Bear Stears deliberately broken via Goldman Sachs
July 2, 2008 — Stefan Fobes
March 31, 2008
Robby Boyd/Fortune
You could detect a trace of fear in his voice. Mostly he seemed stunned. It was March 6, and one of Bear Stearns’s top bond executives had dialed me up unprompted. The executive had dished about competitors in the past, but he had never initiated a discussion, much less one about his own firm. Now he explained that financial institutions that he dealt with - firms he had traded with for years - were suddenly asking him whether Bear had the cash to execute their trades.
Such news had yet to surface in the press, but the investment bank’s shares had dropped nearly 20% in the previous ten days, and there were murmurs that short-sellers were circling. The executive asked whether I’d heard rumors of trouble, and he tried to preempt them. “We’re making money,” he said. “Our counterparties are getting paid, trades are clearing, business is picking up. It doesn’t seem to be the likely scenario for an investment bank’s collapse.”
Ten days later Bear Stearns (BSC, Fortune 500) was swallowed by J.P. Morgan Chase (JPM, Fortune 500). But all the brouhaha over the deal - were the shares worth $2 or $10? should the Federal Reserve have intervened? - has obscured how astonishing Bear’s collapse is. It’s a reminder that in a business based on confidence, when that confidence evaporates, so does the business. A reconstruction of the week before Bear Stearns agreed to be funded, and then acquired, by J.P. Morgan Chase, reveals the speed at which Bear’s longtime customers and counterparties lost their faith in the investment bank and undermined its ability to continue.
It also reveals a psychological gap. Bear had survived one liquidity challenge, in the summer of 2007, when two of its hedge funds cratered after the subprime mortgage collapse. The firm had labored to repair its balance sheet and improve its financing. “Our capital position is strong,” said Bear’s CFO, Sam Molinaro, at an investors’ conference in February. “Balance-sheet liquidity has continued to improve throughout the course of the year. We spent an awful lot of time trying to reduce our higher-risk asset categories.”
However much Bear Stearns saw itself as strengthened by its struggles, customers thought otherwise, and that hastened Bear’s fall. Molinaro’s comments notwithstanding, some had begun inching away months earlier. Bob Sloan, whose S3 Partners finances and advises hedge funds, says he counseled clients last summer to seek other prime brokers because he saw a “30% to 35% chance” that Bear would collapse. By March, Sloan’s clients had pulled out $25 billion in assets. Others, of course, would desert only when the panic hit. And a few days would be all it took to show just how shallow the reservoir of trust for the firm was.
If there’s one thing that companies hate to do, it’s comment on rumors. Such statements, the thinking goes, only confer legitimacy on unfounded gossip. But there it was in a Bear press release on March 10: “There is absolutely no truth to the rumors of liquidity problems that circulated today in the market.” At that moment, it appeared to be true. The firm had some $17 billion in cash. Of course, Bear was noted for its addiction to leverage even at a time when Wall Street, which runs on debt, was drunk on the stuff. Bear had $11.1 billion in tangible equity capital supporting $395 billion in assets, a leverage ratio of more than 35 to one. And its assets were less liquid than those of many of its competitors.
But by March 10, the problem had metastasized into something more dire than a rumor. Late the preceding Friday, a major bank - accounts differ on which - had rebuffed Bear’s request for a short-term $2 billion loan. Such securities-backed repurchase (or “repo”) loans are crucial for investment banks, which borrow and lend billions to fund their daily business. Being denied such a loan is the Wall Street equivalent of having your buddy refuse to front you $5 the day before payday. Bear executives scrambled and raised the money elsewhere. But the sign was unmistakable: Credit was drying up.
Confidence continued to ebb, and Bear again tried to reassure investors. “Why is this happening?” CFO Molinaro asked rhetorically on CNBC. “If I knew why it was happening, I would do something to address it.” The rumors were “false,” he said. “There is no liquidity crisis. No margin calls. It’s nonsense.”
Still, momentum was turning against the firm. That morning Goldman Sachs’s credit derivatives group sent its hedge fund clients an e-mail announcing another blow. In previous weeks, banks such as Goldman had done a brisk business (for a handsome fee, of course) agreeing to stand in for institutions nervous, say, that Bear wouldn’t be able to cough up its obligations on an interest rate swap. But on March 11, Goldman told clients it would no longer step in for them on Bear derivatives deals. (A Goldman spokesman asserts that the e-mail was not a categorical refusal.)
“I was astounded when I got the [Goldman] e-mail,” says Kyle Bass of Hayman Capital. He had a colleague call Goldman to see if it was a mistake. “It wasn’t,” says Bass, who is a former Bear salesman. “Goldman told Wall Street that they were done with Bear, that there was [effectively] too much risk. That was the end for them.”
It was ominous, but it wasn’t yet the end. Bear continued absorbing blows. The cost of insuring $10 million in Bear debt via credit default swaps, which had hovered near $350,000 in the month before, shot past $1 million. By the end of March 11, the rate was irrelevant: Banks refused to issue any further credit protection on Bear’s debt.
When word of the Goldman e-mail leaked out, the floodgates opened. Hedge funds and other clients, eventually running into the hundreds, began yanking their funds.
Dave Hendler, an analyst at research boutique CreditSights, called a Bear contact to find out what was going on. The contact said that all was fine. But then Hendler asked about a $4 billion credit facility due to expire in April. If Bear needed cash, Hendler reckoned, that was probably more than enough. Hendler says he was told that the facility had actually expired in February and several banks had backed out, reducing the credit line to $2.8 billion. Bear, he was told, was waiting until the release of its quarterly earnings to reveal the status of the loan. Neither Bear’s liquidity nor its lenders’ confidence, it appeared, was what it had seemed. (A firm spokesman declined to comment.)
Bear continued to maintain publicly that all was well. This time it was CEO Alan Schwartz - who hadn’t seen the need to return to headquarters, and conducted the interview from Palm Beach - who went on CNBC. “We’re not being made aware of anybody who is not taking our credit as a counterparty,” he said, adding, “We don’t see any pressure on our liquidity, let alone a liquidity crisis.”
By March 13, the gravity of the situation had finally registered at Bear. Schwartz returned to New York and convened a meeting of the top leadership. Liquidity was plummeting; according to published reports, it had fallen to $2 billion at week’s end. Desperate, Schwartz contacted J.P. Morgan CEO Jamie Dimon that evening.
Even as the firm frantically negotiated a rescue package, Bear executives continued to try to convince the world that everything was under control. That evening Schwartz contacted a well-known New York hedge fund manager (a longtime Bear prime brokerage client). He pleaded with the manager to appear on CNBC the next morning and express his confidence in Bear. The hedge fund manager declined politely but wondered why Bear needed a client to convince the world of its health. He wouldn’t wonder long.
AT 9 A.M., Bear announced $30 billion in funding provided by J.P. Morgan and backstopped by the government. In a conference call Schwartz sounded as if he was still fighting reality. “Bear Stearns has been subject to a significant amount of rumor,” he explained. “We attempted to try to provide some facts to the situation, but … the rumors intensified.” He said customer requests to cash out “accelerated yesterday … [and] at the pace things were going, there could be continued liquidity demands that would outstrip our liquidity resources.” The new loan facility, he said, would restore calm.
Of course, that didn’t pan out. Bear’s stock dropped nearly 40% in the first half-hour of trading. Within days, Bear’s 85 years as an independent entity were at an end.
At Maggie’s bar that Friday evening, directly across from Bear headquarters on 47th Street, the sense of shock was complete. A crowd of frazzled Bear employees thronged the bar. Some traders, clearly well past their first round at 6 P.M., expressed amazement at having to navigate camera crews to cross the street to the bar.
Soon after, I happened to sit next to a Bear Stearns managing director on the 6:35 express from Grand Central Station to Greenwich, Conn. “I worked eight years at a firm that promoted me from the back office to investment banking,” he told me as he sipped a Budweiser tall boy. “I had thousands of shares and thought I could afford to send my kids to private schools and college. It’s all gone now. I think I’ll probably move to Pittsburgh, see if the Federal Home Loan Bank needs anybody.”
REPORTER ASSOCIATE Doris Burke contributed to this article. 
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