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What about Equity Holders?

Creditors do not share in the upside of any investment. So they only care about one thing—avoiding the downside. They want to make sure their counterparty is going to stay solvent. Equity holders care about two things—the upside and the downside. So why doesn’t fear of the downside encourage prudence? Even if creditors were lulled into complacency by the prospects of rescue, shareholders—who are usually wiped out—wouldn’t want too much risk, would they?

Why would Bear Stearns, Lehman Brothers, and Merrill Lynch take on so much risk? They didn’t want to go bankrupt and wipe out the equity holders. Why would these firms leverage themselves 30–1 and 40–1, putting the existence of the firm at risk in the event of a small change in the value of the assets in their portfolios? Surely the equity holders would rebel against such leverage.

But very few equity holders put all their eggs in one basket. Buying risky stocks isn’t just for highfliers looking for high risk and high rewards. It also attracts people who want high risk and high rewards in part of their portfolios. It’s all about risk and return along with diversification. The Fannie Mae stock held in an investor’s portfolio might be high risk and (she hopes) high return. If that makes a Fannie Mae stockholder nervous, she can also buy Fannie Mae bonds. The bonds are low risk, low return. She can even hold a mix of equity and bonds to mimic the overall return to Fannie Mae in its entirety. For every $100 she invests, she buys $98 of Fannie’s bonds and $2 of equity. When the stock is doing well, the equity share boosts the return of the safe bonds. In the worst-case scenario, Fannie Mae goes broke, wiping out the investor’s equity. But in the meantime, she made money on the bonds and maybe even on the stocks, if she got out in time.

The same is true of investors holding Bear Stearns or Lehman stock. In 2005, Bear Stearns had its own online subprime mortgage lender, BearDirect. Bear Stearns also owned EMC, a subprime mortgage company. Bear was generating subprime loans and bundling them into mortgage-backed securities, making an enormous amount of money as the price of housing continued to rise. All through 2006 and most of 2007, things weren’t just fine. They were better than fine. The price of Bear Stearns’s stock hit $172. If an investor sold then or even a lot later, she did very, very well. Even though she knew there was a risk that the stock could not just go down, but go down a lot, she didn’t want to discourage the risk-taking. She wanted to profit from it.