Learning from History

Time flies when you're having fun. That saying seems to capture the feeling of the past ten years following the market turmoil of 2008. With a few bumps along the way, since the market lows of early 2009, the stock market has been on a tear.

Now that we're in March and the anniversaries of important Great Recession events approach, it's interesting to sift through market research and news stories from back then. Some of the analysis stands out as oddly prescient, while some of the events are still gut-wrenching to read about even today.

One such event was the fall of the now infamous investment bank Bear Stearns. It was this week, ten years ago, that the firm found itself without a chair when the subprime mortgage music stopped.

In early 2007, just a year before its ultimate collapse, Bear Stearns had been riding high on manufacturing and selling fancy bonds and derivatives based on subprime mortgages and other debt. Leverage was high, and nobody seemed to worry much about it. So long as everyone and everything involved continued to hum along, no amount of leverage seemed too great. Analysts touted the firm's earnings record and continually raised price targets for the company's stock to over $180 per share.

But a few short months later analysts started changing their tune. Troubles were percolating in the housing market and Bear Stearns began losing money after decades of profitability. That summer two of Bear's subprime mortgage-based hedge funds failed, costing billions. Keeping investors and depositors confident was huge for the firm. But confidence quickly eroded and that's when the wheels started coming off. The firm's share price started dropping, declining by more than half into the new year.

By the beginning of March 2008, analysts had reduced their price target for the stock to about $110 and the stock was trading at less than $70. Looking back now it's easy to see the straight line to the bottom for Bear Stearns. But back then the firm's decline was confused by mixed reports in the media about the firm's health and even, in hindsight, blatantly false statements from the firm's CEO on CNBC about Bear having plenty of money to continue operating.

The CEO's statement was a kiss of death for the firm, however. Within a few days it turned out there wasn't enough money, that the firm would have to seek an emergency loan from the Fed, and that the huge amounts of leverage that enabled excess growth for so long would be the firm's downfall. The stock immediately plummeted to about $30 per share. Within a couple more days the Wall Street stalwart was sold off to JPMorgan for $2 per share, although the price would move a bit higher during later negotiations.

From soothing CEO statements to firm liquidation took only about five days but, again in hindsight, the writing had been on the wall for over a year. As with the fall of Lehman Brothers a mere six months later, the reality of overleverage often comes crashing down quickly.

What are some takeaways from this event, ten years' on?

• All things in moderation – Too much leverage isn't good for the long-term, whether it's for companies or households. And debt has a way of creeping up on you, limiting options during times of crisis.
• Don't believe the hype – Bear Stearns CEO's creativity with the truth ended up being repeated by other CEOs during the Financial Crisis. If a CEO must personally reassure the markets that their company is fine, that's a problem. Stock analysts can fall prey to this too, and their analysis can be skewed positive. As much as possible, try to make your own decisions about the health of your investments.
• Diversification is critical for long-term investing success – Diversification is like life insurance; you can't get it after you need it. Many investors lost their shirt on Bear's decline (and Lehman Brothers after that) due to owning stock in the firm and a slew of bonds issued by them as well. The key is not to get too wrapped up in any one company.

Have questions? Ask me. I can help.