Monthly Archives: March 2008

Bear Stearns, the fifth largest investment bank on Wall Street, has fallen.  The end was exacerbated by Bears’ exposure to the subprime markets and the ongoing credit crisis. 

Just days before the Fed and JP Morgan stepped in to rescue Bear, most on Wall Street would have said that it was unthinkable that a major investment firm would fall.  In fact, even as rumors of Bears’ liquidity problems surfaced, no one was speaking of total collapse.  However, within days of the rumors, the Fed and the Treasury Department were working to put a deal together to bail out Bear Stearns.  

On a long Sunday, government officials met with officers and directors of Bear and JP Morgan in an attempt to broker a deal that would prevent the bankruptcy of a major Wall Street player.  At the end of the day, a deal had been reached.  JP Morgan would buy Bear Stearns for $2 a share. 

In the aftermath of the announcement, Bear shareholders were crying foul.  Bear was, afterall, trading for over $150 a share a year ago.  As a result of shareholder discontent, JP Morgan has recently raised its offer to $10.02 a share-still a far cry from what Bear was trading at just two weeks ago.

The question for many investors is ‘how could this happen?’  How could such a prominent Wall Street firm simply fail?  The answer is partly due to the complexities of the products that Bear (and other investment banks) create to sell to investors.

As babyboomers retire and the amounts of investable monies grow, Wall Street is looking for new ways to generate profits (for both themselves and clients).  As a result, investment firms are constantly creating products that supplement the usual stocks, bonds and mutual funds.  One of those newly created investments, collaterized debt obligations (CDOs), is generating quite an impact on the markets today.   

CDOs are investment products that pool mortages and other debt together and are sold to investors.  Much has been written about how mortgages, often of the subprime variety, were packaged by investment banks and sold.  As the housing market burst, many homeowners were left unable to meet their mortgage payments.  The result has been an increase in defaults and therefore a decline in the value of the investments.

It seems to many that a perfect storm came together and that Bear Stearns was a victim of the unforseeable.  However, the problems in the current market were created by Wall Street.  Bear Stearns, and others like them, are not victims of the credit crunch.  They  are responsible for it.  The real victims are the investors who were sold products that were unsuitable, whose risks were not properly disclosed and who have lost millions as a result.

Although the collapse of Bear Stearns is a historic event, the collapse of many investors’ portfolios is the true tragedy.  The government has stepped in to help the investment banks, who is going to help the real victims?             

Jefferson County Alabama, home to Birmingham and 660,000 residents, is facing some tough choices.  The county needs to raise more money or start cutting public goods and services.  If a solution is not found soon, Jefferson County may face default on their derivative contracts and possibly bankruptcy.  

According to Craig Karmin and Liz Rappaport of the Wall Street Journal, Jefferson engaged in $5.4 billion worth of certain derivative contracts, known as interest-rate swaps, in an effort to lower its borrowing costs.  The biggest piece of this borrowing was $3.2 billion to update the county’s water and sewage system. 

Jefferson finds itself in this difficult position as a result of several factors.  The ongoing credit crisis has caused downgrades to the county’s bond insurers, Financial Guaranty Co. and XL Capital Assurance Inc., and the recent auction-rate securities failures have prompted credit firms to lower the county’s debt rating from investment-grade to junk.   

On February 27, 2008, Moody’s lowered Jefferson County’s rating three levels from A3 to Baa3, the lowest investment grade.  

Bank of America, Bear Stearns Cos., J.P. Morgan Chase and Lehman Brothers, concerned over the county’s ability to meet its obligations, are now calling for Jefferson to put up more collateral for the swaps.  To date, Jefferson has failed to do so. 

The Wall Street Journal has reported that county officials are negotiating with creditors and maintaining that they can avoid bankruptcy.  James H. White III, president of Porter, White & Co., the county’s financial advisor, has stated that “[w]e don’t have any present intention to seek relief in bankruptcy court.”      

Like Jefferson County, many cities, towns, universities and other public institutions have taken on debt through the tax-exempt municipal bond market.  These debt markets are suffering from the fallout in the subprime mortgage crisis.  As a result, Jefferson County may not be alone in the struggle. It is expected that other municipalities may also see their swap agreements lose value.  Both Houston and Durham County, North Carolina have used interest-rate swaps to fund local projects.

Gretchen Morgenson penned an insightful piece in the March 9, 2008 Sunday Business section of the New York Times.  Ms. Morgenson likened auction-rate securities to the Hotel California, where investors have checked-in, but they can never leave.

Auction-rate securities are debt instruments whose interest rates reset at regular intervals, often weekly, and usually have long maturities.  The auctions for these notes are overseen by the very Wall Street firms that originally sold them.   

Historically these notes freely traded at the auctions.  As a result, Wall Street sold these products to investors as an alternative to cash.  However, when the $330 billion market for these products halted in February 2008, investors were left holding these notes with no market available.  This freeze has left investors with no immediate way to liquidate their positions.

To date, the auction-rate securities have not defaulted.  Investors are receiving a fixed interest rate as detailed in the note’s offering documents.  But clearly the failing auctions are creating concerns among investors as to when, if ever, they can access their money.  Many feel that it is only a matter of time before we see the first defaults.

What is clear at this time is that these products were misrepresented by Wall Street.  They were sold as cash alternatives.  Considering investors are not free to liquidate at their pleasure, these investments are not cash alternatives.  As Ms. Morgenson suggests in her article, investors are in for a shock when they see their month-end statements reflecting major declines in the value of their auction-rate securities.