In mid-March, the subprime crisis took an ugly turn. Until then, it appeared the damage might be confined to the aggressive lenders responsible for arranging all those junk mortgages in the first place and to the hedge funds and foreign banks (with more money than brains) that bought the idea that financial engineering could turn trash into gold. But then the crisis enveloped Bear Stearns, one of Wall Street’s oldest broker/dealers.
Bear Stearns experienced something those of us coming of age in an era of federal deposit insurance haven’t experienced before, a frightening phenomenon known as a “run on the bank.”
Checks and balances
People don’t like to keep a lot of cash lying around the house. Naturally, your local bank wants to help you out by accepting your cash in a deposit account. The bank might or might not pay you some interest depending on the restrictions placed on withdrawals. But most depositors assume they can withdraw their cash any time they need it.
Of course, the bank doesn’t lock your cash in its vault. Instead, it lends it out to others with the idea of making money on the difference between what it pays you in interest and what it charges its borrowers. While depositors want access to their cash at a moment’s notice, borrowers use their borrowings to buy things not easily converted back into cash. And so the bank exchanges its depositors’ cash for pieces of paper specifying the terms on which their borrowers will repay the bank.
The bank is pretty sure that on any given day, some of its customers will want access to their cash. It calculates how much cash will likely be coming in from borrowers in interest and principal repayments and how much cash depositors might demand. It then tries to anticipate how much the cash demanded by depositors might exceed that coming in from the bank’s borrowers in any given period.
Let’s assume a bank lends out 90 percent of its depositors’ funds and keeps 10 percent of the cash in its vault as a reserve. The 10 percent is expected to cover reasonable depositor demands provided those despositors remain confident the bank will repay them their cash when requested.
Suppose you deposited $10,000 at the First Toonerville Bank, but because of what you hear on the news, you lose confidence the bank will be able to give your cash back when you want it. You go to the bank the next day and close the account, receiving everything back you deposited. Feeling pretty smart, you tell a few of your friends what you’ve done. Some of them realize that maybe they’re not so confident about First Toonerville Bank, either. They present themselves at the bank the next day and draw out all their cash.
As word spreads, in a day or two, a line of depositors appears outside the bank before it opens, trying to be first in line, because they assume it won’t be long before that cash reserve in the vault runs out. The run has now begun. Commuters driving past the bank notice the line outside the door. When they get to the office, they call home and tell the spouse to get down to First Toonerville Bank pronto. Worse, others begin to wonder whether everything is OK over at National Bank of Toonerville, where they have their cash. In an earlier era, bank runs were a frequent phenomenon. The more serious ones affected whole regions—even nations—and led to severe economic dislocations. Deposit insurance was designed to avert bank runs by comforting depositors that, should their bank run low on cash, an armored car would show up with plenty more courtesy of the U.S. Treasury, which can print as much of the stuff as is needed.
Confidence is key
While Bear Stearns isn’t a bank in the usual sense, it operates on the same principal—making money by borrowing on a short-term basis and lending or investing it longer term. Instead of depositors, a broker/dealer like Bear Stearns has “counterparties” who provide the short-term cash needed to create all those securities sold to investors. And when the counterparties believe the institution may not have sufficient cash to repay its short-term obligations, they stop providing the cash needed for it to continue operating.
According to the Wall Street Journal, rumors began around the end of the first week of March that some European banks had stopped doing business with Bear Stearns. By Monday, March 10, some U.S. fixed-income and stock traders pulled their cash; the next day, a major asset manager did the same. By Thursday evening, so much cash had been drained that Bear Stearns management faced a desperate situation. The SEC was alerted; examiners from the Federal Reserve worked throughout the night. At 6 a.m. on March 14, Federal Reserve Chairman Ben Bernacke, Treasury Secretary Henry Paulson and other top officials conferred by telephone and devised how to stop the panic that threatened not only Bear Stearns but other broker/dealers suspected of being financially weak.
Shortly after the markets opened that Friday, a rescue plan was announced whereby J.P. Morgan Chase, acting as intermediary, borrowed short-term money from the Fed using collateral provided by Bear Stearns. On the news, Bear’s stock tumbled to around $30 a share, down from $170 in early 2007. By Sunday, March 16, as I was writing this column, it was over. Bear Stearns was forced to sell itself to Morgan for $2 a share; the collapse leaves 14,000 employees wondering about their futures.
The run on Bear Stearns demonstrates how crucial consumer confidence is to the survival of any business that depends on its promises to repay money owed to others—confidence that’s the essence of the finance industry.
