The Bear Sterns Bailout

To start with little history, Bear Sterns is a financial giant with 80 + years of experience in financial world. This company withstood The Great Depression, the stagflation of the 70s, the dot-com burst but succumbed to the subprime mortgage crisis.

Now what is subprime mortgage crisis?

Subprime mortgage crisis is sudden increase in foreclosures by home owners.

Now, who are “these” home owners and what is foreclosure?

These home owners are people with not so good (less than generally accepted) credit rating and ended up taking home loans with higher interest rate. Subprime loans provide an opportunity for borrowers with less than "not so good" credit rating to access loans at higher interest rates.

With the real estate prices’ increasing continuously, the lure of hedging on homes is too good to resist. Even if the lure is not good enough to entice people to buy homes at high prices, the fear that “if not today, I may never be able to buy a home in this ever rising real estate market” could also be a significant reason.

Let’s look at an example:

A person XYZ takes a loan at higher interest rate (subprime rate) when the real estate prices are sky high with the hope of refinancing at a low interest rates. If XYZ does not have good credit rating, he/she is not entitled to loans at attractive interest rates. However, XYZ can improve his/her credit rating by paying EMIs on time for one year. The problem arises when XYZ cannot pay as planned. The credit rating worsens and the chances of refinancing at lower interest rates are minimal. To add to the problems, if the real estate prices collapse in the midst of all this, XYZ is in real soup now. XYZ took a loan at higher interest rate when the home is valued at a higher price. Now, the home is not valued at the rates for which it was paid for. That means, XYZ is paying more than the current value of the property and he/she is not financially sound enough to manage this. So, XYZ chooses to foreclose the property. When this happens on a bigger scale, boooom, crisis starts.

So, how did a company which was awarded “Most Admired” securities firm in Fortune’s "America's Most Admired Companies" survey get involved in all this? Bear Sterns invested heavily in hedge funds that lost almost all of its value because of subprime mortgage crisis. One thing led to the other and finally, the share which was valued at 87 USD during the last week of February 08 is offered 2 USD on 14/15^th of March 08 by JP Morgan Chase. The firm whose net income during the previous year was 2.1 billion USD (source: http://www.businessweek.com/bw50/2007/74.htm) was purchased 236.2 million USD. That’s how quick fortune changes.

However, If one looks at the bigger picture, I think this is all part of economical cycle. Not everybody would get rich all the time. Few get rich, few get richer and this might mean few getting poorer. It’s all in the game. Mankind has seen many financial collapses like this in the past for different reasons though; many of which we don’t even remember vividly (For those who forgot, remember, there was a much bigger financial collapse just few years back. Does ENRON sound familiar?). The collapse of ENRON had far reaching consequences than the collapse of Bear Sterns. A typical investor in Bear Sterns is much richer than a typical investor in ENRON. Also, it is not as difficult to find another job for employees of Bear Sterns as it was for employees (most of them not highly skilled) of ENRON.

My point here is: We should all look at the bigger picture and not panic when a blip takes place in the economy. An economy is not bound to grow unprecedented. It is bound to have recessions. We should not loose confidence and rather work towards a better tomorrow and a brighter future.