Bear Stearns, the fifth largest investment bank in the US, was established as an equity-trading house by Joseph Bear, Robert Stearns, and Harold Mayer in 1923. With its headquarters in New York City and offices in major cities worldwide including South America, Europe, and Asia, the firm had a global workforce of over 13,500 employees. Despite facing various significant challenges such as the Great Depression, World War II, the 1987 market crash, and the 9/11 terrorist attack throughout its history, Bear Stearns successfully navigated through these obstacles. However, it encountered its initial loss of around $854 million in December 2007.
Failure Analysis:
Following the 9/11 attacks, prominent banks such as Lehman Brothers, Merrill Lynch, Morgan Stanley, and Bear Stearns identified a chance to capitalize on the expansion of the mortgage industry. The growth of this sector was fueled by the Federal Reserve’s choice to boost the money supply in response to the crisis. Consequently, Bear Stearns initiated securitization and commenced issuing a significant quantity of mortgage-backed securities (MBS).
Ralph R. Cioffi oversaw BSAM, the asset management business at Bear Stearns. BSAM included a small division dedicated to hedge funds, where Cioffi created two hedge funds: the Bear Stearns High-Grade Structured Credit Fund (leverage ratio: 35x) and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund (leverage ratio: 100x). The primary investment strategy of these funds was to focus on high-risk collateralized debt obligations (CDOs).
On July 31, 2007, the hedge funds suffered a collapse and filed for Chapter 15 bankruptcy as a result of the subprime mortgage crisis. The lack of sufficient credit insurance to cover their losses led to a liquidity crisis caused by their highly leveraged financial strategy. Bear Stearns, an established market player with an 85-year history, eventually shut down due to managerial greed. In terms of figures, they had $11.1 billion supporting $395 billion worth of assets, resulting in a leverage ratio of 35.5 to 1.
JP Morgan Chase, a rival firm, greatly benefited from the collapse of Bear Stearns when they acquired it for $1.1 billion on March 30, 2008. They bought each share at $10 instead of the originally proposed $2 per share or a total of $236 million. To facilitate this acquisition, JP Morgan Chase received a loan of $30 billion from the Federal Reserve Bank of New York using Bear Stearns assets as collateral. Interestingly, the Federal Reserve Bank had initially agreed to lend Bear Stearns $25 billion secured by its own assets but later retracted this offer.
Furthermore, JP Morgan Chase was given a $29 billion non-recourse loan by the Federal Reserve to prevent them from selling assets at a lower price. According to Mike Cavanagh, JP Morgan’s CFO, acquiring Bear Stearns brought considerable advantages to the company, especially in terms of its Investment Banking Franchise and strong equity platform. This implies that Bear Stearns’ business performance was not as weak as initially believed.
Compare the collapse of Bear Stearns with the failure of LTCM ten years prior.
LTCM, which was established in 1994 by John Meriwether, operated as a hedge fund and had a Board of Directors comprised of Nobel laureates Myron Scholes and Robert C. Merton in the field of Economics Science. The fund’s assets amounted to $126 billion and it primarily focused on investing in foreign currencies and bonds within emerging markets with the aim of generating significant profits for its investors. To achieve this objective, LTCM utilized substantial leverage.
When Russia announced its currency devaluation and default on bonds, LTCM experienced a decrease in funds. Despite unchanged financial strategy, the leverage ratio increased to 200x, leading to a liquidity crisis. Consequently, LTCM’s heavily leveraged investments began to deteriorate. By August 1998, it suffered a 50% loss in capital investment value. Considering numerous banks and pension funds had invested in LTCM, its issues posed a high risk of pushing them towards bankruptcy.
To avoid setting a precedent of rescuing a hedge fund, the Federal Reserve convinced 14 banks to invest $300 million each in a fund that would save the entire financial system. Under the supervision of the Federal Reserve, major financial firms privately implemented this bailout. The following banks participated: Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, JP Morgan, Morgan Stanley, Salomon Smith Barney, and UBS. Societe Generale invested $125 million while Lehman Brothers and Paribas each invested $100 million. Bear Stearns was the only bank that did not participate. However,due to Bear Stearns’ sudden collapse and uncertainty surrounding its mortgage holdings,the Federal Reserve took an active role instead of merely advising as it had done during the LTCM case 10 years earlier.
How could Bear Stearns have avoided their unfortunate outcome?
During the early 2000s, in response to the crisis caused by the 9/11 terrorist attacks, the Federal Reserve decreased interest rates and increased money supply. This led to a need for greater financial discipline from the firm’s directors, especially concerning hedge funds that made poor investments. Furthermore, there was a failure to assess risk, diversify portfolios, and control high leverage. These actions were driven by a desire to justify excessive fees and potentially achieve a 20% profit.
In the summer of 2007, two hedge funds managed by Ralph R. Cioffi collapsed and filed for bankruptcy. Despite prior warnings about the weakness of the subprime mortgage market that year, these funds had heavily invested in mortgage securities. Initially, Bear took no action and claimed that lenders from Merrill Lynch and JP Morgan Chase did not understand how Cioffi’s Fund operated. However, Bear refused to use its own funds to bail out the hedge funds, resulting in default on collateral and causing outrage from JP Morgan’s head of investment banking as well as tarnishing Bear’s reputation among other Wall Street financial institutions.
The company successfully addressed the liquidity challenge through necessary measures. However, the event that would ultimately cause the collapse of Bear Stearns had already been initiated. Since Monday, March 10, 2008, Bear Stearns Board of Directors held ongoing meetings to secure more funding or establish partnerships to prevent a complete downfall. Rather than honestly acknowledging the rumors of a liquidity crisis, they attempted to convince the public that the accusations were baseless. Meanwhile, all of the firm’s clients were trying to retrieve their funds.
They reached a point by the end of the week where it was too late to locate an emergency exit, thus leaving them with no choice but to reluctantly agree to JP Morgan Chase’s humiliating offer. Their oversight was in neglecting a vital aspect: in an industry that depends on confidence, once confidence is lost, so is the business.
Liquidity Crisis and Business Model of Investment Banks:
What is the importance of liquidity for banking and investment banking firms? The concept of liquidity can be understood in various ways. Liquidity refers to the capability of purchasing financial assets and tangible goods and services instantly. Cash is considered the most easily convertible asset.
Currently, both current and deposit accounts, as well as assets like Treasury Bills, have high levels of liquidity. In normal circumstances, banks are important in providing liquidity to the economy and offering funding options to creditworthy individuals and businesses. These activities greatly contribute to the smooth functioning of the economy. Consumers can deposit funds with commercial banks and withdraw them when necessary, allowing the banks to accumulate funds for providing long-term financing to firms for their investment needs. Effective management of liquidity is crucial for banks to meet their depositors’ liquidity requirements.
Customers may have varying liquidity needs at any given date. However, holding liquidity can be expensive due to the higher returns associated with less liquid assets. To make up for this opportunity cost, providers of liquidity to markets must occasionally be able to profit by purchasing assets at prices below their fundamental value (Allen and Carletti, 2008).
Does a banking/investment banking company place more importance on liquidity perception compared to a manufacturing firm, and what is the reason for this disparity? A liquidity crisis occurs when a company lacks enough cash to fulfill its upcoming payment obligations to creditors.
In normal circumstances, a company with more valuable assets than the amount owed to creditors can easily borrow money in the short-term credit markets to meet immediate liquidity needs. Therefore, bankruptcy is not typically caused by a liquidity crisis. However, for an investment bank compared to a traditional manufacturing or distribution business, the market’s perception of liquidity is even more crucial. To understand why this view matters more for an investment bank than for a traditional business, it is important to grasp their operational differences.
Unlike retail depositors, investment banks acquire funding from long-term debt, equity, and interbank markets. The assets on their balance sheets generally have longer durations. The difference between assets and liabilities highlights the importance of having liquid assets on banks’ balance sheets. This disparity was the primary reason behind multiple banks collapsing during the financial crisis as many were funded through the interbank market and held illiquid mortgage-backed securities.
The financial crisis had a ripple effect on the real economy, affecting the financial markets. While banks were unable to provide businesses with financial aid, traditional manufacturing businesses relied on long-term debt or equity for funding and did not face liquidity issues as long as they maintained a consistent cash flow. Unlike bank failures, the collapse of these businesses would not have as significant an impact.
What steps could Bear Stearns have taken to address the liquidity concerns that led to a bank run?
The collapse of Bear Stearns could have been avoided if proper compensation practices had been followed, such as tying bonuses to performance and considering the risks involved, particularly for traders with high risk exposure. To prevent similar situations in the future, it is crucial to reevaluate risk, enforce stricter leverage limits, improve internal risk management, establish external regulatory oversight, and implement stronger internal measures. This event prompts reflection on lessons regarding the investment banking business model.
The cause of the 2008 financial crisis was a bubble caused by the failure of asset-backed securitization. This failure in the United States can be primarily attributed to two causes that were not adequately recognized at the time.
One major factor was the reliance on credit rating agencies as gatekeepers, which became more vulnerable to client pressure due to increased market competition.
Another contributing factor was a change in regulatory rules that shifted towards self-regulation. This allowed US investment banks to take on more debt and reduce diversification in response to competition.
From this, it is evident that competition cannot replace regulation, and the necessity for prudential regulatory supervision of financial institutions is reinforced. In addition, the financial services industry must divulge their internal risk management strategies and the relationship between compensation and risk to adhere to mandatory disclosures regarding risk exposure. Furthermore, both regulated and unregulated companies should promptly report any significant incidents that indicate deficiencies in risk controls or management to a regulator responsible for market stability.
According to Olufunmilayo (2010), external regulation is a useful tool for encouraging the growth of internal risk management within the financial industry.
Are pure-play investment banks finding it harder to maintain profitability, or are they still able to generate the same level of earnings as in the past? The population of pure-play investment banks, which are financial institutions that do not engage in commercial banking activities, is diminishing rapidly. There is a belief that this industry could become less resilient as investors, who were impacted by real estate securities originated by Wall Street, search for safer opportunities to make profits.
Analysts predict that the era of dominant standalone investment banks on Wall Street may be coming to an end following the collapse of Lehman Bros. and Bank of America’s acquisition of Merrill Lynch. At present, only Goldman Sachs and Morgan Stanley remain as significant investment banks. Nevertheless, commercial banks that have acquired former Wall Street giants affected by the credit crunch are now taking charge in the finance industry. It is expected that Bank of America and Merrill Lynch, along with JPMorgan Chase and Bear Stearns, will serve as new benchmarks in this changing environment.
There is a move towards a more conservative approach to managing financial institutions.
Systemic Banking Crisis and Regulation
What Is a “Systemic Banking Crisis”?
A systemic banking crisis is the complete depletion of a country’s banking capital due to multiple defaults in both corporate and financial sectors. This presents considerable difficulties for financial institutions and corporations in meeting their contractual obligations within the given timeframe.
As a result, the banking system as a whole faces a substantial increase in non-performing loans. This leads to the depletion of most or all of its capital. In addition, there is often a decrease in asset prices such as equity and real estate prices, as observed in the current US economy. Consequently, this crisis generates distrust among individuals towards financial institutions. This causes depositors to withdraw their funds due to the widespread belief that these institutions are struggling.
What is “Banking Contagion”?
The global banking system was infected by risky behavior that spread from the collapse of real estate around the world, which is known as banking contagion.
Including a competitive banking sector expands the standard general equilibrium model with the incomplete markets model, incorporating money and default. The commercial banks are diverse and aim to maximize expected profits while adhering to specific state-dependent capital requirements. On the other hand, the non-bank private actors strive to optimize consumption based on their liquidity limitations. The occurrence of widespread defaults within the global banking industry serves as an illustration of a banking contagion.
The Banking Act of 1933 established a “fire-wall” of separation between investment banking and commercial banking in the USA. This was implemented to address the rationale behind Citicorp’s merger with Traveler Group, where they shifted their focus from traditional advisory services to proprietary trading. Citicorp believed that the changing technology, diversification, and globalization of the banking industry had led to a desire for a “one-stop” shop from both individual and corporate customers.
The Banking Act of 1933 in the United States established investment banking and commercial banking, but this changed with the Financial Service Modernization Act of 1999. This act enabled insurance companies, investment banks, and commercial banks to compete equally in various products and markets. The introduction of a “fire-wall” between investment banking and commercial banking aimed to prevent the transmission of risks, specifically concerning credit default swaps, from the investment banking sector to the commercial banking sector. The purpose of these firewalls was to protect banks from the risks associated with their securities units or investment branches. During the Great Depression, firewalls were implemented as a regulation to prevent traditional banks from making risky investments using customer deposits. Many firewalls were implemented in 1987 when bank holding companies were authorized to underwrite and deal in instruments like commercial paper, municipal bonds, and mortgage-backed securities.
The proposals aimed to weaken the 1933 Glass-Steagall Act, which provided a division between banks, securities firms, and insurance companies.
Why did the regulators weaken and phase out that ‘fire-wall of separation’ in the 1990s? The reason behind it was the revolutionization of the mortgage business, which shifted from its traditional lending methods to a global industry that involved issuing mortgages. Banks started selling mortgages to a diverse range of investors, who were keen on charging fees for underwriting.
The investment company started securitizing these mortgages, categorizing them by risk level and selling them to groups of investors. These loans were not in line with the guidelines set by Fannie Mae and Freddie Mac; they were aimed at homebuyers with lower credit scores and those who were financially disadvantaged. These loans had high interest rates, which led to increased returns for the investors, but unfortunately about 90% of these loans ended up in default. Consequently, the banking system suffered a significant loss in capital due to these non-performing loans and the decreased value of the assets.
What is the role of the major Deregulatory Acts in the meltdown of the investment banking industry?
Three crucial acts of deregulation were significant contributors to the collapse of the investment banking industry:
- The Depository Institutions Deregulatory and Monetary Control Act (DIDMCA) which preempts state usury laws DIDMCA permitted a bank to charge interest rates that were higher than the state laws allowed, but did not apply when a bank was charging a fee higher than the state laws allowed,
- The Truth in Lending Act (TILA) of 1968 is a United States federal law and designed to protect consumers in credit by requiring clear key terms of the lending arrangement and all costs.
- Not to allow banks to follow the lending guidelines, which put limitation on the banks and home buyer obtaining financing (a loan) either to purchase or secure against the property from a financial institution, such as a bank, either directly or indirectly through intermediaries. Features of mortgage loans such as the size of the loan, maturity of the loan, interest rate, method of paying off the loan, and other characteristics.
The Gramm-Leach Bliley financial services modernization Act in 1999 eliminated regulations that required insurance companies, investment banks, and commercial banks to be separate across products and markets.
He further undermined investment banking regulations by weakening controls on futures contracts and credit default swaps.
In your opinion, based on lessons from past global banking crises, what measures should regulators implement now to tackle similar future issues? These measures should include establishing resolution procedures for closing troubled financial institutions within the shadow banking system, like investment banks and hedge funds; restricting the amount of leverage that financial institutions can take on; and mandating executive compensation to be more closely linked to long-term performance.
The text calls for the reinstatement of the Glass-Steagall Act, which separated commercial and investment banking, as well as the breakup of institutions that are considered “too big to fail” in order to limit systemic risk. It also suggests regulating institutions that tend to behave like banks in a similar manner. Additionally, the text proposes that banks should have a stronger capital cushion, with regulatory capital requirements that increase as the size of the bank increases, in order to discourage them from becoming too large and to offset their competitive advantage.
Revise the Depository Institutions Deregulatory and Monetary Control Act (DIDMCA) to override state usury laws. Under DIDMCA, banks were allowed to charge interest rates exceeding state limits, but were prohibited from charging fees exceeding state limits. Mandate a minimum down payment of 10% and income verification for home mortgages. Verify that all financial institutions possess sufficient capital to meet their financial obligations.
Implement regulations that govern credit derivatives to reduce counterparty risk and ensure that they are traded on exchanges with adequate capital. Mandate financial institutions to maintain enough “contingent capital” by paying insurance premiums to the government during prosperous periods in exchange for receiving payments during a downturn. Create an early-warning system to identify systemic risk. Apply haircuts on bondholders and counterparties before utilizing taxpayer funds in bailout situations. Take control of insolvent banks through nationalization.
Federal Bailout and Public Policy
Why did the Federal Reserve rescue Bear Sterns? The Federal Reserve established a lending program worth $200 billion to alleviate the public’s apprehension regarding Wall Street. The banking crisis had commenced, and if individuals on “main street” became anxious, it could lead to a frenzied rush on banks. Therefore, in order to uphold financial stability and restore people’s trust in the banking and financial sectors, the Federal Reserve believed that a bailout was necessary.
Why did Lehman Brothers collapse while Bear Stearns did not?
When it became clear that the Bear Sterns bail-out cost American taxpayers $29 billion, the Federal Reserve had no choice but to avoid public funding and try to secure a cash infusion or an acquisition of Lehman from private equity partners. With a new president recently elected, the government assisting financial giants rather than the American public facing unemployment and foreclosures could harm the reputation of the new administration. Is the Fed’s orchestrated sale of Merrill Lynch to Bank of America the best solution to address the crisis? In this specific case, it is the best possible outcome from the global financial crisis. Bank of America had a brokerage arm that was not performing as desired. Acquiring Merrill Lynch would solidify Bank of America as a banking powerhouse and propel it to become the top bank in America. “Proposed reforms in response to the 2008 crisis are certainly far-reaching.”
The Paulson blueprint aligns with the Volcker plan in advocating for the modification or dissolution of long-standing federal government agencies, as stated by Cunningham on page 73.
Is it possible that Morgan Stanley and Goldman Sachs could have survived without becoming bank holding companies? While Goldman Sachs seemed to have a stronger market position compared to Morgan Stanley due to its cleaner balance sheet without toxic real estate loans, both firms were facing increasing financial difficulties. They needed a significant change in their business strategy in order to avoid a similar fate as Merrill Lynch and Lehman Brothers.
Becoming chartered commercial banks has allowed them to generate additional revenue through loans and attract clients to their investment banking arms. This move helps prevent potential loss of clientele to competing investment banks that can accept deposits. In your opinion, what role should the Federal Reserve play in preserving sustainability in the global banking industry and stability in securities markets? It can be argued that in a capitalist society, individuals are responsible for their own success or failure.
To put it simply, individuals are responsible for the consequences of their own actions in the financial markets, and government intervention should be avoided. Regulations exist, and it is up to executives, managers, and stockholders to demand better risk management from the companies they invest in. However, during this difficult time, both households and businesses (Main Street and Wall Street) suffered. If the Fed had not taken quick action, more harm would have been done and public trust in our markets, government, and global trading partners could have been destroyed. Panics are made worse by negative talk and pessimistic opinions of celebrity “experts.” People tend to lose sight of the bigger picture. Policymakers struggle to provide a better future vision, but by then they have lost all credibility (Caballero , pg 12).
What caused the strong public opposition to the bailout of Wall Street investment banks? Not only were Merrill Lynch, Goldman Sachs, Bear Sterns, Morgan Stanley, and other major corporations expecting bailout support from the Federal Reserve, but there were also numerous other large businesses vying for assistance during the process.
The CEO’s of Chrysler, GM, and Ford chose to fly their private corporate jets to Washington in order to request financial assistance. Additionally, the concept of “too big to fail” was invoked to support AIG and prevent it from collapsing. These actions were difficult for the average American to comprehend. According to Cunningham (pg 20), the Federal Reserve and Treasury had to employ innovative methods and legal authority to justify their decision-making and injection of liquidity into the capital markets. However, it remained unclear whether they had the necessary authority given the magnitude of their responses.
Many people were facing similar difficulties. However, instead of having the opportunity to request billions of dollars to be lent or invested in their households, they were losing their jobs or homes due to job loss or reduced work hours. These challenges, along with the abuses of Wall Street, were unacceptable to the American public, who had no one to rely on. The TARP funds provided some assistance by mailing small checks to each household. However, for many individuals, this financial aid was insufficient.
Based on this recent performance, the Federal Reserve’s response to the financial crisis can be rated. Valuable lessons were learned from this crisis which has helped the Federal Reserve formulate a strategy for future crises. The response from both the private and public sectors should serve as a reminder that there should be a clear distinction between government and business. When it comes to assisting Wall Street, the people’s welfare should not be overlooked. Nevertheless, the Federal Reserve acted promptly and appropriately under the circumstances.
Amidst bipartisan discord in Congress, there were delays that led to increased mistrust in business and investment firms. The repercussions of severe financial crises are not limited to “turbulence” but also encompass the dramatic response of economic actors to the unknown. The perceived complexity escalates rapidly and economic actors become incapable of handling risk and lose their inclination to do so. These reactions initiate a sequence of events and negative feedback loops that erode the financial stability of institutions. Ultimately, this downfall spreads to even those institutions that had maintained a relatively sound financial practice before the crisis.
According to Caballero (pg 1), the real economy can suffer devastating consequences as a result of these financial implosions.
Reference
- “The Rise and Fall of Bear Stearns”. Krishnan Dandapani. Finance Course Fall 2010.
- “Bear Stearns”. Wikipedia. http://en. wikipedia. org/wiki/Bear_Stearns “Bear Stearns Cos Inc”. New York Times. http://topics. nytimes. com/top/news/business/companies/bear_stearns_companies/index. html
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“Dissecting The Bear Stearns Hedge Fund Collapse”, Investopedia. com,
- “Why Bear Stearns collapsed”. The Week. http://theweek. com/article/index/36849/why_bear_stearns_collapsed
- “Inside the Bear Stearns Boiled Room”. Fortune. http://money. cnn. com/2009/03/02/magazines/fortune/cohan_houseofcards. fortune/ Caballero, Ricardo J. , 2010.
- “Crisis and Reform: Managing Systemic Risk. ” MIT mimeo, March. http://econ-www. mit. edu/files/5614 Cunningham, Lawrence A. and Zarine, David 2009.
- The Three or Four Approaches to Financial Regulation: A Cautionary Analysis Against Exuberance in Crisis Response” The George Washington Law Review. http://groups. law. gwu. edu/LR/ArticlePDF/78-1-Cunningham-Zaring. pdf
- Allen, Franklin and Carletti, Elena, “The Role of Liquidity in Financial Crises” (September 4, 2008 http://www. kansascityfed. org/publicat/sympos/2008/AllenandCarletti. 08. 04. 08. pdf
- Olufunmilayo B. Arewa, 2010 “Risky Business: The Credit Crisis and Failure” https://litigation-essentials. lexisnexis. com/webcd/app? ction=DocumentDisplay&crawlid=1&doctype=cite&docid=104+Nw. +U. +L. +Rev. +Colloquy+421&srctype=smi&srcid=3B15&key=61c1c2e4813af0e7d941f03f628037cf Dodd–Frank Wall Street Reform and Consumer Protection Act. (2010, November 12).
- In Wikipedia, The Free Encyclopedia. Retrieved 20:00, November 14, 2010, from http://en. wikipedia. org/w/index. php? title=Dodd%E2%80%93Frank_Wall_Street_Reform_and_Consumer_Protection_Act&oldid=396377559 Appendix Bear Stearns stocks chart for the last 12 months Bear Stearns stocks chart for the last 5 days
