Friday, 14 March 2008

Bear Stearns - the balance sheet tells the story

(click on image for a larger version, all numbers are billions of dollars, expect the leverage ratio)

Take a look at Bear Stearns most recent balance sheet. The bank was running out of capital. Take a look at the "leverage ratio", which is simply total assets divided by shareholders equity. Between 2005 and 2007, this ratio increases from 27.1 to 33.5. This ratio tells us how much assets one dollar of capital generates.

The sudden increase in assets and liabilities between 2006 and 2007 must be due to the Bear Stearn's decision to take onto its books the two hedge funds that collapsed last summer. So it was the off balance sheet sub prime activities that brought the bank down. There is a hard lesson there for all investment banks as well as financial regulators - off balance sheet activities matter.

This week has seen two major financial failures. The first was Carlyle capital; the second was Bear Stearns. Ironically, Carlyle capital had a lower leverage ratio than Bear Stearns. So the subprime crisis started out with Bear Sterns bailing out two hedge funds, and ended up turning Bear Stearns into something that looked like a hedge fund.

6 comments:

Roy said...

Great piece of work Alice - a simple but devastating point. I haven't seen anyone else point this out.

Anonymous said...

Looking at it through the eyes of the ukhousingbubble the U.S seems like a giant that is crashing down in slow motion. Not everyone is aware of it yet but once it hits the ground the consequences will send shockwaves throughout the world.

Chefdave

traderboy said...

all banks are leveraged by their nature so I don't think it's as simple as just pointing the leverage out and blaming that for their demise.

the strange thing with Bear Stearns (note correct spelling for next article pls!) is that I still don't understand why they brought those 2 hedge funds onto their balance sheet. Just because they were sponsored by the bank surely didn't mean they were exposed, other than a capital injection to start them off perhaps. if they blew up the bank cos the took the assets back unnecessarily, then they deserve to go out business.

agree with Chefdave...the US is just a disaster unfolding, yet it seems very slow transmitting that shock to the rest of the world. my take at the moment is it is still more a US problem than anywhere else, due to firstly non-recourse lending on property (so you can walk away without many consequences) and secondly way more "creative" financing options for those properties, essentially making them unaffordable after a couple of years after rates reset.

Whereas the UK may have some crazy house prices but lending doesn't seem to have been so poor, and also to escape a bad mortgage you have to basically declare bankruptcy i believe.

Economic Despair said...

Trader,

Of course, all banks are leveraged, but the surprising thing with Bear Stearns is deteriorating leverage. Why does it deteriorate? Because their assets increased (obviously, along with the liabilities). So you are asking the right question, why did they take these POS onto their books,

Ged

Alice Cook said...

Traderboy,

Thanks for the comments and for pointing out the spelling mistakes. I am a terrible spelling and it is weakness I am trying to correct.

I think the external shock is being transmitted. The trade shock is about to hit; although the US current account remains large, high oil prices and the declining dollar is keeping it high. That, in turn, is part of the hole Bernanke is now in, low dollar, low rates, higher inflation, while at the same time facing a financial crisis.

The financial shock is spreading around the world as expected.

Finally, the declining dollar is pushing prices up all over the world.

Give it six months, then we will really see the full magnitude of this mess.

Alice

Anonymous said...

Bravo Alice Cook

Martin in the U.S.