Bear Stearns Troubles

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Of course, banks protect themselves by hedging, which homeowners can rarely do. But even when this factor is taken into account, banks are still exposed. For instance, after trades that are netted out or hedged by other trades are subtracted, Bear had an “adjusted” leverage of 15.5 times its capital at the end of the second quarter. That’s way up from the 11-times level it had been at before the credit boom began. Its gross leverage declined slightly to 29.9 times capital in the third quarter. (By comparison, at the end of the second quarter, Goldman’s gross leverage ratio was 24.5 times, up from 18.7 in late 2003. Its adjusted leverage was up slightly from then.)

In Lehman’s third quarter, its leverage shot up by both measures. Its total leverage was more than 30 times capital, up from 25.8 times a year ago. Net leverage rose almost 20 percent, to 16 times, from a year earlier. (As a benchmark, it’s notable that Long-Term Capital Management, the hedge fund that notoriously blew up in 1998, typically had leverage of 25 to 1.)

When an investor has leverage of 30 to 1, all it takes is a reduction of about 3 percent in the assets to wipe out the equity. In the third quarter, the banks uniformly said that the worst was behind them and that none had lost money. But what happens if the market blindsides them again as it did in August?

Atomic Assets

Just as in the housing market, it’s hard to predict which mechanisms will cause an investment-banking meltdown. It’s almost impossible to tell how risky the assets on the banks’ balance sheets are, for instance, or how they have chosen to hedge or what the risks are that the parties on the other side of their trades will default.

All over Wall Street, investors scrambled this summer to get an education in all sorts of wondrous financial arcana. There are the collateralized debt obligations and their dodgy progeny, known as C.D.O.-squareds. There are the structured investment vehicles and their dubious cousins S.I.V.-lites, the off-balance-sheet vehicles that banks and financial companies use for short-term funding.

And then there’s the investment bankers’ dependence on so-called level-three assets. Thanks to a recent ruling by the Financial Accounting Standards Board, financial institutions now break out the fair value of various types of difficult-to-value assets into levels. There is level one, which is, to put it in the language of buffalo wings, “hot.” A level-one asset is relatively easy to value, with quoted prices in an active market for identical assets or liabilities. Then there is “extra hot,” officially known on Wall Street as level two. On this level, quoted prices for similar assets are out there, but accountants are needed to adjust their prices based on market criteria. And then there is “atomic”—level three. Nothing comparable to level-three assets trades on any market, and there isn’t even an objective standard by which to value them. Level-three assets include bespoke derivative contracts that never trade, complex distressed debt, and mortgages that have gone bad. To value these assets, the banks have sophisticated internal models, which they point out are carefully pored over by their auditors. But it’s sort of like finding the asset’s value by sticking your finger in the wind.

It may not have been an accident that unraveling all this is so tough. Indeed, an official at one of the banks told me that the balance sheets are opaque on purpose: “We don’t make it easy to understand what instruments we use to make that leverage.”

Like frat boys at a sports bar, Wall Street has binged on level-three assets. In the first half of this year, Bear Stearns ended up with $18 billion of level-three assets on its balance sheet. That’s 135 percent of its entire book value, or net worth. For Lehman, level-three assets represented 104 percent of its book value. And for Goldman, 141 percent.

When things are going well, level-three assets are lucrative, since the investment banks have the expertise to dominate the market for them. But things might be changing. The canary in this particular mine shaft is Bear, which actually took losses on these risky assets in the first half of this year. In the third quarter, Lehman’s level-three assets rose both in dollar terms and as a percentage of assets, compared with the second quarter. Morgan Stanley’s and Goldman’s level-three assets rose as well. (Third-quarter level-three profitability disclosures aren’t available yet.)

Hunting Bear

It’s hard to find any corner of the U.S. investment-banking world that’s doing well. Structured finance issuance is down. Mergers-and-acquisitions activity is slowing. The banks are already making small numbers of employees redundant. Bonus season this year will make Montgomery Burns look generous. Of the five banks, only Goldman is looking solid.

It’s unlikely that Bear will be able to stay independent. Lehman has been trying to imitate Goldman, which logged blockbuster earnings in the third quarter even as its competitors were staggering. But whether Lehman will have any success depends on whether this crisis has truly passed, and that bet has long odds. In the meantime, expect the perennial takeover speculation surrounding Morgan Stanley and Merrill Lynch to reheat.

There is an end-of-era feel to the whole thing. After all those years of investment bankers being mistakenly lambasted as rogues, it will be ironic if the moment Wall Street finally embraced its reputation became its undoing.

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