Bear Stearns: How the First Domino Toppled

Founded in 1923, Bear Stearns was a storied New York-based global investment bank that survived the Great Depression but collapsed during the Great Recession in 2008.

The much admired firm offered a wide range of successful financial services beyond just investment banking, including but not limited to wealth management and securities trading. In 2006, Bear Stearns hit record highs, claiming that net income had climbed 40 percent, to $2.05 billion), and revenue had risen 25 percent, to $9.23 billion.

But just a year later, revenue dropped to $5.95 billion. This dip and eventual freefall in 2008 was very much caused by securities trading, handled by Bear Stearns’ hedge fund division. JPMorgan Chase eventually bought and thus dissolved the company.

The Hedge Fund 2 and 20

A major reason for Bear Stearns collapse, as well as the mortgage crisis in general, was the ‘2 and 20.’

The 2 and 20 refers to the standard compensation structure for hedge fund managers: 2% of assets in management fees, and 20% in incentive fees on all profits. As a point of comparison, investment managers receive no cut of the profits.

The combination of the low management fees and high incentive fees motivates hedge fund managers to take big risks in order to generate as much profits as possible. That’s how they can maximize their 20% incentive fee. Their high-risk investment typically depends on leverage (using borrowed capital as a funding source) to generate adequate returns to justify the considerable fees involved in using hedge fund managers.

Leverage, all that capital Bear Stearns had borrowed, ended up bringing about its failure. Specifically, its hedge fund managers were using leverage to profit from collateralized debt obligations and other debt securities (more on this later).

Did you know AIG played a major role in the 2008 financial crisis?

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Bear Stearns’ Investment Strategy

The company’s investment strategy was neither cutting edge nor unique in the hedge fund world. In truth, it was simple enough to explain in a four-step process.

DEFINITIONS

Collateralized Debt Obligation (CDO): Debts of varying types and risk levels (a.k.a. tranches) bundled into a single package and sold to investors.

Credit Default Swap (CDS): A financial swap agreement where the seller of the CDS compensates the buyer in the event of a debt default (failure by the borrower to mee the legal requirements and/or obligations of the loan).

Mortgage-backed Security (MBS): An investment comprised of a bundle of home loans issued by banks and offered to investors. Subprime loans: Loans offered to borrowers who cannot qualify for a conventional loan because they have low credit. These loans come with high interest rates and fees.

The Process

Buy collateralized debt obligations (CDOs) that pay an interest rate exceeding the cost of borrowing. AAA-rated (the highest grade in credit rating) tranches of subprime mortgage-backed securities (MBS) were used.
Use leverage to purchase more high-interest CDOs than you can afford with capital. The more leverage used, the greater the expected return from each trade. But also the more leverage used, the greater the risk for the investment portfolio.
Purchase insurance in the form of credit default swaps (CDS) to protect against defaults in the credit market.
Subtract the price of the leverage (or debt) and CDS from the returns or ‘positive carry.’ That’s the actual profit the hedge fund manager has made.

For this to work, credit markets must either remain quite stable or behave similarly to historical trends. This strategy produces consistent positive carry under these conditions. Of course, matters drastically and quickly changed when it came to the 2008 mortgage crisis.

The Collapse of Bear Stearns

The housing bubble burst, and the home loans included in these securities plummeted in value. That means, those high-risk investments were not generating profits, which in turn caused a run on the shadow banking system. Traders in Bear Stearns’ High-Grade Structured-Credit Strategies Fund and the Enhanced Leverage Fund, in other words, began redeeming their investments en masse.

From The New York Times

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Without the profits from its high risk investments using borrowed capital, Bear Stearns did not have the capital to meet these obligations. This created a vicious circle: as prices on bonds decreased, the fund experienced losses, thus causing it to sell more bonds, further lowering the prices of the bonds, and so on and so forth.

Bear Stearns announced its first ever quarterly loss, posting $859 million in losses. Furthermore, the company reported a $1.9 billion write-down (reduction of recognized value) of its subprime mortgage holdings. Moody’s, the widely recognized bond credit rating company, downgraded Bear Stearns’ debt from A1 to A2.

As Bear Stearns fell deeper into a hole, fewer and fewer entities were willing to take on its debt. Credit rating agencies continued to downgrade its debt. Just a month after Bear Stearns had received an upper medium grade on its, Moody’s gave Bear Stearns’ mortgage-backed securities (MBS) grades of B or below. That’s a highly speculative (i.e. highly risky) or ‘junk bond’ status. By March 13, Bear Stearns was penniless, and its stocks practically worthless.

On March 16, JPMorgan Chase announced it would purchase Bear Stearns at $2 per share using money loaned to them by the Federal Reserve. JPMorgan Chase ended up having $19 billion in fines and settlements against Bear Stearns and Washington Mutual, another bank they acquired.

Investigations into Bear Stearns Management

On June 19, 2008, the Securities and Exchange Commission (SEC) announced in a press release that it had charged the managers of the two hedge funds of fraud. The SEC alleged, “Ralph R. Cioffi and Matthew M. Tannin deceived their own investors and certain institutional counterparties about the funds’ growing troubles until they collapsed and caused investor losses of approximately $1.8 billion.”

The SEC accused the pair of two major deceptions:

“Cioffi misrepresented the funds’ April 2007 monthly performance by releasing insufficiently qualified estimates — based only on a subset of the funds’ portfolios — that projected essentially flat returns. Final returns released several weeks later revealed actual April losses of 5.09 percent for the High-Grade Structured Credit Strategies Fund and 18.97 percent for the High-Grade Structured Credit Strategies Enhanced Leverage Fund.”
“Monthly written performance summaries highlighted direct subprime exposure as typically about 6 to 8 percent of each fund’s portfolio. However, after the funds had collapsed, the BSAM sales force was ultimately told that total subprime exposure — direct and indirect — was approximately 60 percent.”

Cioffi and Tannin settled the case for $1.05 million, without admitting or denying the SEC’s complaint.

The Impact of Bear Stearns’ Collapse

The collapse of Bear Stearns marked the first of many collapses on Wall Street, sending the global economy spiraling downward to near destruction. Many have yet to fully recover from the monetary and emotional damages left by high-risk securities trading.

According to The Washington Post, Americans lost $9.8 trillion in wealth. And while you might think the executives lost truck loads of cash, research has shown that the top executive team from Bear Stearns came out with $1.4 billion, due to much success particularly from CDOs during 2000-2008.

Does that sound fair to you? And does that sound familiar to you?

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Beyond Bear Stearns…

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