Dan Gross on Bear Stearns's Hedge Fund Bailout

Bear Stearns has always been the pesky, streetwise, kid brother in the Wall Street family—smaller, younger (it was founded in 1923), and less polished. Bear lacks Goldman Sachs' tradition of public-minded financiers, the brand name of Merrill Lynch, the proud WASP lineage of Morgan Stanley, or the overwhelming size of Citigroup and Chase. Bear Stearns' market capitalization is a measly $21 billion, less than one-tenth that of Citigroup. CEO Jimmy Cayne isn't a Harvard MBA; he's a former scrap-iron salesman who didn't complete his studies at Purdue. Bear Stearns confirmed its outsider status in 1998 by refusing to participate in the Wall Street-orchestrated bailout of faltering hedge fund Long Term Capital Management.

But now Bear Stearns has finally joined the club. Last month, facing a crisis at two large hedge funds run by its asset management unit, Bear Stearns agreed to bail out one of the funds (and its many creditors) by providing a $1.6 billion line of credit. The move, intended to spare Bear Stearns embarrassment and protect the reputation of its asset management business, also had a take-one-for-the-team result. It insulated fellow Wall Street firms from losses and prevented widespread damage to similar hedge funds.

The details of the Bear Stearns rescue may fascinate only those who devour the Money & Investing section of the Wall Street Journal. But because it reinforces the notion that the big boys get pampered when their investments go bad, the bailout should resonate.

The two Bear Stearns hedge funds ran into trouble by borrowing heavily to invest in CDOs (collateralized debt obligations), investment vehicles that hold bits and pieces of subprime mortgages. (Wall Street's Jungle-esque food-processing machinery chops and dices mortgages like clams, into strips, bellies, and other parts, and peddles them to investors with different appetites for risk.) This year, the value of many of the assets in CDOs has fallen as delinquency rates on subprime mortgages have risen to record levels. According to the Mortgage Bankers Association, in the first quarter of 2007, 5.1 percent of subprime loans were in foreclosure and a whopping 15.75 percent were delinquent.

The falling prices of the securities backed by such loans spelled trouble for the Bear Stearns hedge funds, and for gigantic Wall Street firms like Merrill Lynch, which had extended billions of dollars in credit to them. Falling returns could push investors to ask for their money back, which could force the funds to liquidate. To protect themselves, lenders could effectively foreclose on the fund—grab the assets posted as collateral and sell them. In June, Merrill Lynch seized some $850 million in assets from the Bear Stearns funds. Not surprisingly, Merrill had a hard time getting a good price for them. After all, these were distressed assets in a distressed market. Had other firms followed Merrill's lead and dumped billions of dollars of securities onto the market, it would have thrown the whole subprime mortgage-backed securities market into chaos. By selling them at fire-sale prices, the firms would have forced all the other hedge funds run by their colleagues, friends, and customers, which held similar assets, to mark down the value of their subprime CDO assets.

By stepping in, Bear Stearns averted a swift collapse for the subprime CDO market. But it seemed out of step with Wall Street's prevailing sink-or-swim ethos. Last year, the $9 billion hedge fund Amaranth, caught out by a trader's reckless natural gas trade, was allowed to sink like the Titanic. We are constantly told that hedge funds, private equity firms, and the giant Wall Street firms that back them are dynamic creatures whose intolerance for poor performance leads them to seek and destroy economic inefficiency. Failures, even large-scale failures like Amaranth, are a necessary and natural part of the system. But in the case of the Bear Stearns funds, Wall Street firms seemed positively European in their aversion to creative destruction. They clamored to be bailed out from their reckless extension of credit to a subprime hedge fund. Bear Stearns obliged.

And yet the financial services firms that made many of these soured loans in the first place are not nearly so kind to their down-market customers. Many of the unfortunate homeowners losing their houses to foreclosure are, directly or indirectly, customers of firms like Merrill Lynch and Morgan Stanley, both of which recently acquired subprime lending companies. Foreclosing on subprime borrowers has the same ruinous impact on homeowners as it has on subprime hedge-fund managers. When foreclosures are concentrated in a particular area, it hurts the whole neighborhood. In a fantastic Wall Street Journal article (subscription required) about the impact of subprime lending on a single block in a lower-middle-class section of Detroit, a real estate broker noted that banks would have a tough time selling homes on which they had just foreclosed. "Nobody's going to want to buy into a neighborhood with 20 percent foreclosures," he said. "You end up with no neighborhood."

Note the similarities—and the differences—between the neighborhoods in which subprime borrowers live and the financial neighborhood in which subprime lenders operate. Wall Street executives didn't foreclose on the Bear Stearns hedge fund, which borrowed imprudently, because (1) the fund had a rich parent to bail it out, and (2) doing so would have imposed financial hardships on themselves, on their friends, customers, and neighbors. The residents of neighborhoods targeted by subprime lenders typically receive no such consideration. When you owe the bank $10,000, it's your problem. When you owe the bank $10 billion, it's the bank's problem.

Wall Street these days seems to be willfully obtuse when it comes to the appearance of its business practices, whether it's the differential attitudes toward foreclosure, obscene pay packages for CEOs, or the special tax break for private-equity managers. (See under: Schwarzman, Steve.) The rapid expansion of subprime lending has tethered the fortunes of higher-income Wall Street to the fortunes of lower-income Main Street. As Main Street has foundered, financial companies have generally responded by severing the lines and leaving struggling borrowers to their fate. They might be well-advised to throw some life preservers.

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