What sank Bear Stearns?

Bear Stearns was taken to the very brink of insolvency over the past 24 hours by a sudden collapse in confidence on the part of its hedge-fund clients.

There was a wholly modern hedge-fund run on the investment bank.
Here’s how it happened.

One of Bear Stearns’s most profitable businesses was its prime brokerage, which provides lending and admin services to hedge funds with a fixed-income bent.

These hedge funds deposit their assets at Bear Stearns, which the investment bank uses as a source of liquidity.

But – according to a banker close to Bear Stearns – in the last day or so a number of those hedge funds decided to terminate their respective relationships with Bear Stearns.

They were spooked by the rampant speculation about Bear Stearns’ fragility and its supposedly excessive exposure to US mortgages.

The hedge funds stampeded to withdraw their assets, so the investment bank was deprived of a vital source of liquidity.

That’s why it had to go cap in hand to the New York Fed for financial succour.

Perhaps the most shocking aspect of this episode is that help was in sight for Bear Stearns at the very moment the hedge funds pulled the plug.

As of March 27, Bear Stearns would have been able to exchange its illiquid holdings of mortgage-backed securities for high-quality, liquid US Treasuries, under a scheme announced last Tuesday by the US Federal Reserve.

That would have provided Bear Stearns with sufficient liquid funds to continue as a going concern.

But its hedge-fund clients weren’t prepared to stick with it even for 13 days.
It’s a very frightening manifestation of the nervousness of even sophisticated investors such as hedge funds.

In today’s highly uncertain markets, they are not prepared to give an 80-year-old Wall Street firm the benefit of the doubt for even a fortnight.
http://www.bbc.co.uk/blogs/thereporters/robertpeston/2008/03/how_hedge_funds_sunk_bear_stea.html

Or maybe a bunch of hedge funds bought puts on Bear Stearns and then decided to jump ship. Anyone remember the 50,000 March 35 puts bought at .15 when the stock was at 60? For a cost of $750,000, these puts, that closed at $9 on Friday, were worth $45,000,000. Add in the exceedingly heavy purchases of the 50, 55 and 60 strike, and you are starting to talk real money.

Dr. J had this to say about BSC last week:
Bear Stearns (BSC) volatility in the front month March calls now tops 160 for the at the money 60 puts. Volatility in April at the money options is also sky-high, pricing at 125%. As a metric for comparison, the 100 day average volatility in Bear Stearns was 55%.

We've got very active put buying all the way down to the March 30 puts, but the institutional paper is trading in the March 60, 55 and 50 puts. In other words, the amateurs are buying up what they perceive to be “cheap” puts below the 50 strike, but most professional paper is more realistic.

The April 55 put (BVDPK) are up $3.90 to $6.00 on double the open interest. Volume tops 6,300 puts at this strike, against 3,200 open interest. Just how desperate are the put buyers?

Well, my DepthCharge shows buyers of the January 10 puts of 2009, where nearly 3,000 puts have trade up $.55 to $.85, a gain of 185 percent on the session. Like the action in Washington Mutual (WM) we cited Friday, this is bankruptcy fear rearing its ugly head in Bear Stearns, folks.

On the session over 95,000 puts have changed hands in BSC, or nearly five times the open interest in the first 2 ½ hours of trade.
http://www.optionmonster.com/#action=home

Only in this market, where nerves are so frayed, can a "run on the bank" start and end so quickly.