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Abstract:

 The case examines how Bear Stearns, the fifth largest investment bank inthe US, faced liquidity crisis in March 2008, leading to its collapse. Itdetails the sequence of the events that led to its collapse and the

measures taken by the bank to avoid the same.

 The case covers a detailed note on the sub-prime crisis in the US and howBear Stearns incurred significant losses in its investments in mortgagebacked securities. It also examines the role of the US Fed to bail out BearStearns by helping JP Morgan Chase buy the troubled investment bank.

Issues:

» Understand the reasons that led to the subprime crisis in the US and itsimpact on financial institutions.

» Appreciate the importance of risk management in financial institutions.

» Examine the need for strict regulations for controlling OTC derivativesmarket.

» Study the drawbacks of high leverage in the investment banking business.

» Analyze the role played by the US Fed to bail out Bear Stearns.

Given the exceptional pressures on the global economy and financial system,

the damage caused by a default by Bear Stearns could have been severe andextremely difficult to contain."1

- Ben Bernanke, Federal Reserve Chairman, in April 2008.

"You get to where people can't trade with each other. If the Fed hadn't actedthis morning and Bear did default on its obligations, then that could havetriggered a very widespread panic and potentially a collapse of the financialsystem."2

- James L. Melcher, President of Balestra Capital3, in March 2008.

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Introduction

On March 17, 2008, US-based JP Morgan Chase (Morgan), a leading wholesalefinancial services firm, announced that it had entered into a deal to buy thetroubled investment bank Bear Stearns (Bear). Morgan agreed to buy Bear in a

stock swap deal where it valued Bear's share at US$ 2.52. As per theagreement, each Bear share would be swapped with 0.05473 of Morgan'sshare. The price at which Morgan announced that it would buy Bear's sharescame as a shock to financial experts as it was at a discount of over 90% toBear's closing price of US$ 30 on its previous trading session, March 14, 2008(Refer to Exhibit I for Bear's Stock Price Chart). However, on March 24, 2008,Morgan revised its bid from US$ 2.52 to US$ 10 per share as it could not getthe approval of Bear's shareholders for its previous bid.

 This deal rung the curtains down on the 85-year-old investment bank, the fifth

largest in the US and one of the major underwriters of mortgage backedsecurities.

According to the analysts, even though Bear had huge exposures to the sub-prime mortgage related securities, this was not the major reason behind itsfall.

 The trouble was actually triggered by a rumor in the market about theliquidity crisis at Bear on March 10, 2008. The rumor caught Bear'smanagement unawares and as did the significant fall in Bear's share pricedespite it having US$ 18 billion in cash reserves.

Even after Bear's CEO Alan Schwartz (Schwartz) assured the markets thatthere was no liquidity crisis in the company, the stock declined by 11% to endat US$ 62.3 on the New York Stock Exchange on March 10, 2008, its lowestlevel since March 2003.4

 The US Federal Reserve (Fed) announced that it would lend US$ 200 billion to

Wall Street banks starting from March 27, 2008. Bear's stock closed at US$

62.97 on March 11, 2008, rising by 1.1%.

 The liquidity at Bear came down to US$ 11.5 billion on March 11, 2008, as

compared to US$ 18 billion on March 10, 2008, as some of the lenders

withdrew their funds following the rumors of a liquidity crisis.

 The following day, the liquidity position of Bear increased to US$ 12.4 billion

but the stock fell by 2% to close at US$ 61.58...

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Excerpts

The Sub-Prime Crisis

After the dot com bust and the terrorist attacks in 2001, the Fed started

slashing rates aggressively to revive the US economy that was slipping intorecession. Low interest rates, with the prime rate reaching 4.5% in January2003 as against 9.05% in January 2001, led to a significant increase in thenumber of home loan borrowers...

Bear's Risky 'Hedge' Funds

Bear had been involved in the mortgage business since the early 1990s. Theinvestment bank had established a subsidiary called EMC MortgageCorporation (EMC) in 1990 which specialized in the servicing, securitizing, anddisposition of residential loans...

Rumors that Killed the Bear

On March 10, 2008, rumors of liquidity problems at Bear started making therounds. Rating agency Moody downgraded a few of the bonds issued by Bearon that day. As the rumor of the liquidity crisis at Bear gathered momentum,Bear's shares started falling sharply...

The Blame Game

Some of Bear's executives blamed short sellers for spreading rumors about

the liquidity crisis in their organization. They also blamed Alan Greenspan(Greenspan), Former Chairman of the Fed, for restricting investment banksand allowing only commercial banks to access the Fed discount window whenthe Glass-Steagall Act was repealed...

Exhibits

Exhibit I: Stock Price Chart of Bear Stearns (March 2004 - March 2009)Exhibit II: Pictorial Representation of Subprime Crisis

Exhibit III: Key Financial Details of Bear Stearns (2003 - 2007)

Exhibit IV: Unusual Trades in Derivative Instruments of Bear StearnsExhibit V: Risk Management Practices at Bear StearnsExhibit VI: Note on Value at Risk and Stress Testing

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Bear Stearns' Subprime Bath

Hit by the subprime market's collapse, investors in a highly leveraged—and losing—hedge fund find they can't get out

by Matthew Goldstein 

Investors in a 10-month-old Bear Stearns (BSC) hedge fund are learning thehard way the danger of investing in risky bonds with borrowed money. Theinvestment firm's High-Grade Structured Credit Strategies Enhanced LeverageFund, as of Apr. 30, was down a whopping 23% for the year.

 The situation is so bleak that Bear Stearns' asset management group issuspending redemptions at the onetime $642 million fund—meaning investorshave no choice but to sit on their losses. And that's got some hopping mad.

"At the end of the day, I'd like someone to be honest with me about what'sgoing on," says one investor in the hedge fund, which bet heavily on bondsbacked by subprime mortgages, or home loans to consumers with shaky credithistories. An investor in Europe, who didn't want to be identified, says he'sbeen trying to get his money out of the hedge fund since February.

No Questions

He's particularly incensed that on a June 8 conference call the fund'smanagers set up to discuss performance, Bear Stearns officials refused to field

investors' questions. "They specifically said they weren't taking anyquestions," says the investor. "They didn't want to say anything."

A Bear Stearns spokesman declined to comment. Several hedge fundmanagers also didn't respond to an e-mail request for a comment. But in a June 7 letter to investors, Bear Stearns says it's suspending redemptionsbecause the "investment manager believes the company will not havesufficient liquid assets to pay investors." Bear Stearns' asset managementgroup, led by Ralph Cioffi, took the action after investors stormed the gates,seeking to redeem about $250 million, sources say.

In barring investor redemptions, Bear Stearns is trying to buy time for thehedge fund. But there's no guarantee the fund, now down to about $500million in assets, can turn it around.

Swift Decline

In fact, things deteriorated rather quickly at the fund. The hedge fund got off to a good start, posting a cumulative 4.44% return over its first four months,

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according to a Bear Stearns investor letter. But early this year the fund'sperformance began to suffer as the market for subprime mortgages began toimplode. Coming into April, the fund was down 4% for the year.

 Then things really fell apart. In April, the hedge fund posted an 18.97%

decline, according to the June 7 letter obtained by BusinessWeek . But evenmore shocking than that big loss: only weeks earlier, the company had said itlost just 6.5% for April, according to a May 15 letter the firm sent fundinvestors. It's not clear what happened in those intervening weeks to forceBear Stearns to significantly revise upward its estimated April losses.

Bear Stearns isn't the only big investment firm with a hedge fund that ran intotrouble making bets on the subprime market. In May, UBS (UBS), the Swiss-based banking giant, announced it was shutting down its Dillon Read CapitalManagement hedge fund after incurring a $123 million loss because of itsexposure to the U.S. subprime market. The hedge fund's woes helped drag

down first-quarter profit at UBS.

The Perils of Leverage

Bear Stearns is scheduled to report second-quarter earnings on June 14, butits hedge fund troubles are not expected to weigh on the firm's results. Still,there's concern about whether the pain in the subprime market will start tocrimp profits at big Wall Street firms, which rake in fat fees from underwritingmortgage-backed bonds and generate big revenues from trading in thosesecurities. Lehman Brothers Holdings (LEH) eased some investor fears on June12 when it reported that second-quarter profit at the New York investment

house rose a healthy 27% from the year-ago quarter, to $1.25 billion.

But the trouble at Bear Stearns' hedge fund is another illustration of thedanger facing funds that rely heavily on borrowed money to make investmentbets. True to its name, the High-Grade Structured Credit Strategies EnhancedLeverage Fund made liberal use of borrowed money. People familiar with thefund say many investments were leveraged 3 to 1, meaning for every dollarinvested in a risky bond, the fund would borrow another three. Making highlyleveraged bets works well if the value of an investment rises, but it can quicklycrush a hedge fund if the investment declines in value.

 That's what happened last September to Amaranth Advisors, which lost nearly$6 billion in a single week after a highly leveraged bet on the future price of natural gas prices blew up. "While leverage is great for returns in good times,leverage also magnifies the effects of a mistake and can hurt returns," says Janet Tavakoli, a Chicago financial consultant who specializes in advisingclients on asset-backed investments

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 The losses this year are much smaller at another Bear Stearns hedge fundwhich invests in similar bonds, but doesn't use as much borrowed money. BearStearns' High-Grade Structured Credit Strategies is down about 5%, accordingto sources. Launched in October, 2003, it has enjoyed a good run. The fundhas generated annualized average returns of 12.82%, according to a Bear

Stearns investor letter. The "structured credit" fund was the model for the"enhanced leverage" fund. The marketing literature for both hedge funds saythey mainly invest in "high quality, floating rate, structured finance securities,"which includes asset-backed bonds, collateralized debt obligations (CDOs),and bank loans.

Meanwhile, the poor performance of the 10-month-old "enhanced leverage"fund is another black eye for Bear Stearns' plans to roll out an initial publicoffering for its Everquest Financial affiliate. The investment firm createdEverquest last fall, and filed documents on May 10 to sell a stake to the public(see BusinessWeek.com, 5/11/07, "Bear Stearns' Subprime IPO").

Bear Stearns' two hedge funds then sold some of their riskiest CDOinvestments to the new entity. A CDO is a sophisticated bond made up of pieces of lots of other asset-backed bonds—often bonds backed by subprimeloans. Nearly two-thirds of Everquest's portfolio of CDOs were purchased fromtwo hedge funds. In return, the hedge funds got $149 million in cash and 16million shares, valued at $400 million, in the soon-to-be public company. Buteven that largesse from the Everquest deal wasn't enough to overcome thefund's poor April showing.

Matthew Goldstein is an associate editor at BusinessWeek , covering hedge

funds and finance.