The Fall of Bear Stearns

7/26/2008 The Fall of Bear Stearns By Bobby McFarlane “Ronald Reagan used to say, "The nine most terrifying words in the English language are: 'I'm from the government and I'm here to help." Reagan's line always got a belly laugh. Well, folks, not in this Bear market.” - Ellen Goodman, on the federal government helping to save Bear Stearns while refusing to help homeowners facing foreclosure. (Boston Globe, March 21, 2008) On the evening of Saturday, October 21, 1907, financier J.P. Morgan invited the presidents of the top New York trust companies to his private library and locked the door behind them. From dusk on Saturday until dawn on Sunday, Morgan and the trust company executives discussed ways to keep their banks afloat and halt the financial panic threatening New York. High on the agenda was the question of what to do with the Trust Company of America, a bank that faced insolvency and the threat of a bank run. Morgan demanded that the executives band together to save the company, claiming that if one bank were to fail, the others would too, one after another. The other bank executives argued that they must safeguard their assets to protect their own banks. After much debate, Morgan prevailed; the group of banks bailed out the Trust Company of America and redirected funds amongst themselves. In addition, they bought up stock in healthy corporations and secured international lines of credit. After a few weeks, the financial crisis subsided with no lasting effects on the country’s economy. 1 1 -Norris, Floyd. "When Bankers Fear to Act." The New York Times 22 Feb. 2008. nytimes.com>. One hundred and one years after J.P. Morgan came to the rescue of the Trust Company of America, the multi-billion dollar financial services firm that bears his name, JPMorgan Chase, performed a similar bailout under strikingly similar conditions. Once again the financial markets were on the verge of a meltdown, this time brought on by a bursting housing bubble combined with defaults on subprime mortgages and other types of loans made to high-risk borrowers. Financial institutions around the world were losing billions of dollars thanks to escalating loan defaults and provisions for loan losses. One of the hardest hit was Bear Stearns & Co, the nations fifth largest investment bank with total assets exceeding $350 billion.2 Two of Bear Stearns most active hedge funds had invested heavily in securities backed by subprime loans, which plummeted in value when the housing bubble exploded. When these two hedge funds went under, shockwaves swept throughout the company, causing sharp drops in profits and market value. Fearing that insolvency at Bear Stearns would crescendo into a total market collapse, on March 14, 2008, JPMorgan Chase, in conjunction with funds backed by the Federal Reserve, bailed out Bear Stearns in an attempt to save Wall Street from what could have been a catastrophic failure. It was the first time since the 1960s that the US central bank authorized the provision of funds to a financial institution other than a regulated depository bank.3 Before the markets opened on Monday, March 16, 2008, JPMorgan Chase had negotiated and executed the purchase of Bear Stearns for an astoundingly cheap price of $2/ share, a swift and vital move that would have made J.P. Morgan, himself proud. Instead of being locked inside a plush midtown Manhattan library, as the bankers who saved Wall Street in 1907 had been, top bank executives met via an impromptu conference call the evening Bear Stearns was rescued. CEOs from all of the major investment banks- Goldman Sachs, Lehman Brothers, Morgan Stanley, UBS, HSBC and more- met to discuss the future of the financial markets. The meeting was led by Henry Paulson, the Treasury secretary, and Timothy Geitner, the president of the New York 2 -Bernard, Stephen, and Joe B. Bruno. "Fed and Rival Bail Out Bear Stearns." The Associated Press 14 Mar. 2008. . 3 "How Bear Stearns Ran Out of the Necessities." The Daily Telegraph 17 Mar. 2008. . Federal Reserve Bank.4 Over the course of the late night meeting, each participant pledged their support to Bear Stearns and the pre-emptive actions of JPMorgan Chase and the Federal Reserve. They recognized, as one participant said, that without a major buy out, “ the markets were on the precipice of a real crisis.” Given the over $2.5 trillion worldwide locked up in trading contracts involving Bear Stearns, the collapse of such a major investment bank could have meant “the possibility of a global run on the bank.”5 How did Bear Stearns dig themselves into such a deep hole? Andrew Wilkinson, senior market analyst at Interactive Brokers Group, pointed to the fact that Bear Stearns had "the least-diversified earnings stream of all of Wall Street securities firms,”6 as cause for their catastrophic failures. Specifically, Bear Stearns faltered due to the failure of two hedge funds, the Bear Stearns High-Grade Structured Credit Fund and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund.7 By the summer of 2007, hedge funds were struggling across the board as some banks, such as UBS, decided to shut down hedge fund operations altogether.8 Worried that their reputation would be damaged if Bear Stearns stuck investors and lenders with huge losses, on June 22nd the company pledged $3.2 billion to the smaller of the two failing funds, which was suffering badly from the slumping housing market. A major problem with the two Bear Stearns funds was that they were thinly diversified and held a substantial amount of mortgage-backed securities, or MBS, and collateralized debt obligations, or CDOs, which invest in bonds backed by loans and other financial instruments.9 When the market for subprime mortgages plummeted, the CDOs and mortgage-backed securities lost nearly all of their value, sparking concern of contagion 4 Sorkin, Andrew. "Leveraged Planet." The New York Times 2 Apr. 2008. . 5 Ibid. 6 Bernard, Stephen, and Joe B. Bruno. "Fed and Rival Bail Out Bear Stearns." The Associated Press 14 Mar. 2008. . 7 Bland, Ben. "Bear Stearns Hedge Funds Wiped Out." The Daily Telegraph 19 July 2007. . 8 Shenn, Jody. "Bear Stearns, Creditors May Help Save Hedge Fund." Bloomberg 19 June 2007. . 9 Bland and causing markdowns of assets in other portfolios. Bear Stearns was one of the most aggressive banks in expanding throughout mortgage market, relying heavily on a strong US housing market, while firms like Goldman Sachs and JPMorgan were more conservative in this regard.10 The hedge fund that Bear Stearns put up $3.2 billion to help liquidate holdings was originally valued at over $10 billion, and now saw losses totaling roughly $1.6 billion. Clearly, Bear Stearns’ gamble in the housing market was beginning to take a devastating toll. In addition to a steadily declining stock price, Bear Stearns & Co. faced legal action initiated by multiple investors in the failing funds. Suits claimed that Bear Stearns had misled investors regarding the level of exposure to the funds, as well as that Bear Stearns took only “meager steps” to prevent the collapse.11 Plaintiffs in a recently filed suit claim that the two funds, presented by Bear Stearns as relatively safe investment vehicles, were never designed to withstand even a "slight downtick" in the housing market .12 In the fall of 2007, the failure of the two hedge funds caused Bear Stearns to post a 61 percent drop in total profit, and their first quarterly loss in the bank’s 84 year history. Because it was purely an investment bank, Bear Stearns had no customer deposits to call on were there to be a bank run. Thus, as failing hedge funds from around the world scrambled to reclaim their money from Bear Stearns, a liquidity crush ensued. Despite claims by Hank Paulson and former Bear Stearns Chief Executive Alan Greenberg that rumors of a liquidity crisis were ludicrous, investors were skeptical and rushed to withdraw funds.13 On Thursday, March 13, Carlyle Capital Corporation- a seven-monthold Dutch hedge fund worth $22 billion - collapsed due to mortgage-backed securities. 10 Sorkin, Andrew. "Leveraged Planet." The New York Times 2 Apr. 2008. . 11 “Bear Stearns Sued Over Collapse of Fund." The New York Times 10 Aug. 2007. . 12 Chasan, Emily. "Bear Stearns and Deloitte Sued Over Hedge Fund Losses." Reuters 8 Apr. 2008. . 13 "How Bear Stearns Ran Out of the Necessities." The Daily Telegraph 17 Mar. 2008. . Bear Stearns, which owned 15 percent of the fund, saw stocks plummet by 17 percent.14 On Friday, March 14, 2008, Bear Stearns stock dropped from $57/ share to $30/ share in a matter of minutes. The drop represented a loss of about $5.7 billion, or about half of Bear Stearns’ market value. One year earlier, that same stock was at $170/ share.15 With Bear Stearns facing a complete loss of investor confidence and the reality of a liquidity crisis, rival bank JPMorgan Chase, through $30 billion of loans backed with collateral guaranteed by the Federal Reserve, bailed out the failing company. Federal Reserve Chairman Ben Bernanke’s controversial decision to authorize the provision of funds to JPMorgan resulted from the fact that Bear Stearns was too interconnected to be allowed to fail. JPMorgan CEO Jamie Dimon and Bear Stearns CEO Alan Shwartz had discussed a merger in previous talks, but with worsening market conditions, the risk to JPMorgan had been too high.16 Shwartz said the new fed-backed loans, which were to be extended for 28 days, would give Bear Stearns time to prove to its customers that the firm could operate on its own and proceed with business as usual. Furthering the attitude of the Federal Reserve was Richard Bove, analyst for Punk, Ziegel & Co., who believed that should Bear Stearns go under and become insolvent, it would “have the potential of bringing down the whole market.”17 In the weekend following the historic loan, Bear Stearns signed a merger agreement with JPMorgan in a stock swap worth $2/ share. At $2/ share, the deal valued Bear Stearns at $236 million, a sheer fraction of what it was worth a year earlier, when the bank was valued in excess of $18 billion. Through the deal, JPMorgan gave investors 0.05473 shares of its common stock for every share of Bear Stearns they owned.18 This represents a staggering financial loss, on par with Enron and other extraordinary market 14 15 Ibid. Andrews, Edmund L. "Fed Acts to Rescue Financial Markets." The New York Times 17 Mar. 2008. . 16 Ibid. 17 Bernard, Stephen, and Joe B. Bruno. "Fed and Rival Bail Out Bear Stearns." The Associated Press 14 Mar. 2008. . 18 Peston, Robert. "Rescue for Troubled Wall St. Bank." BBC News 17 Mar. 2008. . failures. A week later, JPMorgan increased the Bear Stearns’ share price to $10/ share in response to angry shareholders and reduced the loan from the Fed by $1 billion. In response to Bear Stearns’ historic collapse, Securities and Exchange Commission Chairman Christopher Cox claimed that market rumors about Bear Stearns’ difficulties became self-fulfilling. He noted that the decline in consumer confidence only started once rumors of a liquidity crisis spread rampant. Bear Stearns liquidity, he notes, was $18 billion on March 10, and over the course of three days, fell to $2 billion.19 Bear Stearns had always made a name for itself as a rogue investment firm. From it’s founding, it has separated itself from the white-shoe Wall Street firms and been willing to take risks that other banks refused to take. It’s noncompliance was put on display in 1998 when it was the only major firm unwilling to help bail out Long Term Capital Management, a struggling hedge fund that ended up folding two years later.20 In the long run, it was that risk-taking spirit that led to Bear Stearns’ downfall. Recently, top US officials considered granting aid to, or even buying out mortgage giants Fannie May and Freddie Mac, which own or guarantee roughly half of all home loans. As with Bear Stearns, it was the fear of a devastating ripple effect that caused such drastic consideration. To an even greater degree than Bear Stearns, Fannie and Freddie do considerable business with virtually all US banks. Had the two companies gone under, securing a home loan would have become impossible, since it is these two companies that provide banks with the capital they use to write new loans.21 Without the power to grant loans, financial institutions would be further debilitated and their value worsened. 19 Tharp, Paul. And Zachery Kouwe “Bear May Have Lived; Cox: Firm had Ample Capital” The New York Post 23 Mar. 2008. 20 Sorkin, Andrew R., and Landon Thomas. "JPMorgan Acts to Buy Ailing Bear Stearns At Huge Discount." The New York Times 16 Mar. 2008. . 21 Duhigg, Charles. "Loan-Agency Woes Swell From a Trickle to a Torrent." The New York Times 11 July 2008. With so much emphasis placed on a cutthroat, survival of the fittest brand of Wall Street, it is important to note that in dire times of financial crisis, the best strategy is often cooperation. With interdependencies abound on Wall Street, financial markets can only survive by working as a cohesive organism. Had Bear Stearns been left for dead, the ripple effect could have catapulted the United States into the next great depression. Just as financier J.P. Morgan taught the bankers of his era and JPMorgan has shown the firms of the present, cooperation between firms is necessary for the survival of the whole. Bear Stearns Companies Inc. (NYSE:BSC) July 16, 2007: Bear Stearns’ Hedge Funds loose nearly all their value amid rapid decline in subprime mortgage market. December 20, 2007: Bear Stearns reports first quarterly loss in its 84 years history. S&P downgrades their credit rating from AA to A March 13, 2008: Bear Stearns’ stock begins to plummet after failure of Carlyle Fund March 21, 2008: JPMorgan originally buys out Bear Stearns at $2/Share. Later, JPMorgan would increase Bear Stearns’ share price to $10/ share. Works Cited -Andrews, Edmund L. "Fed Acts to Rescue Financial Markets." The New York Times 17 Mar. 2008. . - “Bear Stearns Sued Over Collapse of Fund." The New York Times 10 Aug. 2007. nytimes.com>. -Bernard, Stephen, and Joe B. Bruno. "Fed and Rival Bail Out Bear Stearns." The Associated Press 14 Mar. 2008. . -Bland, Ben. "Bear Stearns Hedge Funds Wiped Out." The Daily Telegraph 19 July 2007. 7 Apr. 2008 . -Chasan, Emily. "Bear Stearns and Deloitte Sued Over Hedge Fund Losses." Reuters 8 Apr. 2008. . -Goldstein, Matt. Interview with Melissa Block. All Things Considered. 17 Mar. 2008. Natl. Public Radio. New York. 17 Mar. 2008. -"How Bear Stearns Ran Out of the Necessities." The Daily Telegraph 17 Mar. 2008. . Duhigg, Charles. "Loan-Agency Woes Swell From a Trickle to a Torrent." The New York Times 11 July 2008. -Norris, Floyd. "When Bankers Fear to Act." The New York Times 22 Feb. 2008. . -Peston, Robert. "Rescue for Troubled Wall St. Bank." BBC News 17 Mar. 2008. . -Shenn, Jody. "Bear Stearns, Creditors May Help Save Hedge Fund." Bloomberg 19 June 2007. . -Sorkin, Andrew. "Leveraged Planet." The New York Times 2 Apr. 2008. . -Sorkin, Andrew R., and Landon Thomas. "JPMorgan Acts to Buy Ailing Bear Stearns At Huge Discount." The New York Times 16 Mar. 2008. 7 Apr. 2008 . -Tharp, Paul. And Zachery Kouwe “Bear May Have Lived; Cox: Firm had Ample Capital” The New York Post 23 Mar. 2008.