The demise of Bear Stearns

Bear Stearns has been absorbed by JP Morgan for just $2 per share – reportedly valuing the company at $236 million. It has been a dramatic collapse of a Wall Street Firm that was the darling of employees and stock markets. The employees seem to own nearly 30% of the company (though a significant chunk is likely to be owned by the top few executives) and it has been a terrible loss of personal wealth for them.

I feel sorry for Bear Stearns employees and investors. But I think such incidents tend to make the market healthier by weeding out excesses.

It is apt to be a little philosophical at times like these. Incidents like these reinforce our belief in the laws of Systems Thinking and Behavioral Economics

a) In my post of 30th March 2007, I had discussed how the ballooning asset bubble was threatening to push the financial markets off a cliff and the events that are unfolding now were not so hard to predict even a year earlier.
b) Students of Game Theory know about “Prisoner’s Dilemma”. To cut a long story short, it says that every individual acts in his own interest, thereby causing systemic failures. This failure ends up harming the individuals’ interest which they thought they could protect by acting in a “selfish” manner. Run on banks follows the same principle. When everyone is in a hurry to withdraw their assets from a bank (to protect their own savings, and in hurry to withdraw the asset before the neighbor next door does so), the bank collapses. It does not require erosion in the value of assets of the bank to trigger a crisis like this – it requires just erosion in confidence in the bank.
c) “The law of unintended consequences” is playing catch up: The last few moves of the Fed have had quite a few undesirable effects. Excessive rate cuts by the US Fed have always created asset bubbles – Nasdaq, Subprime, and now a short lived bubble in emerging market equities. Despite the rate cuts, the mortgage crisis is only gathering pace and the economy does not seem to stop sinking into a recession.

The US Fed is blamed by many for taking no action to prvent the crisis. It is interesting to read the comments of Alan Greenspan, the former Fed Chairman, as gathered by Paul Krugman, a columnist with the New York Times

What Greenspan said: “The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.
Home price stabilisation will restore much-needed clarity to the marketplace because losses will be realised rather than prospective. The major source of contagion will be removed. Financial institutions will then recapitalise or go out of business. Trust in the solvency of remaining counterparties will be gradually restored and issuance of loans and securities will slowly return to normal.”

What Keynes said: In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.