By DAVID MOON, Moon Capital
August 12, 2007
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
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 conference calls
discussing corporate results typically attract a few dozen analysts. A recent
Bear Stearns call attracted more than 2,200 listeners.
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
The bear at
Bear is a result of carnage in its mortgage investments.
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.
Bear Stearns' co-president Warren Spector, once traded mortgage securities.
Actually, Spector is the ex co-president. He lost his job on August
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
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.
it works. Or, at least how it is supposed to work. And then how it doesn't
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.
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?
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.
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).