Bear Stearns: Its Collapse and Bailout
How a Bank That Survived the Depression Started the Great Recession
Bear Stearns was an investment bank that survived the Great Depression only to succumb to the Great Recession. Founded in 1923, it became the fifth-largest investment bank by 2008. In 2006, it produced a record $9.23 billion in revenue. By 2007, that had fallen to $5.95 billion.
The well-respected firm offered a variety of successful financial services, including investment banking, brokerage services, and securities trading. The one that led to its downfall was its hedge fund business that dealt in securitizing mortgages. That caused its demise in March 2008, signaling the start of the 2008 financial crisis.
How it Started
The trouble began in May 2007, when two Bear Stearns hedge funds saw the value of their assets plummet. Traders in the two funds began redeeming their investments. The funds, High-Grade Structured-Credit Strategies Fund and the Enhanced Leverage Fund, couldn't meet these obligations.
On June 7, Bear Stearns froze redemptions by investors in those funds, and it lent one of the funds $1.6 billion. Bank of America guaranteed $4 billion of the funds' loans. On June 20, Merrill Lynch sold off some of its holdings in the two funds. On July 31, both hedge funds declared bankruptcy.
In October 2007, Bear Stearns entered a partnership with CITIC Securities Co. of China to get an injection of much-needed cash.
In November 2007, the Wall Street Journal published an article criticizing Bear's CEO, James Cayne. It accused Cayne of playing bridge and smoking pot instead of focusing on saving the company. The article further damaged Bear Stearns’ reputation.
On December 20, 2007, Bear Stearns announced its first-ever loss.
Bear Stearns lost $859 million for the fourth quarter and announced a $2 billion write-down of its subprime mortgage holdings. Moody's downgraded its debt from A1 to A2.
In January 2008, Moody's downgraded Bear's mortgage-backed securities (MBS) to B or below, which is junk bond status. As a result, Bear had trouble raising enough capital to stay afloat. Bear's CEO, James Cayne, resigned and Alan Schwartz took over.
The Federal Bailout
On Monday, March 10, 2008, many of Bear's trading partners decided to stop trading with the bank. That put Bear in a bind, as it had only $18 billion in cash reserves.
On March 11, 2008, Moody's downgraded Bear's MBS to B and C levels. The two events triggered an old-fashioned bank run, and its clients pulled out their deposits and investments.
By March 13, Bear Stearns' only had $2 billion left in cash. How did that happen so quickly? Bear hemorrhaged cash when the other banks called in their repurchase agreements and refused to lend more. No one wanted to get stuck with the Bear's junk securities.
Like many other Wall Street banks, Bear relied on short-term loans called repurchase agreements. In a repurchase agreement, a dealer trades its securities to other banks for cash. When the repurchase agreement ends, the banks reverse the transaction and the lender earns a quick and easy 2%-3% premium.
Bear's CEO realized it didn't have enough cash to open for business on March 14. He asked Bear's bank, JP Morgan Chase, for a $25 billion overnight loan. Chase CEO Jamie Dimon needed more time to research Bear's real value before committing. He asked the New York Federal Reserve bank to guarantee the loan so Bear could open on Friday.
Without the Fed's intervention, Bear Stearns' bankruptcy could have spread to other banks. These included money market funds used by small businesses.
At 9:15 a.m. on March 14, the Fed's Board held an emergency meeting. It approved a loan through its discount window to Chase to pass through to Bear. The amount was limited to Bear's collateral and Chase could default on the loan if Bear did not have enough assets to pay it off.
The Fed used its Section 13(3) lending authority to bail out Bear. It allows the Fed to lend to any private entity with sufficient capital, but it cannot buy a company's stock or guarantee its assets. The Fed had last used this authority to save banks during the Great Depression.
On March 16, Chase announced it would purchase Bear for $236 million. It purchased Bear for $2 a share, its closing price on March 15. It was a steep decline from the $170 share price that Bear stock had fetched a year earlier.
The Fed's March 14 loan to Chase was repaid on March 17. The Fed Board met on March 16 to approve a $30 billion loan to Chase in return for Bear's assets. The Fed would be able to sell the assets at a higher value in several years, once the market had improved.
On June 19, 2008, the Securities and Exchange Commission charged the managers of the two hedge funds of fraud. The two managers, Ralph Cioffi and Matthew Tannin, lied about how badly the funds were doing. They didn't tell investors that the Enhanced Leverage Fund was down 18.97% in April 2007. Instead, they said returns were even with March.
They also lied about how much of the funds were exposed to subprime mortgages. They said only 6%-8% of the funds' portfolio was subprime loans. Instead, it was 60%.
Impact of Bear Stearns' Collapse
Bear's demise started a panic on Wall Street. Banks realized that no one knew where all the bad debt was buried within the portfolios of some of the most respected names in the business. This caused a banking liquidity crisis, in which banks became unwilling to lend to each other.
Chase CEO Jamie Dimon regrets buying both Bear Stearns and another failed bank, Washington Mutual. Both cost Chase $13 billion in legal fees. Winding up Bear's failed trades cost Chase another $4 billion. Investors lost confidence as Chase took on Bear's sketchy assets. That depressed Chase's stock price for at least seven years.