Entries
Learning from Bear Sterns’ Collapse
Posted by Deamiter
March 17th, 2008
Economy, Investing
This weekend, Bear Sterns, a major mortgage-backed investment firm, announced that they’d lost a whole lot of money and had to borrow money from the government and J.P. Morgan to avoid becoming worth less than they owed. Bear Sterns stopped returning investor money as they worried they didn’t have enough assets to cover redemptions, and they agreed to be purchased by J.P. Morgan for $2 per share — a huge drop from around $60 per share just day ago! J.P. Morgan is paying around a fifth of the value of just Bear Sterns’ Manhattan office building so they must have invested a whole lot of borrowed money in sub-prime mortgages to reach this point!
What’s interesting to me is that Bear Sterns profited heavily from sub-prime lending, but ended up losing everything by leveraging, or borrowing money to invest in these mortgages. Just like people who took out home-equity loans when home values were rising, Bear Sterns made a lot of money investing borrowed money. Similarly, just as many people are now left owing more money than their homes are worth, Bear Sterns proved once again that investing borrowed money is inherently risky.
The lesson: don’t place bets with borrowed money! At Rocket Finance, rocketc is doing something similar — investing the money from 0% credit card offers in the historically safe money market funds. Money market funds are historically extremely safe, but if he’d put the money in a stock market fund, he’d be seriously risking his money. If you’re going to need the money in 12 months (say to pay back your credit card when the 0% offer ends, or to pay off investors when they ask for their money back) playing with borrowed money is risky. In my mind, it’s no better than a lottery — in an up market you have a good chance of making a lot of money, but you can neither predict when the market will turn on you nor how far it will fall when it does.
unfortunately, the Fed is killing balance transfer arbitrage. . . ING direct is down to 3% and will probably move below that very soon.
Posted on March 19th, 2008 at 10:27 pm
I hear you — it’s better than nothing, but I’m no longer impressed by high yield savings now that we’re all focused on keeping the stock market as high as possible.
As an aside — why don’t you invest your credit card money in CDs or treasury bonds? It might be pretty pointless now, but you could have locked in decent rates in 1-year or 6-month CDs.
Posted on March 20th, 2008 at 5:14 am