Mar 16, 2008 - Bear Stearns Collapses

We last wrote about Bear Stearns during its hedge fund debacle in June 2007. Click here. Just prior to that time, its stock was trading above $160. Unfortunately for Bear Stearns customers, investors and 13,000 employees, that wake-up call was not heeded.

Jimmy Cayne, CEO for 15 years, was pressured to step down in January. That was shortly after Stan O'Neal was removed from Merrill Lynch and Charles Prince exited Citigroup.

As March 2008 opened, Bear Stearns was the fifth largest investment banking firm in the U.S. and its stock was trading at $65. Jim Cramer was still bullish in this hilarious classic.

Bear Stearns was heavily involved in securitizing subprime mortgages and asset-backed securities. It had accumulated of $50 billion of mortgage backed securities. As losses mounted in the subprime market and as mortgage-backed securities were declining in value, Bear Stearns actually increased its position in these instruments and expanded its leverage.

On the evening of March 10, the Federal Reserve held an emergency conference call to consider options for supporting the financial markets. The chilling transcript shows that William Dudley was very blunt on the call: "There were rumors today that Bear Stearns was having funding difficulties." The following morning, it announced a $200 billion term securities lending facility along with increases in reciprocal swap lines with the European Central Bank and the Swiss National Bank. The plan was to provide overwhelming support which would then calm the markets.

That same day, Moody's downgraded Bear's MBS to B and C levels. Investors began to recognize the extent of the problems. Clients withdrew their cash, investors stopped buying commercial paper and banks demanded more collateral. This left Bear Stearns without sufficient cash to operate. A run ensued during the week of March which depleted Bear Sterns of its entire $18B in cash reserves.

By Thursday Mar 13, Bear's situation was dire. JP Morgan turned down a request for a $30B credit line. Bear then notified the SEC that it would be "unable to operate normally on Friday". That trigged a late night series of called between Bear CEO Alan Schwartz, JP Morgan CEO Jamie Dimon, NY Fed President Tim Geithner and Treasury Secretary Hank Paulson. Ultimately, by the opening of the market on Friday, the Fed had arranged as $12.9B loan to Bear channeled through JP Morgan.

The loan quickly proved inadequate within hours. After the market closed, Paulson and Geithner informed Schwartz that Bear needed to find a buyer before Asian markets opened on Sunday evening.

However, the markets were not fooled and heard just one message: "Bear Stearns is in real trouble and the central bankers are scared". The hemorrhaging of Bear Stearns began in earnest.

Ultimately, over the weekend of March 15-16, 2008 the New York Fed arranged and underwrote the bailout of Bear Stearns through a sale to JPMorgan.

As part of this rescue, the New York Fed extended a $30 billion, 10-year credit, backed by Bear Stearns’ assets. It also agreed to indemnify JP Morgan against certain losses. JP Morgan would be responsible for only $1.15B of the load. The Fed, citing "unusual and Exigent circumstances", incredibly would absorb the rest - $28.85B. (Too bad Bank of America didn't negotiate that well when it bailed out Countrywide!) JP Morgan agreed to pay $2.00 per share but raised that price to $10.00 at closing.

The headline in a March 17 Wall Street Journal article by Robin Sidel told the story: "J.P. Morgan Buys Bear in Fire Sale, As Fed Widens Credit to Avert Crisis. Ailing Firm Sold For Just $2 a Share In U.S.-Backed Deal"

The multiple levels of moral hazard created by this arrangement, most likely broadened and deepened the extent of the crisis. Significantly, this bailout reinforced market expectation that the Fed would bail out other large, troubled firms; this expectation was particularly germane to the Lehman Brothers situation. Treasury Secretary Paulson told the FCIC "Could you just imagine the me we would have had?" And "You would have Lehman going . . . almost immediately." Well, we had that mess and more.

The Financial Crisis Inquiry Commission placed blame at the Securities and Exchange Commission.

"The Commission concludes the failure of Bear Stearns and its resulting government-assisted rescue were caused by its exposure to risky mortgage assets, its reliance on short-term funding, and its high leverage. These were a result of weak corporate governance and risk management. Its executive and employee compensation system was based largely on return on equity, creating incentives to use excessive leverage and to focus on short-term gains such as annual growth goals.?

Bear experienced runs by repo lenders, hedge fund customers, and derivatives counterparties and was rescued by a government-assisted purchase by JP Morgan because the government considered it too interconnected to fail. Bear’s failure was in part a result of inadequate supervision by the Securities and Exchange Commission, which did not restrict its risky activities and which allowed undue leverage and insufficient liquidity."

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