Lest anyone think that institutions are immune from the allure of greed, let me remind you that Bear Stearns was once a profitable investment bank.
In
his excellent book Stress Test[i]
former chairman of the Federal Reserve Bank of New York and former
Secretary of the Treasury, Tim Geithner, tells the story of the excesses and
eventual collapse of the investment bank Bear Stearns. Geithner writes, “Bear Stearns had to ratchet
up its reliance on tri-party repo in 2007 after creditors stopped rolling over
its commercial paper; now a sizable chunk of the collateral behind its repo
book was in illiquid assets, and it wasn’t clear how long its lenders would
accept them.”[ii] Let’s decipher the Fed-speak in that
statement.
Bear Stearns was heavily invested in
“two big hedge funds . . . including one called, incredibly, the Enhanced
Leverage Fund”[iii]
the hedge funds, in turn, were invested in “subprime investments.”[iv] The subprime investments, mostly residential
mortgages, were originated by other lenders, packaged into large clusters of
loans known as mortgage securities, and sold to investment banks like Bear
Stearns. The investment banks had to
borrow in order to finance the sale of the loan packages. The lenders to Bear Stearns (JPMorgan Chase
and Bank of New York Mellon, for example) asked for collateral which was
provided in the form of the loan packages.
This is what is known as “tri-party repo.”[v]
This put the investment bank in
the position of having to “ratchet up its reliance on tri-party repo.” Eventually, something had to give. And it did.
Eventually, JPMorgan Chase saw
the danger to its own institution if it did not come to the rescue of Bear
Stearns. With great pressure and a loan
from the New York Fed[vi],
JPMorgan Chase made an offer to purchase the stock and assume to liabilities of
Bear Stearns. “So, the offer was just $2
a share, or $236 million for a firm that had been valued at $20 billion the
previous year.”[vii]
[i] Timothy F. Geithner, Stress Test (New York: Crown Publishers, 2014).
[ii] Geithner, Stress
Test, 146.
[iii] Geithner, Stress
Test, 115.
[iv] Geithner, Stress
Test, 115.
[v] Geithner explains “tri-party repo” as “a
complex market . . . selling securities while agreeing to repurchase them at a
specified time, often as soon as the next day --- essentially, borrowing
overnight with the securities as collateral.” Geithner, Stress Test, 123. There are
three parties: the owner of the loan packages, the investment bank, and the
lender to the investment bank. When the
lender to the investment bank becomes concerned about its collateral, it has
the right under the loan documents to demand more collateral while threatening
not to roll over (renew) its short term (usually daily) commercial paper
(loan).
[vi] JPMorgan Chase was subject to regulation by
the Federal Reserve Bank but Bear Stearns was not; it was regulated by the
Securities Exchange Commission.
[vii] Geithner, Stress
Test, 155.