The Rise and Fall of Bear Stearns

The rise and fall of Bear Stearns

Introduction

Bear Stearns, the fifth largest investment bank in US, was established as an equity-trading house in 1923 by Joseph Bear, Robert Stearns, and Harold Mayer. Its headquarters was located in New York City with offices in the major US cities, South America, Europe, and Asia, employing more than 13,500 people around the world. The firm survived every major crisis like the Great Depression, World War II, the 1987 market crash, and the 9/11 terrorists attack and never had a losing quarter in its history until December 2007, when Bear Stearns announced the first loss for about $854 million.

1. Failure Analysis:

1.1. Major factors that contributed to Bear Stearns failure

After the 9/11 terrorist attacks, all the major bankers such as Lehman Brothers, Merrill Lynch, Morgan Stanley, and Bear Stearns wanted to capitalize on the mortgage boom that happened when the Federal Reserve loosened the money supply as part of its financial policy to try to solve the crisis. Bear Stearns began to be involved in securitization and issued lot amounts of mortgage-backed securities (MBS).

One of Bear Stearns profit centers was a small hedge fund division, ran it by Ralph R. Cioffi, that was part of the firm's relatively small asset management business known as BSAM (Bear Stearns Asset Management). Cioffi raised two hedge funds, the Bear Stearns High-Grade Structured Credit Fund (using a 35x leverage) and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund (with a 100x leverage) that invested in risky collateralized debt obligations (CDOs). The collapse of these hedge funds, which filed for Chapter 15 bankruptcy on July 31, 2007 as a consequence of the subprime mortgage crisis, had insufficient credit insurance to protect against these losses in addition to the liquidity crisis product of the level of leverage employed in the financial strategy ($11.1 billion supported $395 billion in assets which means a leverage ratio of 35.5 to 1) and the greed of the firm's managers made Bear Stearns closed after 85 years in the market.

1.2 Who stood to benefit from its implosion?

The one who most benefited from Bear Stearns collapse was its rival JP Morgan Chase, who bought the firm on March 30, 2008 for $10 per share or $1.1 billion (instead of $2 per share or $ 236 million originally offered). JP Morgan Chase received a $30 billion loan from the Federal Reserve Bank of New York (collateralized by Bear Stearns Assets), who before agreed and then declined a $25 billion loan to Bear Stearns collateralized by its own assets. In addition, the Federal Reserve agreed to issue a $29 billion non-recourse loan to JP Morgan Chase to avoid the need for any kind of a fire sale of assets. According to J.P. Morgan CFO Mike Cavanagh, JP Morgan got to add the strength of Bear Stearns to the firm, especially the Investment Banking Franchise and its strong equity platform. Apparently, Bear Stearns business was not too bad after all.

1.3 How did Bear Stearns' collapse differ from LTCM failure a decade earlier?

LTCM was a hedge fund established in 1994 by John Meriwether and whose Board of Directors included Myron Scholes and Robert C. Merton, who share the 1997 Nobel Prize in Economics Science. The fund had $126 billion in assets and had been invested in foreign currencies and bonds in emerging markets in order to be able to provide high returns to its investors the fund incurred the use of highly leveraged. When Russia declared it was devaluing its currency and basically defaulting on its bonds, the fund began to drain money and, without any change in its financial strategy, the leverage ration raised to 200x, resulting in a liquidity crisis.

As a result, LTCM's highly leveraged investments started to collapse. By the end of August 1998, it lost 50% of the value of its capital investments. Since so many banks and pension funds were invested in LTCM, its problems threatened to push most of them to near bankruptcy. In order to save the US banking system and wishing to avoid the precedent to bailout a hedge fund, the Federal Reserve convinced 14 banks to invest into the fund, to avoid the collapse of the entire financial system. The result was a private bailout by the major financial firms and supervised by the Federal Reserve. Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, JP Morgan, Morgan Stanley, Salomon Smith Barney, and UBS agreed to contribute with $ 300 million each one, while Société Générale invested $125 million and Lehman Brothers and Paribas did the same