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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. 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 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 subprime 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 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 leveraged and losinghedge fund find they can't get out by Matthew Goldstein 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 letter. But early this year the fund's performance began to suffer as the market for subprime mortgages began to implode. 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 even more shocking than that big loss: only weeks earlier, the company had said it lost just 6.5% for April, according to a May 15 letter the firm sent fund investors. It's not clear what happened in those intervening weeks to force Bear Stearns to significantly revise upward its estimated April losses. Bear Stearns isn't the only big investment firm with a hedge fund that ran into trouble making bets on the subprime market. In May, UBS (UBS), the Swissbased banking giant, announced it was shutting down its Dillon Read Capital Management hedge fund after incurring a $123 million loss because of its exposure 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, but its 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 to crimp profits at big Wall Street firms, which rake in fat fees from underwriting mortgage-backed bonds and generate big revenues from trading in those securities. Lehman Brothers Holdings (LEH) eased some investor fears on June 12 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 the danger facing funds that rely heavily on borrowed money to make investment bets. True to its name, the High-Grade Structured Credit Strategies Enhanced Leverage Fund made liberal use of borrowed money. People familiar with the fund say many investments were leveraged 3 to 1, meaning for every dollar invested in a risky bond, the fund would borrow another three. Making highly leveraged bets works well if the value of an investment rises, but it can quickly crush 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 advising clients on asset-backed investments

The losses this year are much smaller at another Bear Stearns hedge fund which invests in similar bonds, but doesn't use as much borrowed money. Bear Stearns' High-Grade Structured Credit Strategies is down about 5%, according to sources. Launched in October, 2003, it has enjoyed a good run. The fund has 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 say they 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 public offering for its Everquest Financial affiliate. The investment firm created Everquest 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 CDO investments to the new entity. A CDO is a sophisticated bond made up of pieces of lots of other asset-backed bondsoften bonds backed by subprime loans. Nearly two-thirds of Everquest's portfolio of CDOs were purchased from two hedge funds. In return, the hedge funds got $149 million in cash and 16 million shares, valued at $400 million, in the soon-to-be public company. But even that largesse from the Everquest deal wasn't enough to overcome the fund's poor April showing. Matthew Goldstein is an associate editor at BusinessWeek, covering hedge funds and finance.