Bear Stearns Collapse: What Happened in the 2008 Crisis

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Bear Stearns collapsed in March 2008 because it ran out of cash. The firm had loaded up on mortgage-backed securities and funded itself with short-term borrowing. When the housing market turned and confidence in those assets disappeared, lenders and clients pulled their money within days. On Sunday, March 16, 2008, JPMorgan Chase agreed to buy the 85-year-old investment bank for $2 a share. The Federal Reserve backed the deal with a guarantee of about $30 billion in mortgage-related assets. The price was later raised to $10 a share, against a stock that had traded near $170 roughly a year earlier.

What Bear Stearns was

Bear Stearns was founded in 1923 as an equity trading house. It survived the 1929 crash, went public in 1985 and by the early 2000s ranked among the largest securities firms on Wall Street. It had a reputation as a scrappy, trading-driven firm rather than a blue-chip advisory house.

Its businesses included trading, investment banking, asset management and prime brokerage, which means providing financing and clearing services to hedge funds. Bear was an early adopter of securitization, which pools loans such as mortgages into tradable bonds. It became a major underwriter and trader of mortgage-backed securities, and mortgages became central to its profits.

How the mortgage bet was built

Securitized mortgage products appeared safe as long as home prices kept rising. Struggling borrowers could refinance or sell, defaults stayed low, and the highly rated tranches of mortgage pools and CDOs paid steady income.

Bear amplified the bet in two ways:

1. Leverage. Like other investment banks, Bear held assets many times larger than its shareholder equity. With that kind of leverage, a small percentage decline in asset values can erase a large share of the firm’s capital.
2. Short-term funding. Bear financed much of its balance sheet in the repurchase (repo) market. In a repo, a firm borrows overnight or for short terms and pledges securities as collateral. The loans have to be rolled over continually, so the firm depends every day on lenders accepting its collateral.

Under that structure, a decline in the value of mortgage securities meant two things. The firm took losses, and its collateral bought it less funding, often at the moment lenders were growing nervous.

The 2007 hedge fund collapse

The first visible crack came from two hedge funds run by Bear Stearns Asset Management: the High-Grade Structured Credit Fund and the High-Grade Structured Credit Enhanced Leverage Fund. Managed by Ralph Cioffi and Matthew Tannin, they invested in CDOs and other securitized debt and borrowed heavily to increase returns.

As subprime defaults rose in early 2007, the value of these holdings fell, and lenders to the funds demanded more collateral. In June 2007 Bear committed billions of dollars of its own money to support the less leveraged fund. Both funds still collapsed and filed for bankruptcy protection at the end of July 2007, wiping out most of their investors’ capital.

At first, the damage looked manageable. Bear’s market value was around $20 billion, and the losses, although large, did not by themselves threaten the parent company. The writedowns continued through the year, however. In the fourth quarter of 2007 Bear reported its first quarterly loss in its 80-plus-year history. Rating agencies kept downgrading mortgage-backed securities, so more of Bear’s holdings became hard to sell at any reasonable price. Longtime chief executive James Cayne stepped down as CEO in January 2008 and was replaced by Alan Schwartz.

March 2008: the run on Bear Stearns

Rumors that Bear was short of liquidity spread in early March. A firm that funds itself overnight is exposed to rumors in a way a deposit-funded bank is not. Repo lenders began refusing Bear’s mortgage collateral or demanding larger haircuts. Hedge fund clients moved their cash and securities out of its prime brokerage. Trading counterparties tried to step away from derivatives contracts with Bear.

On March 11, the Fed announced the Term Securities Lending Facility, which would let dealers swap less liquid securities for Treasuries, but it was not scheduled to lend until later in the month, too late for Bear. Public reassurances from management did not stop the outflows. By March 13 Bear told regulators it could not meet its obligations the next day without help.

On Friday, March 14, the Federal Reserve Bank of New York extended emergency funding to Bear through JPMorgan Chase, since Bear was not a commercial bank and had no direct access to the Fed’s discount window. The loan was meant to buy time until the weekend. Markets read it as a sign of how desperate the situation was. Bear’s stock fell by roughly half that day and closed around $30.

JPMorgan Chase’s acquisition

Over the weekend, regulators pushed for a buyer before Asian markets opened on Monday. Bear had sought a larger Fed loan, reported at $25 billion, but it did not get one. On Sunday, March 16, JPMorgan agreed to buy Bear Stearns in a stock swap valued at about $2 a share.

The deal depended on the Fed. The New York Fed agreed to finance about $30 billion of Bear’s harder-to-value mortgage assets so that JPMorgan would not have to take them onto its own balance sheet. Those assets were placed in a special vehicle, Maiden Lane LLC. JPMorgan agreed to absorb the first $1 billion of any losses, and the Fed’s loan covered the rest of the financing. The Fed acted under Section 13(3) of the Federal Reserve Act, which allows emergency lending to non-banks in “unusual and exigent circumstances.” That same Sunday, the Fed also opened the Primary Dealer Credit Facility, giving the remaining investment banks access to emergency loans.

The $2 price angered shareholders, many of them Bear employees who held large amounts of company stock. The merger agreement was also drafted in a way that raised doubts about whether it would get shareholder approval. On March 24 the terms were amended: the price rose to about $10 a share, and JPMorgan bought newly issued shares giving it 39.5% of Bear, which made approval close to certain. The deal closed at the end of May 2008.

JPMorgan CEO Jamie Dimon later described the purchase as buying “a house on fire,” not a house. In his 2008 letter to shareholders he said the price would have been considered low under normal conditions. He also said that unwinding Bear’s trades and settling its legal liabilities cost JPMorgan billions.

What happened to shareholders and employees

Bear Stearns shareholders received JPMorgan stock worth about $10 for each Bear share. That was about a third of the $30 closing price on March 14, and a small fraction of the roughly $170 the stock had traded at a year earlier. Investors who bought near the peak lost most of their money.

Holders who kept the JPMorgan shares they received did eventually recover. According to The Wall Street Journal, the position broke even about 11 years after the deal. Shareholders arguably came out better than in a bankruptcy, which could have left them with nothing. Bear’s employees were hit twice: many lost a large part of their savings in company stock, and thousands lost their jobs in the merger.

Why it mattered: Lehman Brothers and the rest of 2008

Rescuing Bear Stearns stopped one run but did not fix the underlying problem. Other investment banks had the same combination of mortgage exposure, high leverage and short-term funding. Lehman Brothers, a major originator and securitizer of subprime and commercial real estate debt, held about $111 billion in real estate assets and securities in 2007, more than four times its shareholder equity.

Through 2008, Lehman tried to raise capital and reduce leverage, but confidence kept eroding. Talks with Bank of America and Barclays fell through, and regulators declined to provide Bear-style support. Lehman filed for bankruptcy on September 15, 2008, and that same weekend Merrill Lynch agreed to sell itself to Bank of America. Goldman Sachs and Morgan Stanley, the two remaining large independent investment banks, converted into bank holding companies that month. The Lehman Brothers collapse set off a crisis far more severe than Bear’s. Critics argued that saving Bear encouraged others to expect help, while supporters argued that letting Bear fail in March could have caused a Lehman-style panic six months earlier.

Did deregulation play a role?

Some economists connect the crisis to the 1999 Gramm-Leach-Bliley Act, which repealed parts of the Glass-Steagall Act separating commercial banking from investment banking. Supporters of that view say the change helped create large, complex firms that issued, underwrote and held the securities at the center of the crisis.

The argument applies less directly to Bear, a standalone investment bank of the kind Glass-Steagall had always allowed to underwrite securities, and one that took no deposits. A more specific criticism targets a voluntary SEC program begun in 2004 to supervise investment bank holding companies’ capital and liquidity. That oversight did not prevent the leverage and funding risks that sank Bear.

Who was held accountable

Few people faced legal consequences. Ralph Cioffi and Matthew Tannin, who ran the two failed Bear hedge funds, were indicted in 2008 on charges of misleading investors about the funds’ condition. A jury acquitted both of them in 2009.

FAQs

The Bottom Line

Bear Stearns matters to anyone studying how the 2008 crisis unfolded or weighing the risks of firms that borrow short term to hold hard-to-sell assets. Its collapse showed that high leverage and overnight funding can turn falling asset values into a run within days. The rescue stopped that run, yet the same weaknesses brought down Lehman Brothers six months later.