Please Do Not Feed BearHey, how come that hedge fund got bailed out and I didn't?
Posted Tuesday, July 3, 2007, at 5:24 PM ET
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StumbleUponBy stepping in, Bear Stearns averted a swift collapse for the subprime CDO market. But it seemed out of step with Wall Street's prevailing sink-or-swim ethos. Last year, the $9 billion hedge fund Amaranth, caught out by a trader's reckless natural gas trade, was allowed to sink like the Titanic. We are constantly told that hedge funds, private equity firms, and the giant Wall Street firms that back them are dynamic creatures whose intolerance for poor performance leads them to seek and destroy economic inefficiency. Failures, even large-scale failures like Amaranth, are a necessary and natural part of the system. But in the case of the Bear Stearns funds, Wall Street firms seemed positively European in their aversion to creative destruction. They clamored to be bailed out from their reckless extension of credit to a subprime hedge fund. Bear Stearns obliged.
And yet the financial services firms that made many of these soured loans in the first place are not nearly so kind to their down-market customers. Many of the unfortunate homeowners losing their houses to foreclosure are, directly or indirectly, customers of firms like Merrill Lynch and Morgan Stanley, both of which recently acquired subprime lending companies. Foreclosing on subprime borrowers has the same ruinous impact on homeowners as it has on subprime hedge-fund managers. When foreclosures are concentrated in a particular area, it hurts the whole neighborhood. In a fantastic Wall Street Journal article (subscription required) about the impact of subprime lending on a single block in a lower-middle-class section of Detroit, a real estate broker noted that banks would have a tough time selling homes on which they had just foreclosed. "Nobody's going to want to buy into a neighborhood with 20 percent foreclosures," he said. "You end up with no neighborhood."
Note the similarities—and the differences—between the neighborhoods in which subprime borrowers live and the financial neighborhood in which subprime lenders operate. Wall Street executives didn't foreclose on the Bear Stearns hedge fund, which borrowed imprudently, because (1) the fund had a rich parent to bail it out, and (2) doing so would have imposed financial hardships on themselves, on their friends, customers, and neighbors. The residents of neighborhoods targeted by subprime lenders typically receive no such consideration. When you owe the bank $10,000, it's your problem. When you owe the bank $10 billion, it's the bank's problem.
Wall Street these days seems to be willfully obtuse when it comes to the appearance of its business practices, whether it's the differential attitudes toward foreclosure, obscene pay packages for CEOs, or the special tax break for private-equity managers. (See under: Schwarzman, Steve.) The rapid expansion of subprime lending has tethered the fortunes of higher-income Wall Street to the fortunes of lower-income Main Street. As Main Street has foundered, financial companies have generally responded by severing the lines and leaving struggling borrowers to their fate. They might be well-advised to throw some life preservers.
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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)