A) THE STORY OF THE BEAR Bear has been in serious trouble for a while. The trouble starting coming to a head not last week, but the week before. By Thursday night people were pulling out of transactions, counter-parties were refusing to take the other side of deals with Bear, and people were starting to form a not-so-orderly line at the front door demanding their money. Bear, very late in reacting to the problem, called their biggest partner JP Morgan. Bear, primarily a brokerage house, has a bulk of their credit lines extended from JP Morgan. Normally, these credit lines allow Bear to function without worrying about short-term variations in which cash is actually received, they are a good thing... almost always. They're not a good thing for JPM when Bear draws on those credit lines and then goes bust.
Jamie Dimon, JPM's CEO gets the call and says 'no,' probably screams a line of obscenities, then proceeds to call the NY Fed Branches Chief. The NY Fed branch handles all the open market operations (i.e. those auctions Bellz is always talking about), so they are kind of a big deal. Now why would the Fed need to stop Bear Stearns from going under. Well as a brokerage house, one of their lesser known but HUGE businesses is interest rate swaps.
Interest rate swaps allow companies to essentially change the type of interest they pay on debt. By paying a fee to a brokerage such as Bear, Bear will structure a contract for Company A. If Company A just issued floating rate debt in Euros, Bear can create a swap where they pay fixed interest rate in dollars. Bear makes money and everyone's happy unless one of the parties can't perform their part of the obligation.
If you read the footnotes in any 10-k from a financial company to an industrial company to McDonald's to you-fill-in-the-ticker, you will find a disgusting amount of interest rates swaps. Billions if not trillions of dollars PER COMPANY. You add it up. Bear is a counter-party (the other side) of many of these swaps and the middle man in many of the rest. The point is, if Bear goes under, it's more than their traders that will lose their jobs, there will be trillions and trillions of dollars worth of contracts held by a bankrupt company.
So all these big wigs get on the phone. On Friday they announce that JPM and the Fed are working on a bailout. This is enough to keep people from knocking the doors down demanding money. Yes, it was almost a run on the bank of Bear Stearns. BSC recognized it can't just go bankrupt like most illiquid companies do because it would be too devastating. The Fed and Treasury Secretary Paulson recognized this too. If they're not going bankrupt they need someone to either buy them or give them a ton of cash money, otherwise they're still an illiquid company that can't meet their obligations. Well, in case you have missed since July... cash isn't readily available right now, so someone needs to buy BSC. Who better to buy BSC than their lead bank. Almost all Bear transactions go through JPM in one way or another, so the Fed recognized that this was the most realistic proposition.
Why does JPM get to offer 1 share of their stock for every 20 of BSC? Why is that the magic number? Why is the sky blue? Because it is. Theres nothing magic. If you had to figure out how much to pay for one of the worlds biggest financial companies over a weekend you'd pull a number out of your rear at some point too. That's why the offer jumped so much (from $2 to $10). The offer came initially on the low side because if JPM is going to take on Bear has some of the worst of all the crappy paper out there on it's books, so if a public firm is going to bailout a company going bankrupt, it has to be a phenomenal deal, almost a win-win. That's why they got to come out with such a low offer and that's why they received so much support from the Fed.
That is the all too brief summary of how Bear went from 60 to 4 in 2 days. I encourage all of you to read articles on this. The Wall Street Journal has phenomenal coverage as always. Today's (Tues) was particularly good. You can access it through ProQuest courtesy of the University of Illinois if you don't subscribe. Otherwise, Bloomberg has good coverage too.
B) WHAT WE SHOULD LEARN ABOUT MAKING MONEY FROM THIS
Believe it or not, you could have very easily seen this major drop in Bear coming, if you were watching the correct indicators. We are currently in a vicious part of the economic cycle. What does leverage do? In good times it amplifies returns, in bad times it amplifies problems. So if you were looking for a financial to short, you should have first looked at who used the most leverage. This would have led you to Bear who was levered 34-1 (gasp) as of 12/31/07. Second place, which interestingly enough was receiving more TV commentary on the short side than Bear over the last few months was Lehman with a little under 30 times. How do you find these leverage numbers... do your homework, look in the 10-k's and do some 5th grade math.
So we know with a highly levered company, as 34x defines, if things go wrong, they can spiral out of control in a hurry. So even if you didn't want to short you should have been looking for signs of trouble. These are what was happening leading up to the 14th: pulling collateral, backing out of transactions, no one willing to deal with Bear, etc. Did you miss these articles on yahoo finance? Nope they weren't there. Think about it. Is Bear going to go to the media and say no one wants to do business anymore and we may go bankrupt? If you think your bank is going bankrupt are you going to tell the media? No. Are you going to tell your friend and then go get your money or are you going to go get your money and then tell your friend? I don't know about you but I'm doing the latter. Are any of us friends with the guys who run the companies that have these substantial deals with BSC? No. We don't get the memo.
How do we know Bear's in trouble? Prices in the stock and options market are driven by major hedge funds, many of whom do get the memo when companies like Bear are in trouble. So there are two easy places to look: the price of the stock and options activity. In the options pits, over the week of Friday the 14th, especially Thursday and Friday, you would see the volume and prices on puts (the write to sell a stock at a set price on a set date) that were WAY out of the money (below the current price of the stock) sky-rocketing, even in the near month (just a few days to expiration). This says that people are making bets that the price of BSC is going to absolutely tank soon... they were right.
The chart above, courtesy of TD Ameritrade , shows BSC over the last 16 days with 30 minute sticks. The first big drop is Friday the 14th when the Fed and JPM announced that a bailout was in the works but there weren't any details. The huge gap lower in Monday morning, with the $2 offer. Look before the deathly drop though. If you have no prior chart reading experience, this shows the definition of bearish price action. The stock makes lower highs and lower lows and gets punished at either the open or the close EVERY DAY. Big money drives prices, and they have a better idea of what's actually going on, their price action told you that Bear was just starting to go down.Learn from what led to the huge fall in Bear and keep it in mind. This is an interesting time to live in and be learning but it won't be the only one of our lives. There will be more bailouts, more stocks going from 60 to 4 in 2 days, learning how to recognize and profit from these falls will do all of us well.
*In a rush tonight, didn't proofread, sorry for any typos.
to clarify on Dave's point: JPM and Lazard (who advised Bear Sterns) both had no idea what to value Bear Sterns at, because nobody has any idea what most of Bear's financial assets are worth.
ReplyDeleteSo JPM offers around $2 a share, Lazard says that's a fair assumption, then JPM's offer jumps to around $10 a share, and Lazard still finds that to be a fair assumption. (either way, JPM is buying this firm at bargain basement prices)
Essentially, Bear Stearns had to use their own estimates to calculate the fair value of much of their assets - as opposed to a mark-to-market or mark-to-model evaluation. Those estimates are completely subjective.