All these firms hold the same investments.
There is STILL considerable risk in the group.

Why did this happen to just Bear Stearns?

One of the first things I learned about investments was when it comes to bonds, think chocolate and vanilla, super simple: when interest rates rise, bond prices (values) go down.

And when interest rates drop, the price of your bond (the value of your existing bond) goes up. It is called an inverse relationship – think of a seesaw in the playground. When one side goes up (rates), the other side goes down (prices).

It always works. Well, it always works, until it does not work.

Ask Bear Stearns. And Goldman Sachs. And Lehman Brothers.

(and Merrill Lynch, Citibank, Morgan Stanley, UBS, JP Morgan, and many more)

See, while the Federal Reserve has been busy lowering rates lately, the bonds held by these brokerage firms were also dropping (apparently dropping by the hour!) in price.

Bond prices going down — while rates are going down? That never happens, right?

Stay with me on this, ok?
According to the Wall Street Journal and Dorsey Wright, firms like Bear Stearns and Goldman Sachs have been leveraging (borrowing against the assets they hold, using margin) by a factor of 25 to 1. Wow!

I scratch my head wondering why they would leverage their balance sheet by a factor of 25. Imagine you and me only needing to put up 4 cents to invest $1.00. Or another way of looking at it, your $1 can buy you $25 worth of securities. Pretty good, eh?

Still with me? Ok, now go another step: Goldman Sachs reported earnings this week. Their return on equity (what they earned on their own capital) for the past 12 months has been 29.5%. If the math is right, they are really earning about 1.1% on their capital, but then goosing the numbers (through 25 to 1 margin) to get to 29.5%.

That does not sound so good, does it?

Let’s talk about MARGIN

Now how can they borrow so much money? When you borrow (margin) against stocks, you can start by borrowing 50% of the current value. Since stocks go up and down, you are permitted to see that equity percentage drop to 30% before running into danger of a margin call (where you either need to add money, to increase your equity percentage closer to 50%, or start selling).

So if you had $50,000 in a margin account, you could actually withdraw $25,000 in cash (borrow against the stock). Or, instead, you could not take any cash out, but buy $100,000 worth of stock, putting up just the $50,000. And the net value can drop to near $30,000 before you face a margin call.

But when you borrow against bonds, you can borrow significantly more. Unlike stocks, where you can initially borrow 50%, with bonds you can borrow 80% and sometimes 90%. That is a lot more leverage!

And when the Fed starts lowering rates (like they are now), well, we already discussed how prices of bonds rise. Right?

What happened to Bear Stearns, and every other brokerage firm (and lots of banks) is the values of the bonds they hold have been dropping. They hold a lot of these sub-prime mortgages and loans — which have been very toxic. Additionally, every firm apparently has bushels and bushels of these cancerous bonds on their hands. They cannot sell to anyone, since everyone they deal with has the same toxic stuff on their books.

So if you try to sell, and there is no demand, what happens to the price?

You already know–  if there is no demand for you what you are selling, prices start dropping — drastically.

So, the next question is — how can you borrow — when no one wants your stuff? The real problem became trying to accurately value what all these toxic bonds were worth. That was difficult, because no one was willing to buy.

Here is another way of looking at it: what happens when there are no sales of homes on your street — for a year? Have home prices really dropped? Maybe. But the price of your home will drop like a rock the minute your neighbor sells for a lot less than you expect. Every home on the street just got marked down, right?

What happened at Bear Stearns can happen at Goldman Sachs, Lehman Brothers and lots of banks conducting the same business in bonds. And since all these firms consistently trade securities among each other all the time, they may sometimes feel compelled to extend an offer to buy some toxic bond. But they will offer prices so far below the current market no one would ever accept.

But then the offer is accepted! And the whole neighborhood gets “marked down.”

And that marks down the price of every other bond just like it. It is a negative downward spiral. Think of it as playing musical chairs on the Titanic. All the players in the game are muttering: “Pretty soon the music will stop, I hope I have a chair, but the end result is we are all in trouble.”

Now Go Talk About It!