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The leveraged Bear | ||
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By DAVID MOON, Moon Capital
Management The bear is claiming his victims. And I'm not talking about a bear market for stocks. Believe it or not, the Dow Jones Industrial Average sits where it did less than a month ago. That's hardly a disaster.
But if
you're looking for disaster, look no farther than Bear Stearns. In the last
couple months, the 84-year-old investment firm has lost more than a billion
dollars of its clients' capital. Its stock has declined 28 percent in less than
two months. Company
On July 31, Bear Stearns froze the assets of one of its hedge funds that had lost a bundle in mortgage investments. The following day, two other Bear funds filed for bankruptcy.
The bear at Bear is a result of carnage in its mortgage investments.
The mortgage securities hedge funds were, for a time, incredibly profitable for both the firm and its clients. It wasn't unusual for these funds to rack up annual gains of 50 percent or more.
Ironically, Bear Stearns' co-president Warren Spector, once traded mortgage securities. Actually, Spector is the ex co-president. He lost his job on August 1.
How does a smart guy with a background in trading mortgage securities allow his firm's clients ' there is no record of Spector having money in any of the failed funds ' to lose more than a billion in mortgage securities? Even the worst default rates in the sub-prime mortgage market don't exceed 15 percent. How can you lose all of your money if only 15 percent of your investments go belly-up?
Leverage. As Archimedes said in 230 BC, with enough leverage and a place to stand, he could move the world.
The folks at Bear Stearns were using a huge lever. Then they lost their place to stand. And their world came crumbling down on them.
Here's how it works. Or, at least how it is supposed to work. And then how it doesn't work.
When you borrow money to buy a house, the rate on your mortgage might be 6 percent. If your loan is particularly risky (say you're borrowing a lot of money relative to your income), the bank might charge you a higher rate, perhaps 8.5 percent. That is a subprime loan.
The bank then takes a bunch of those subprime loans and sells them to someone like the Bear Stearns hedge funds.
But if the funds are buying a bunch of assets that pay only 8.5 percent, how were they making 50 percent a year?
With leverage. That is, by borrowing a bunch of money so they could buy more loans than each of the funds has the assets to purchase without the loans.
One of the Bear funds borrowed $10 for every dollar of investor funds. When borrowers started defaulting, it didn't take many bad loans for the fund to take a huge hit. Assume you borrow $4.5 billion to buy a total of $5 billion in mortgages. Your equity investment is only $500 million. If 15 percent of the loans go into default, that is $750 million worth of loans. While $750 million is only 15 percent of the total portfolio, it's more than 100 percent of your $500 million original investment.
Leverage is a two-edge sword. David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).
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