Tuesday, March 18, 2008

Bear Sterns Bail Out


To start with little history, Bear Sterns is a financial giant with 80 + years of experience in financial world. This company withstood The Great Depression, the stagflation of the 70s, the dot-com burst but succumbed to the subprime mortgage crisis.

Now what is subprime mortgage crisis?

Subprime mortgage crisis is sudden increase in foreclosures by home owners.

Now, who are “these” home owners and what is foreclosure?

These home owners are people with not so good (less than generally accepted) credit rating and ended up taking home loans with higher interest rate. Subprime loans provide an opportunity for borrowers with less than "not so good" credit rating to access loans at higher interest rates.

With the real estate prices’ increasing continuously, the lure of hedging on homes is too good to resist. Even if the lure is not good enough to entice people to buy homes at high prices, the fear that “if not today, I may never be able to buy a home in this ever rising real estate market” could also be a significant reason.

Let’s look at an example:

A person XYZ takes a loan at higher interest rate (subprime rate) when the real estate prices are sky high with the hope of refinancing at a low interest rates. If XYZ does not have good credit rating, he/she is not entitled to loans at attractive interest rates. However, XYZ can improve his/her credit rating by paying EMIs on time for one year. The problem arises when XYZ cannot pay as planned. The credit rating worsens and the chances of refinancing at lower interest rates are minimal. To add to the problems, if the real estate prices collapse in the midst of all this, XYZ is in real soup now. XYZ took a loan at higher interest rate when the home is valued at a higher price. Now, the home is not valued at the rates for which it was paid for. That means, XYZ is paying more than the current value of the property and he/she is not financially sound enough to manage this. So, XYZ chooses to foreclose the property. When this happens on a bigger scale, boooom, crisis starts.

So, how did a company which was awarded “Most Admired” securities firm in Fortune’s "America's Most Admired Companies" survey get involved in all this? Bear Sterns invested heavily in hedge funds that lost almost all of its value because of subprime mortgage crisis. One thing led to the other and finally, the share which was valued at 87 USD during the last week of February 08 is offered 2 USD on 14/15th of March 08 by JP Morgan Chase. The firm whose net income during the previous year was 2.1 billion USD (source: http://www.businessweek.com/bw50/2007/74.htm) was purchased 236.2 million USD. That’s how quick fortune changes. One of my colleagues was talking about an English guy who holds 10% in Bear Sterns. Man, that guy would have wept his heart out after all this. I even came to know that few employees of Bear Sterns who hold stock options could not control their emotions during all this mess. After all, we are all human.

However, If one looks at the bigger picture, I think this is all part of economical cycle. Not everybody would get rich all the time. Few get rich, few get richer and this might mean few getting poorer. It’s all in the game. Mankind has seen many financial collapses like this in the past for different reasons though; many of which we don’t even remember vividly (For those who forgot, remember, there was a much bigger financial collapse just few years back. Does ENRON sound familiar?). The collapse of ENRON had far reaching consequences than the collapse of Bear Sterns. A typical investor in Bear Sterns is much richer than a typical investor in ENRON. Also, it is not as difficult to find another job for employees of Bear Sterns as it was for employees (most of them not highly skilled) of ENRON.

My point here is: We should all look at the bigger picture and not panic when a blip takes place in the economy. An economy is not bound to grow unprecedented. It is bound to have recessions. We should not loose confidence and rather work towards a better tomorrow and a brighter future.



DISCLAIMER: The contents of this blog are strictly my personal opinions and not those of any organization/institution I am a part of, nor made in any official capacity of such organization/institution unless expressly stated otherwise and where I am explicitly authorized to do so.

7 comments:

Vijay Bhaskar Chowdary --> VBC said...

Wow !! Fed cuts rate by 75 bps. It is going to make homes more affordable.

However, what about inflation which is already affected by high gas prices and weak dollar?

Anonymous said...

cool post anna...
most of it was informative...
but i jus loved the disclaimer.that was the best i guess!!! ;-)
cheers...

Vijay Bhaskar Chowdary --> VBC said...

Thanks Sitaram for you comments :)

Anonymous said...

Here are my inputs

For a person who has good credit rating, the banks charge the lowest interest possible - as they think the risk associated with defaulting (this is default risk) is very low and so the other party should be benefited

Now people might already be having a loan and they might not be actually eligible for a loan - or just manage to be eligible for a loan. in such cases, bank charge an interest rate that is higher than the one in the first case - so they would make the delta profit on this.

The banks analyze thru their risk systems and come to a conclusion how much of their customers can be in this range - and their default risk percentage.

There is another third category of customers - who have a pretty bad credit rating - and under usual circumstances cannot be guaranteed a loan - banks play into the hands of these customers by offering a loan (this is what the customer wants) @ a interest percentage that is higher (very much more) than the usual.

Now they have all these loans accumulated in their books - and they are carrying the risk of default or late payments - which they want to avoid. So, the banks create structure products out of these loans and sell it to investment banks.

IBs got interested based on the assumption that the rising real estate market would not go down in near future and they would benefit. The real estate market started going down - coz of raising inflation & oil prices -and this whole thing spread like a fire.

Vijay Bhaskar Chowdary --> VBC said...

Thanks for your inputs harikiran. Your comments would help readers understand the topic better.

Appreciate it.

Raju said...

Very informative post. Good explanation with example. Disclaimer is funny ;). Looking forward to see more posts.

Vijay Bhaskar Chowdary --> VBC said...

@Raju

Thanks for your comments.