If you keep up with current events and/or financial news, then you probably heard about the demise of Bear Stearns, a once large investment brokerage firm. Many were shocked when the news came out that JP Morgan would be buying Bear Stearns at $2 a share, when months ago the stock was trading at $85 dollars a share. Then, JP Morgan realized that others were trying to compete to buy Bear and offering a higher price, so JP Morgan increased the buy-out to $10 a share. So, let’s take a look at why Bear Stearns crumbled overnight.
Their debt to equity ratio was 32!
Debt to equity ratio is basically the liabilities of the company divided by the equity that the firm holds. Anything over 2 is supposed to be considered a high for a d/e ratio, and Stearns was at 32! The problem with all of these large investment firms is that they are a bunch of eggheads that went to famous business schools that taught them to leverage the hell out of their assets. You can argue that every company leverages their debt, but many don’t have a D/E ratio more than 2 or 3.
What this means to you: I am a strong proponent of not encouraging people to leverage their debt or assets. Many people are doing this with credit cards. They are maxing out the 0% credit card and placing the money in an online savings account to earn 3 to 4% interest. The problem is that by the time you consider taxes and the return that risk eats up, it’s not worth playing games with debt. A home equity line of credit is another way of leveraging one of your biggest assets, your home. When you take out a HELOC, that lender is going to become a second lienholder on your home. Don’t add more risk to the roof over your head. You can disagree with me on this one, but just look at Stearns. They took a financial principle taught every day and exploited it. Look where it got them? You may be able to get away with leveraging debt if you are conservative with it, but the problem is that greed rears itself into the equation and before you know it, you’re in over your head.
Bear Stearns invested in an unproven market
Bear Stearns had a lot of cash invested into the subprime mortgage industry. It’s funny because I am sure there were executives and senior analysts in the company that remember the LAST time the subprime mortgage industry crumbled. Subprimes have a place in society. They help people with less than perfect credit become homeowners, but the problem is that it gets exploited by greedy lenders and consumers with eyes bigger than their stomachs get sucked in. But, the fact that Stearns put so much of their assets into hedge funds that invested in the subprime market makes you wonder where the Stearn’s executives were educated. Again, it may have been just a case of greed.
How do you learn from this? Diversification of your investments is the single most important concept when becoming a serious investor. Investing heavily into one company, one industry, or having only one investment strategy is foolish. You are banking on the fact that the one company or industry will always do well, and it will never perform good at all times. You must make your investment portfolio diverse. I always make sure that my investments have an element of international stocks, so when the U.S. market is slow, it still has the chance for Asia and Europe to keep the portfolio strong.
I am guessing that this won’t be the only brokerage firm to go under, because many of them are still employing the same strategies as Bear Stearns. Hopefully, they will learn from the mistakes of Bear Stearns.