Diary of a Very Bad Year Chapter 2 - Bear Stearns Goes Down

This is part of my series retelling Diary of a Very Bad Year. Today we’re covering Chapter II.

Six months have passed since the first interview. It’s March 26, 2008. The Dow is at 12,422. Unemployment is 5.1%. And Bear Stearns just got bought for pocket change.

The interviewer walks into HFM’s hedge fund office for the first time. Flat screens everywhere, people staring at numbers, and no TVs. HFM got rid of the TVs because he spent his day making up dialogue for Maria Bartiromo on CNBC and inventing new scripts for a foot fungus commercial that kept playing. So the TVs went.

But this is not a fun visit. Things have gotten bad.

The Problem Got Bigger Than Expected

When HFM talked to n+1 the first time, he said things would be fine. Now he admits he was partly managing the message. He didn’t want a literary magazine to start a bank run.

But here’s the thing. He was also genuinely wrong about one thing. He thought banks had sold most of the subprime risk to European and Asian buyers. Turns out, a lot more risk stayed on the banks’ own books than anyone expected.

Merrill Lynch wrote down over $8 billion. UBS lost $11.3 billion in one quarter. Citibank had a ton of this stuff sitting right there on their balance sheet.

And the rot was spreading. First subprime. Then Alt-A mortgages. Then prime mortgages. Then companies that depended on consumer spending. When your risk models assume different asset classes won’t all tank at the same time, and then they all tank at the same time, you’ve got a real problem.

How Bear Stearns Actually Died

Bear Stearns was an investment bank with a specialty in asset-backed securities. They ran hedge funds that were leveraged 50 to 1 in subprime assets. Those funds blew up in the summer of 2007. Gone overnight.

Now, that was other people’s money, not Bear’s own capital. But from that point on, everyone wondered: if they did this with other people’s money, what’s on their own books?

Bear was leveraged about 30 to 1 on their own balance sheet. For comparison, regular banks operated at about 10 to 1. At 30 to 1, even a small drop in asset values means your equity is gone.

And here’s the impossible part. Bear couldn’t prove they were fine. They had thousands of asset-backed bonds, each backed by thousands of mortgages, and nobody could price them. There was no market. You can’t open your books and convince everyone in a weekend that everything adds up. It’s an information problem. There’s just too much stuff and nobody knows what any of it is worth.

So confidence evaporated. Customers started moving money out. And once that starts, each withdrawal makes the next person more likely to withdraw. Classic bank run mechanics.

HFM describes watching it happen from his trading floor. Bear’s stock lost 60% of its value in a couple hours. The phone stopped ringing. Bloomberg messages stopped. Everyone in finance was just watching their screens, stunned. No news, no announcement. Just the stock falling off a cliff.

On Thursday, Bear said everything was fine. On Friday, the withdrawals were so massive they had to call the Fed for help. By the weekend, JPMorgan was buying them for $2 a share. A stock that traded at $170 not long before.

Why $2 a Share?

HFM and his team had a theory. The Treasury Department went to Bear’s top executives and basically said: make this deal happen by Monday, or we’ll find a reason to put you in jail. Post-Enron, post-Sarbanes-Oxley, every officer of a public company is terrified of prosecution. As HFM puts it, quoting Beria: “You show me the man, I’ll find the crime.”

So it wasn’t just risking $2 per share by saying no. It was $2 plus serious legal consequences.

JPMorgan later raised the offer to $10. Still a disaster for shareholders who bought at $170.

But from the government’s perspective, the goal was to protect the financial system without creating moral hazard. They needed to show everyone that if your bank blows up, the system gets saved but you personally get destroyed. As HFM says: “From time to time you have to kill a management team to encourage the others.”

The Argentina Flashback

HFM was in Argentina during their bank run in 2000. He was in a bank building having meetings all day. Everything was normal. Then he came down the elevator late afternoon, and there was a line of people out the door.

He couldn’t tell you why it happened that day. Argentina had been in economic trouble for a year. But that day, the run started. The government froze deposits. People stood outside banks banging on pots and pans. The government fell.

Bank runs are unpredictable. Bear Stearns had eight months of suspicion hanging over it. Then in 48 hours, it was over.

Zombie Banks and Why Losses Need to Happen Fast

This is where HFM gets into the Japan comparison and the concept of zombie banks.

After Japan’s crash in the early nineties, banks refused to recognize their losses. A bank would have a loan to a clearly insolvent company but wouldn’t restructure it because that meant admitting the loss. So these banks and companies just existed in limbo. Undead. They couldn’t lend, couldn’t grow, couldn’t do anything useful. Japan’s economy stagnated for a decade.

HFM makes a key point here. When someone builds a 6,000-square-foot house in Florida where it should never have been built, the loss already happened. The tree is cut down, the cement is poured, the resources are wasted. What matters now is how you allocate that loss.

You can do it fast and fair: shareholders eat the losses, banks recapitalize, everyone moves on. Or you can do the Japan thing and pretend the losses aren’t there. Then you get zombie banks that can’t lend and an economy that can’t recover.

He had just visited family in Florida and saw it firsthand. A development of 2,500 homes where the first phase sold out fast. Then investors bought units in the last phase to flip them. And now? It looked like a movie set. Like a neutron bomb went off. Nobody there.

Keeping Calm on the Trading Floor

The interviewer asks if HFM is worried. His fund is conservative, low leverage, lots of liquidity. They planned for bad times. The tradeoff is that in good years they never return 80% or 100%, but they also don’t blow up.

What does worry him is the hedge fund industry. Too many blowups. Too much correlation between funds that were supposed to be uncorrelated. Investors paying 2% fees plus 20% of profits for returns that are just as risky as everything else.

But the big picture? HFM says America is not finished. The fact that losses are being recognized, that Bear got taken out and shot in front of everyone, that’s the healthy path. The system is dealing with the problem instead of hiding it.

He looks out the window at a guy in a white shirt on another floor, seemingly putting in his office. “That guy’s done. Everyone else is okay.”

Previous: Chapter I - Primetime for Subprime

Next up: Chapter III - On the Eve