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.
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.
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.
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 Societe Generale nvested $125 million and Lehman Brothers and Paribas did the same thing with $100 million. The only bank that refused the join the syndicate was Bear Stearns. In the Bear Stearns case, the sudden collapse of the firm and the impossibility to calculate the risk of taking Bear’s mortgage holdings forced the Federal Reserve to be involved actively into the bailout instead of the “advisory” role it took in the LTCM case 10 years earlier.
What could Bear Stearns have done differently to avoid this fate?
In the early 2000’s, after the Federal Reserve dropped the interest rate and raised the money supply trying to control the crisis produced by 9/11 terrorist attacks, the firm’s directors should have been more disciplined with the financial strategies, especially the ones related with hedge funds who made poor quality investments. Furthermore, the failure to evaluate the risk, to diversify the portfolio, and to control the use of high leveraging was driven by the need to justify the enormous fees they charged for their services and to obtain the potential payoff of getting 20% of profits. In summer 2007, the 2 hedge funds ran by Ralph R. Cioffi, which had been heavily investing in mortgage securities in spite of the rumblings about the weakness of the subprime mortgage market in the spring of the same year, collapsed and filed for bankruptcy. The firm did not take any actions immediately arguing that lenders from Merrill Lynch and JP Morgan Chase did not understand Cioffi’s Fund operation. The issue that Bear refused to use any of its own money to save the funds and the default of a lot of money in collateral, caused the anger of JP Morgan head of investment banking and the lost of the firm’s reputation trough Wall Street financial institutions.
The firm survived the liquidity challenge after took some actions, but the seed that would cause the collapse of the institution a few months later had been planted. Bear Stearns Board of Directors had been on permanent meeting since Monday, March 10, 2008, trying to find more equity or make any alliance to prevent the total collapse of the company. Instead, they tried to convince the general public that the rumors about the liquidity crisis were false and the firm was making money and paying its counterparties while all its clients were trying to get they money back.
When they tried to find an emergency exit at the end of the week, it was too late and they had to accept the humiliating offer from JP Morgan Chase. They forgot that in a business based on confidence, when that confidence evaporates, so does the business.
Liquidity Crisis and Business Model of Investment Banks:
What is the role of liquidity for banking and investment banking firms? The term liquidity is used in many different ways. Liquidity is the ability to buy financial assets and real goods and services immediately. The most liquid asset is cash.
Current and deposit accounts and assets such as Treasury Bills are also very liquid. In Normal times banks provide liquidity to the economy and funding for credit-worthy businesses and individuals. These activities are crucial for a well functioning economy. Commercial Banks allow consumers to deposit funds that they can withdraw when they have liquidity needs. This liquidity provision allows banks to accumulate funds that they can use to lend to firms to fund long-term investments. Banks must manage their liquidity so that they can meet the liquidity needs of their depositors.
At any given date its customers may have more or less liquidity needs. Holding liquidity is costly because less liquid assets usually have higher returns. In order for providers of liquidity to markets to be compensated for this opportunity cost, they must on occasion be able to make a profit by buying up assets at prices below fundamentals. (Allen and Carletti, 2008)
Is perception of liquidity more important for a banking/investment banking firm than manufacturing firm? Why? A liquidity crisis occurs when a company does not have access to enough cash to make payments to creditors as the payment come due in the near future.
In normal times a strong company (one whose market value of assets exceeds the amount owed to creditors) can usually borrow money in the short-term credit markets to meet the urgent liquidity needs. Thus, a liquidity crisis usually does not trigger a bankruptcy. The market perception of liquidity is more important for an investment bank than it is for a traditional manufacturing or distribution business. In order to understand why market perception of liquidity is more important for an investment bank than a traditional business, we need to nderstand how these two businesses operate. Investment banks do not raise money from retail depositors; their source of funding is long-term debt, equity and the interbank markets. The assets on the bank’s balance sheet are generally more long-term. The disparity between assets and liabilities makes it very important that the assets the banks hold on their balance sheet are very liquid. This was main reason behind the collapse of many banks in the financial crisis as most of them were being funded in the interbank market and were holding illiquid mortgage backed securities.
This had a contagion on the financial markets and slowly the crisis extended to the real economy, as banks were not able to provide funding to businesses On the other hand, a traditional manufacturing business would generally be funded by long-term debt or equity and consequently they do not face liquidity issues as long as they have steady cash flows from business operations. Even in the case of a collapse of such businesses, it would not have the same contagion effect as in the case of a bank.
What could Bear Stearns have done to address its liquidity concerns, which initiated the run of the bank?
Bear Stearns should have followed best practices with respect to compensation and bonuses based on performance in which compensation rewards take account of risks, particularly for traders whose activities entail significant risk exposure. Reframing risk that requires greater limitations on leverage and more comprehensive internal company risk management, with both external regulatory monitoring and more robust internal efforts. 2. 4 Looking back, what lessons can we infer from Bear Stearns’s failure regarding the business model of investment banks?
The 2008 financial crisis was the direct product of a supply-driven bubble in which asset-backed securitization failed. In the US, this failure seems attributable in large measure to two under-recognized causes: (1) disproportionate dependence on a gatekeeper—the credit rating agency—which became increasingly subject to client pressure as competition increased in its market; and (2) a change in the direction of more self-regulatory rules that permitted US investment banks to increase leverage and reduce diversification under the demands of competition.
The policy lesson seems clear: competition is not a substitute for regulation, and the case for prudential regulatory supervision of financial institutions becomes stronger. Financial services industry should also be required to disclose their internal risk management strategies in detail, as well as the configuration between compensation and risk, in order to comply with obligatory disclosures in risk disclosure. All regulated and unregulated firms should also be required to immediately report all material incidents that reflect a failure of risk controls or risk management to a market stability regulator.
External regulation can be used to promote development of internal risk management in the financial industry. (Olufunmilayo, 2010)
Looking forward is the concept of “pure –play” investment banks sustainable? The ranks of the pure-play investment banks, financial institutions with no commercial banking operations, are quickly declining. There is a growing sense that it will be harder for investment banks to make the kind of money that had been made in the past. Business may be less robust as investors burned by the real estate securities created by Wall Street will seek a less-risky approach to making money.
After the collapse of Lehman Bros. and the purchase of Merrill Lynch by Bank of America, some analysts say pure-play investment banks that have been on the top of Wall Street’s power pyramid may be nearly over. Only two major investment banks are left: Goldman Sachs and Morgan Stanley. Still, the emerging powerhouses are commercial banks that have taken over ex-Wall Street titans damaged by the credit crunch. We assume the new model will be Bank of America and Merrill Lynch, and JPMorgan Chase’s marriage to Bear Stearns.
A shift is underway towards a more conservative approach to running financial companies.
Systemic Banking Crisis and Regulation
What Is a “Systemic Banking Crisis”?
A systemic banking crisis is one where all or almost all of the banking capital in a country is wiped out. Our clear understanding of a systemic banking crisis is when country’s corporate and financial sectors experience a large number of defaults and financial institutions and corporations face great difficulties repaying contracts on time.
As a result, non-performing loans increase sharply and all or most of the aggregate banking system capital is exhausted. This situation may be accompanied by depressed asset prices as seeing in the US economic today, i. e. , equity and real estate prices. In such cases, the crisis will cause depositor runs on banks with a general realization that systemically the financial institutions are in distress.
What is “Banking Contagion”?
Banking contagion refers to the spread of risky behavior that infected the global banking system stemming from real estate collapse around the globe.
Incorporating a competitive banking sector extends the standard general equilibrium with the incomplete markets model with money and default. Commercial banks are heterogeneous and are assumed to maximize expected profits subject to bank-specific state-dependent capital requirements. The non-bank private actors maximize utility of consumption subject to liquidity constraints. The spread of substantial defaults across the global banking industry is an example of a banking contagion.
What was the rationale for the creation of ‘fire-wall’ of separation between investment banking and commercial banking in USA that was institutionalized by the Banking Act of 1933? The rationale for the creation of ‘fire-wall’ of separation between investment banking and commercial, was when Citicorp made the largest corporate merger with Traveler Group, shift away from traditional advisory services to proprietary trading. Citicorp believed that with the change in technological, diversification, globalizing of the banking industry, that both individual and corporate customers desire for a “one-stop” shop.
The investment banking and commercial banking in USA that was institutionalized by the Banking Act of 1933 was overturn by the Financial Service Modernization Act 1999, permitting insurance companies, investment banks, and commercial banks to compete on equal footing across product and markets. The creation of ‘fire-wall’ of separation between investment banking and commercial banking was a means of at least stopping the banking contagion or infection of the credit default swap from the investment banking sector to the commercial anking sector. Firewalls were intended for the purpose of insulating banks from the risks incurred by their securities unit or investment branch. Firewalls were instituted during the depression as a regulation for keeping traditional banking from making risky investments with deposits from its customers. Most of the firewalls were adopted in a 1987 order authorizing bank holding companies to underwrite and deal in instruments such as commercial paper, municipal bonds or mortgage-backed securities.
The proposals were intended to water down the 1933 Glass-Steagall Act, which separated banks from securities firms and insurance companies.
Why did the regulators weaken and phase out that ‘fire-wall of separation’ in 1990s? The regulators weaken and phased out that “fire-wall of separation’ in the 1990s because mortgage business was revolutionized from its traditionally ways of lending to a global industry way of issuing mortgages. Banks began to sell mortgages to varied group of investors. These investors were fervent in charging fees for underwriting.
Then investment began securitizing these mortgages based on risk factor and sold them to investor groups. These loans did not meet Fannie Mae and Freddie Mac guidelines, they were geared toward the riskier homebuyer with poor credit histories and the poor. They carried high interest rates, increases to the investor returns and a default to about 90% of the loans. As a result for these non-performing loans accompanied by depressed asset prices all or most of the aggregate banking system capital is worn out.
Identify the major Deregulatory Acts and its role in the meltdown of the investment banking industry?
Three major deregulatory acts that play a role in the meltdown of the investment banking industry are:
- 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.
Gramm-Leach Bliley financial services modernization Act in 1999, which removed regulations on separation across products and markets by insurance companies, investment and commercial banks.
He act further weakened investment banking regulations by weakening regulatory controls on futures contract and credit default swaps.
In your opinion, based on lessons from past global banking crisis, what steps should regulators institute now to address similar future problems? Establish resolution procedures for closing troubled financial institutions in the shadow banking system, such as investment banks and hedge funds. Restrict the leverage that financial institutions can assume. Require executive compensation to be more related to long-term performance.
Re-instate the separation of commercial (depository) and investment banking established by the Glass-Steagall Act in 1933 and repealed in 1999 by the Gramm-Leach-Bliley Act. Break-up institutions that are “too big to fail” to limit systemic risk. Regulate institutions that “act like banks ” similarly to banks. Banks should have a stronger capital cushion, with graduated regulatory capital requirements (i. e. , capital ratios that increase with bank size), to “discourage them from becoming too big and to offset their competitive advantage.
Revisit 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, and not allow banks to charge a fee higher than the state laws allowed. Require minimum down payments for home mortgages of at least 10% and income verification. Ensure any financial institution has the necessary capital to support its financial commitments.
Regulate credit derivatives and ensure they are traded on well-capitalized exchanges to limit counterparty risk. Require financial institutions to maintain sufficient “contingent capital” (i. e. , pay insurance premiums to the government during boom periods, in exchange for payments during a downturn. Establish an early-warning system to help detect systemic risk. Impose haircuts on bondholders and counterparties prior to using taxpayer money in bailouts. Nationalize insolvent banks.
Federal Bailout and Public Policy
Why did the Federal Reserve bail-out Bear Sterns? The Federal Reserve’s $200 billion lending program was created to calm the public’s fear about Wall Street. The banking crisis had begun and “main street” concern would cause a panic run on banking institutions. As such, the Federal Reserve felt that in the best interest of maintaining financial stability and regaining banking and financial confidence from the public, a bail-out would do exactly that.
Why was Lehman Brothers allowed to collapse while Bear Stearns was not?
When it became evident that the Bear Sterns bail-out came at the expense of American taxpayers in the amount of $29 billion, the Federal Reserve had no choice other than to not provide public funding and attempt to facilitate a cash infusion or an acquisition of Lehman from private equity partners. A new president had just been voted into office and the public perception of government continuing to assist financial giants instead of the American public facing job loss and foreclosures could be detrimental to the standing of the new office. . Is the Fed orchestrated sale of Merrill Lynch to Bank of America the optimal solution for addressing the crisis? In this particular case, this is the best outcome that could have arisen from the global financial crisis. Bank of America had a brokerage arm, which while not floundering it was not performing as desired. The addition of Merrill Lynch would further encapsulate Bank of America as a banking giant and catapult it to the position of number one bank in America. “Proposed reforms in light of the 2008 crisis are certainly sweeping.
The Paulson blueprint calls for the alteration or disbandment of federal governmental agencies that have been around for a century, and the Volcker plan echoes those calls” (Cunningham, pg 73).
Could Morgan Stanley and Goldman Sachs have survived with out becoming bank holding companies? Goldman Sachs appeared to have a better market position than Morgan Stanley as its balance sheet was not filled with toxic real estate loans; however, both firms were in deepening financial trouble and would require a dramatic change in business as to avoid the fate of Merrill Lynch and Lehman Brothers.
By becoming chartered commercial banks, the deposits they would take would now provide for additional revenues through the process of loans and would bring in clientele to their investment banking arms that otherwise would have possibly gone to a competing investment bank who could take deposits. In your view, what public policy role should the Federal Reserve play in maintaining sustainability in global banking and stability securities markets? It can be argued that in a capitalist state, you go on your on merit or peril.
In other words, you earn your own rewards or demise and there should not be any government assistance or interference into the financial markets. Regulations exist and it should be the responsibility of the executives, managers and stockholders to demand better risk management from the firms they invest in. However, this was a trying time and both households and businesses (Main Street and Wall Street) were both in sufferance. Had the Fed not acted quickly, more damage would have occurred and public confidence in our markets, our government and our trading partners worldwide could have crumbled us. Panics are exacerbated by the negative chatter and apocalyptic views of celebrity “experts. ” Somehow, people cease to be able to see much beyond their own noses. Policymakers struggle to outline a better future but by then they have lost all credibility”(Caballero , pg 12).
Why was there such public out-cry against the bailout of Wall Street investment banks? Throughout the process of the Federal Reserve either planning bail-outs of Merrill Lynch, Goldman Sachs, Bear Sterns, Morgan Stanley, etc. , there were even more big business with their hands out.
The CEO’s of automotive giants of Chrysler, GM and Ford decided to fly their private corporate jets to Washington to ask for handouts. Furthermore, the “too big too fail” rationale was just introduced to assist AIG to stay afloat. This type of activity was way too much for the common folk of the United States to understand. “The Fed and Treasury’s dealmaking and injection of liquidity into capital markets forced both to resort to the novel use of legal authority to justify their actions. And, given the scale of responses, it was never clear that either had that authority” (Cunningham, pg 20).
Many were experiencing the same difficulties, except instead of having the opportunity of being able to request billions of dollars to be lent or invested into their households, they were being terminated at their current place of employment, or they were losing their homes because of the inability to pay due to job loss or cut in work hours. These realities, coupled with the abuses of Wall Street, were unsatisfactory to the American public, which had no one to lean on. TARP funds allowed for small checks to be mailed to each household to assist, but for many, this was a drop in a bottomless bucket.
Based on this recent performance how would you rate the Federal Reserve’s response to financial crisis? Much was learned from this financial crisis and the Federal Reserve now has a blueprint of what to do in the future. The response of both the private and public sectors should serve as the constant reminder that there should be separation between government and business. Big government is not the choice of the people when it comes to helping Wall Street if the people aren’t being helped. Otherwise, the Federal Reserve acted appropriately in as fast a fashion as it could.
Bipartisan bickering in Congress resulted in delays that caused further distrust in business and investment firms. “Severe financial crises not only involve ‘turbulence’ but also the dramatic reaction of economic agents to the unknown. Perceived complexity builds up quickly and economic agents lose their ability, and hence their appetite, to handle risk. These reactions trigger a chain of events and perverse feedback? loops that quickly disintegrate the balance sheets of financial institutions, eventually dragging down even those institutions that followed a relatively healthy financial lifestyle prior to the crisis.
The consequences of these financial implosions for the real economy can be devastating” (Caballero, pg 1).
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- “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