Northern Rock was the first major financial institution to fail during the current crisis and Bear Stearns is the second. While optically both Northern Rock and Bear Stearns were “bailed out”, the reality is that neither was. Both went bust. A bail out implies special-case financial assistance that allows the entity in trouble to overcome its problems and continue to survive. Northern Rock survived in name only -- it is now a division of the British Government; Bear Stearns didn’t.

A year ago Bear Stearns’ stock was trading at almost $160. The company had a market capitalization of $21 billion and paid a dividend of $1.28 per share. Last week Friday the stock closed at $30 and had a market capitalization of $3.5 billion: a fall of 81% in less than a year. The stock lost another 93% over the weekend. The total loss was 99% in less than a year, all while the company paid a dividend.

One of Bear Stearns’ core businesses was as prime broker for many hedge funds, particularly hedge funds with fixed income assets. As prime broker Bear cleared their transactions, held custody of their assets, supplied administrative and back office services and made loans. In order to get a loan the hedge fund client had to have a margin account with Bear.

The business works like this: A hedge fund buys securities, such as collateralized debt obligations, and deposits them in their account with Bear Stearns. But they don’t pay for the securities in full, they borrow say 80% of the money from Bear Stearns at a fairly high interest rate (margin rates are high). Bear Stearns in turn goes to a commercial bank and borrows money at the prime interest rate, since it’s such a strong financial company, and pockets the difference between the cost of the money (prime) and the margin rates it charges its clients.

The banks will lend money to brokers such as Bear as long as they believe that Bear in turn is making sound loans to its clients, in this case the hedge funds. Bear was an aggressive lender to hedge funds that owned collateralized debt obligations, packaged mortgage assets, and such. It was also a large player in the packaging of those assets and an aggressive trader for its own account, i.e. using its own capital.

When the credit markets started freezing up and collateralized debt obligations became illiquid, Bears’ business got into trouble. Remember, Bear had made aggressive loans to hedge funds that owned these assets and Bear was also an aggressive trader with its own capital. Bear’s ability to generate income by packaging debt assets and selling them to the hedge funds had vanished.

The fine print of any margin account application states that any assets deposited into a margin account can be borrowed without further notice by the broker. I suspect that by last week Bear was borrowing client assets, without the clients’ knowledge (it’s legal), and pledging those assets for loans to keep the business going.

As Bear Stearns’ financial condition deteriorated hedge funds began withdrawing their assets -- they’re not stupid. But when a hedge fund client closes its account it also has to settle any remaining margin debt and I suspect that the funds that closed their accounts at Bear were the least leveraged and financially most sound, leaving Bear with the rest. That meant a deterioration in Bear Stearns’ balance sheet. The outflow of funds was quite large: in just two days last week clients withdrew $17 billion from Bear Stearns.

As a result of its rapidly deteriorating balance sheet Bear Stearns could no longer get loans in the short term repo market. Other banks refused to lend it money and it had to turn to the Federal Reserve for emergency funding and thus ended the history of an eighty-five year old bank.

Bear Stearns’ demise was obviously its aggressive business practices but the mechanism of its collapse was an old fashion run on the bank, when depositors, in this case its hedge fund clients, closed their accounts and withdrew their assets. But to admit that would have caused tremendous psychological damage, which is why it had to be “saved”.

I previously made a big deal of the fact that the US banking system is in the worst shape it has ever been; worse than during the midst of the Great Depression when Roosevelt closed the banks and called a bank holiday.

The Federal Reserve was created to avoid bank runs and bank collapses. It is the lender of last resort and can create money out of thin air if it needs to save a bank. Fiat money has no value: its only value lies in the confidence people have that the money will still exist tomorrow. A fractional banking system works the same: the money doesn’t exist and the system only functions as long as people have confidence their accounts will still be there tomorrow. But when that confidence is shaken the banks and the currency can collapse very quickly, as happened to Bear Stearns and as is happening to the US dollar.

I don’t keep my stock certificates in a brokerage account any longer; they are in my own safety deposit box. I have no reason to believe that any of the financial institutions I deal with are in trouble, or at risk, but why take the chance? It appears that most, if not all of the people who worked for Bear Stearns did not understand that it was bankrupt until last week. My stock certificates are where I can touch them and my cash is in physical gold, where I can touch it.

I certainly hope that I am being overly cautious with my assets but I have the responsibility to protect them: looking after my family is not a responsibility that I can delegate to anyone else, and therefore I have to make whatever decisions I have to make to enable me to sleep well at night.

Last week I mentioned that I would not be surprised to see a rally in the dollar and a decline in the price of gold. Both occurred this week and the gold price fell by $110 an ounce from its high (10.7%). Anything can happen next week but I personally hope the gold price falls further, and then finds a bottom, so that we can have more confidence in a future rally. The price ran too high, too fast, for my comfort.