like clams, into strips, bellies, and other parts, and peddles them to investors with different appetites for risk.) This year, the value of many of the assets in CDOs has fallen as delinquency rates on subprime mortgages have risen to record levels. According to the Mortgage Bankers Association, in the first quarter of 2007, 5.1 percent of subprime loans were in foreclosure and a whopping 15.75 percent were delinquent.

The falling prices of the securities backed by such loans spelled trouble for the Bear Stearns hedge funds, and for gigantic Wall Street firms like Merrill Lynch, which had extended billions of dollars in credit to them. Falling returns could push investors to ask for their money back, which could force the funds to liquidate. To protect themselves, lenders could effectively foreclose on the fund—grab the assets posted as collateral and sell them. In June, Merrill Lynch seized some $850 million in assets from the Bear Stearns funds. Not surprisingly, Merrill had a hard time getting a good price for them. After all, these were distressed assets in a distressed market. Had other firms followed Merrill's lead and dumped billions of dollars of securities onto the market, it would have thrown the whole subprime mortgage-backed securities market into chaos. By selling them at fire-sale prices, the firms would have forced all the other hedge funds run by their colleagues, friends, and customers, which held similar assets, to mark down the value of their subprime CDO assets.

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Daniel Gross is the Moneybox columnist for Slate and the business columnist for Newsweek. You can e-mail him at . He is the author of Pop! Why Bubbles Are Great for the Economy.
Illustration by Mark Alan Stamaty.
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Remarks from the Fray:

This article seems like a very strained attempt to make Wall Street look hypocritical. It is not very convincing.

At the end of the article it states that the Wall Street firms refused to foreclose on the funds. Not true, as stated in the beginning of the article Merrill Lynch did foreclose on the funds (i.e. seized their assets).

It also states that the Wall Street firms were clamoring for a bail out. No evidence of this is provided and I have not seen anything of the sort described in the financial press.

Finally, the article says that Wall Street relented when Bear Sterns loaned the fund money. Why is this surprising? If you have a sub-prime mortgage and your rich uncle lends you money, the bank will back off.

The article seems to imply that Wall Street is unwilling to accept the financial discipline that average joe borrowers have. In fact, Bear Sterns (part of Wall Street) is paying a big price for setting up some lousy hedge funds. That is real financial discipline.

--SFBurke

(To reply, click here.)

As they say, when a bank loans a man a hundred grand, the bank owns him. When the bank lends a corporation or limited liability partnership a billion dollars, [the company] owns the bank.

The Bear Sterns example shows that the fundamental justification for capitalist security holders taking increasingly huge shares of the productivity/profit pie (as opposed to the other half of the economic equation, labor, or as I think of it, you and me), is that they take risks.

Yup, real risky to invest in high yield hedge funds for the gains while secretly safety netted with more capital from sources that can't afford for you to fail. Capital investment, after you get to a certain level, is about the most unrisky thing out there. Less risk than taking the bus to work, by and large. So why do they get such a big piece of the pie?

Safety nets are grand. Someday, us folks need to get us some, too. Like the millionaire speculators.

--doodahman

(To reply, click here.)

So, Bear Stearns bailed out its own hedge funds. As I gather it from Gross' article, they took money from pile 'A' and put it into pile 'B.' In and of itself, I'd be inclined to say, so what?

But the troubles in the housing market aren't limited to the agony of those who took out subprime loans, nor to those who are getting whacked for having loaned it to them. The impact is now being felt most acutely in working-class neighborhoods in Detroit and Philadelphia. Will it stop there?

Sales of existing homes are down 25% from a year ago. That's a Depression-sized drop! And it ratchets up every step of the line. Since most home-buying activity is in the existing home market, where new buyers generally begin with the lower-priced starter, which enables those former owners to leverage their equity into a 'better' home, and so on, up the price scale, failure at the bottom will choke off activity at the top. This has ominous implications for the economy as a whole.

After all, how much of the past six years of economic activity can be attributed to new home construction and all the ancillary business that goes along with it?

The expansion of suburbia leads to the inevitable laying of new roads, construction of strip malls, proliferation of Starbucks, sales of cars and trucks, manufacturing of furniture and appliances, bank loans and a myriad of other things.

Our economy is like the proverbial hamster in a wheel, running as hard as it can to stay in place. Now, a key part of that mechanism has wrenched short. So, what's next?

--revrick

(To reply, click here.)

(7/5)

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