Case Study on Bear Stearns

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Abstract:
The case examines how Bear Stearns, the fifth largest investment bank in the US, faced
liquidity crisis in March 2008, leading to its collapse. It details 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 how Bear Stearns
incurred significant losses in its investments in mortgage backed securities. It also examines
the role of the US Fed to bail out Bear Stearns by helping JP Morgan Chase buy the troubled
investment bank.
Issues:
Understand the reasons that led to the subprime crisis in the US and its impact on
financial institutions.
Appreciate the importance of risk management in financial institutions.
Examine the need for strict regulations for controlling OTC derivatives market.
Study the drawbacks of high leverage in the investment banking business.
Analyze the role played by the US Fed to bail out Bear Stearns.

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Given the exceptional pressures on the global economy and financial system, the damage caused by a default
by Bear Stearns could have been severe and extremely 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 acted this morning and Bear did
default on its obligations, then that could have triggered a very widespread panic and potentially a collapse of
the financial system."2
- James L. Melcher, President of Balestra Capital3 , in March 2008.

Introduction

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On March 17, 2008, US-based JP Morgan Chase (Morgan), a leading wholesale financial services
firm, announced that it had entered into a deal to buy the troubled 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 the agreement, each Bear share would be swapped with 0.05473 of Morgan's share. The
price at which Morgan announced that it would buy Bear's shares came as a shock to financial
experts as it was at a discount of over 90% to Bear'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 get the 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 backed securities.
According to the analysts, even though Bear had huge exposures to the sub-prime mortgage
related securities, this was not the major reason behind its fall.
The trouble was actually triggered by a rumor in the market about the liquidity crisis at Bear on
March 10, 2008. The rumor caught Bear's management unawares and as did the significant fall in
Bear's share price despite it having US$ 18 billion in cash reserves.
Even after Bear's CEO Alan Schwartz (Schwartz) assured the markets that there was no liquidity
crisis in the company, the stock declined by 11% to end at US$ 62.3 on the New York Stock
Exchange on March 10, 2008, its lowest level 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...
Excerpts
The Sub-Prime Crisis
After the dot com bust and the terrorist attacks in 2001, the Fed started slashing rates aggressively
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to revive the US economy that was slipping into recession. Low interest rates, with the prime rate
reaching 4.5% in January 2003 as against 9.05% in January 2001, led to a significant increase in the
number of home loan borrowers...
Bear's Risky 'Hedge' Funds
Bear had been involved in the mortgage business since the early 1990s. The investment bank had
established a subsidiary called EMC Mortgage Corporation (EMC) in 1990 which specialized in
the servicing, securitizing, and disposition of residential loans...
Rumors that Killed the Bear
On March 10, 2008, rumors of liquidity problems at Bear started making the rounds. Rating agency
Moody downgraded a few of the bonds issued by Bear on 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 banks and allowing only commercial banks to access the Fed discount
window when the 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 Stearns
Exhibit V: Risk Management Practices at Bear Stearns
Exhibit VI: Note on Value at Risk and Stress Testing

Bear Stearns' Subprime Bath

Hit by the subprime market's collapse, investors in a highly leveragedand losinghedge
fund find they can't get out
by Matthew Goldstein

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Investors in a 10-month-old Bear Stearns (BSC) hedge fund are learning the hard way the danger of
investing in risky bonds with borrowed money. The investment firm's High-Grade Structured
Credit Strategies Enhanced Leverage Fund, as of Apr. 30, was down a whopping 23% for the year.
The situation is so bleak that Bear Stearns' asset management group is suspending redemptions at
the onetime $642 million fundmeaning investors have 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's going on," says one
investor in the hedge fund, which bet heavily on bonds backed by subprime mortgages, or home
loans to consumers with shaky credit histories. An investor in Europe, who didn't want to be
identified, says he's been 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's managers set up to discuss
performance, Bear Stearns officials refused to field investors' questions. "They specifically said they
weren't taking any questions," says the investor. "They didn't want to say anything."
A Bear Stearns spokesman declined to comment. Several hedge fund managers 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 redemptions because the "investment manager believes the company will not have
sufficient liquid assets to pay investors." Bear Stearns' asset management group, 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 the hedge fund. But there's
no guarantee the fund, now down to about $500 million 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, according to a Bear Stearns investor

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