Bear Stearns and Leverage

I don't know much about institutional trading and was shocked to hear that both LCTM, intimately tied to Bear Stearns, and the initial two Bear Stearns' hedge funds in the subprime crisis that went down in flames had only 3% in actual assets. Is that really legal? Doesn't that seem like excessive risk?!? Why would investors invest in anything with that kind of leverage?

Bear Stearns sounds like the poster child for smart guys with absolutely no common sense! Why wouldn't you learn the first time around?

Below is the link and an excerpt:

http://www.nytimes.com/2008/09/07/business/07ltcm.html?_r=2&ref=business&oref=slogin&oref=slogin

"No firm had a closer view of Long-Term Capital than Bear Stearns, the broker that cleared its trades. And it was Bear that sounded the first shot in the current mortgage crisis. In summer 2007, amid a sharp rise in delinquencies on subprime mortgages, two hedge funds sponsored by Bear that invested in high-rated mortgage securities imploded. As foreclosures kept rising, other institutions suffered losses and the crisis spread.

Bear was warned to raise more capital by selling stock, but its senior executives, led by James E. Cayne, the chief executive, thought the company’s stock was cheap and refused. Mr. Cayne, who was an original investor in Long-Term Capital, should have remembered that the hedge fund’s most obvious flaw was its excessive borrowing, or leverage. Before its annus horribilis, Long-Term had intentionally reduced its equity to a mere 3 percent of assets. It was a fatal mistake.

This time around, Bear gambled that it could survive with a weak balance sheet — its equity-to-assets ratio was an identical 3 percent. By March, worries that Bear was overleveraged prompted a run on its stock and pushed it to the brink of bankruptcy. Again, Wall Street feared that a chaotic collapse could jeopardize the financial system, and the Fed orchestrated a rescue. "

 

Ironically enough, Bear was the only firm on Wall Street ( among 14 ) that did not wish to participate in the NY Federal Resserve's "bail-out" of LTCM back in the Summer of 1998.

Leverage is very common on Wall Street, especially as it applies to mortgage backed securities.

I believe that the two funds that were in the Asset Management division of Bear Stearns that went under last March/April were leveraged at 25:1 and 33:1, respectively.

Nothing new.

 

An interesting sidenote is the fact that Bear Stearns survived the Great Depression of the 1930s only to blow up in 2008. Ironic.

 

It'd be interesting to know the leverage back then...