Moral of Bear Stearns Debacle: Don't Buy What You Can't Understand

The first lesson that came to my mind when I heard about the Bear Stearns (BSC) debacle was straight from Buffett: Don’t buy what you can’t understand. Was Bear a simple and understandable business? Of course not. Their investments were so complex that it is not unlikely that no single individual at the firm understood them all. If this is true, then it is even less likely that ordinary investors understood them.

But the lesson for the Bear employees heavily invested in Bear stock should have already been learned. Remember Enron? Remember the sketchy (ultimately fraudulent) ways they seemed to be making money out of thin air? The Enron employee didn’t understand how the company was making money. If he had he would have known it was all a farce. But nonetheless many, many hardworking people put their faith in their employer’s stock and in many cases invested their entire retirement in it. Big mistake.

But it need not have even be an issue of understanding the company. From a pure diversification standpoint any employee is better off keeping his investments out of company stock since his human capital (read: income) is already 100% invested in the company. Instead, these folks have lost not only their jobs but also their savings.

I don’t mean to take the high road, nor do I mean to downplay the tragedy that this has caused families. Indeed, it is not even their fault. It is their employer’s fault for encouraging them to invest their retirement in company stock, since I assume most of them are not financially sophisticated enough to understand the diversification argument while an investment house like Bear certainly should be, and for creating the illusion that the company was strong enough to warrant their investment. It’s a rotten situation all around.

Much has been made about Bear’s current stock price, which is 200% higher than the JP Morgan (JPM) acquisition price. It could be that investors are betting that either the bid will get raised before the deal goes through (a highly unlikely notion in my opinion given the Fed’s involvement) or that they think the deal will be delayed long enough for the company to right itself so that it eventually survives as a standalone.

Even considering these possibilities, it remains somewhat puzzling. But I think the explanation is a bit more academic than it might seem at first glance. Specifically, this is a textbook example of behavioral finance. According to theory, there are two requirements for irrational investors to drive prices from intrinsic value and, consequently, for the market to inefficiently price securities. Those two things are a) psychological biases and b) limits to arbitrage. In this case I think both are met.

The probability that the bid will get raised or that Bear will actually survive is not zero. But I think it is low. How low exactly I am not sure, but it is certainly not high enough to justify a stock price three times that of the most likely outcome – that the JP Morgan deal goes through as planned. Rather, the stock price is three times that of the bid price because there are irrational investors betting on the aforementioned possibilities and there is no arbitrage opportunity for more level-headed investors who would otherwise correct this blatant mispricing. At least that is the way it seems to me. Has anyone been able to successfully place a large short sale on BSC shares within the last week? I tried and I couldn’t. The lack of shares available for short is a natural limit to arbitrage and, according to behavioral finance theory, opens the door for irrational investors to control prices.

The investors willing to pay $6 a share for Bear seem to me to be falling victim to the following psychological biases:

Overconfidence – These irrational investors are overconfident in their own assessment of the situation, so much so that they are willing to pay a price far in excess of what would seem logical. They are also likely overconfident in Bear’s ability to weather this storm. This is understandable since big storied companies like this typically don’t just vanish overnight. But that doesn’t mean that can’t.

Endowment Effect – The investors who already have an equity interest are valuing their shares at a price much higher than the $2 bid. This too is understandable. Most people are reluctant to sell a stock for next to nothing when it was worth $150 as recently as a year ago, even if a price of $2 seems reasonable given today’s information set.

Disposition Effect – If these investors give in to the current offer, they will feel a tremendous amount of regret. Regret for not selling at $50, regret for having ever invested in a company with subprime exposure. To mitigate this regret, they are willing to increase their stakes by buying more shares, all while convincing themselves that since they liked the stock at $60, they should really like it at $5.

These biases create the environment in which mispricing might occur and the inability to short sell creates the limit to arbitrage that allows it to persist. So behavioral finance should explain the bizarre mispricing we are witnessing. Unfortunately, inherent in a situation like this is the inability for the rational investor to take advantage of it. Said differently, the stock would never have become mispriced if it could be arbitraged, so clearly there is no way for us rational investors to arbitrage it now. What a bummer.

Comments

[Karl Zachar]

Andy Kern writes that employees should not have voluntarily kept their money in BSC shares for diversification reasons. However, what Kern fails to mention is that many Bear Stearns employees had no choice. I am sure Bear strongly encouraged (READ: "forced") their employees to hold BSC shares. These shares are typically part of any bankers/brokers annual compensation. Even if you wanted to sell your shares, you could not. Much of these employee-owned shares had serious selling restrictions attached to them.

So...the ship was sinking, and you could not jump out!

Karl Zachar
karlzachar.com

[User 168609]

This article appears to be written before the announcement of JPM raising the bid for BSC.

The author may have a point on investors being irrational, under the microscope of behavioral finance theory.

But I do want to point out those "irrational investors", who paid $6 a share for Bear, doubled their money in a week. The author should be glad that he could not find BSC to short.

[David V.]

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[Hinterlander]

Being a conspiracy theorist, could it be insiders at JPM or elsewhere buying up the shares knowing full well that a higher offer was coming in?

[who]

Comparing Enron with BS is completely wrong. Former was ran by crooks, later run by risk takers.

Not investing in complex companies is almost impossible - mega companies are complex by nature - products, markets, cultures, governance, etc.

By probability you understand your own company better then reading analyst or company reports because you are an insider. Sure, you may actually know a very small part but you can feel the pulse and policies.

[deecee]

@Hinter.... nah, in this country? Ya think?

@159950: They only became crooks after they were fully investigated, but while they were in charge at Enron, they were also risk takers.

[notsosmart]

could there be a tendency for risk takers to turn crooked if things bo bad?you think?

[youngj]

I think this analysis is a perfect example of behavioral finance - sounds good in theory, but tends to only be good for retrospective explanations and not for predictions.