Why Did The Fed Bailout Bear Stearns?
Amid the impact of the global financial crisis and recession from 2007 through 2009, thousands of financial service companies suffered considerable operational shrinkage and many fell into bankruptcy.
Before the Great Financial Crisis, Bear Stearns was one of the largest securities trading and brokerage firms, was the first domino to fall in the recession. On June 22, 2007, Bear Stearns pledged a collateralized loan of up to 3.2 billion, bailing out the Bear Stearns High-Grade Structured Credit Fund. Furthermore, in the week of July 16, 2007, Bear Stearns revealed that their two subprime hedge funds had lost nearly all of their values.
In addition, on August 1, 2007, investors of the two funds took action against Bear Stearns to ask their money back from the security. Then during January of 2008 the ratings firm Moody’s downgraded the mortgage-backed securities (MBS) of Bear Stearns to B or below. Moreover, a junk bond status. And then, as a result, Bear Stearns had trouble raising enough capital to remain in business. Their CEO, James Cayne became forced to resign and his deputy Alan Schwartz would take the reins. However, Schwartz’s attempts to save the firm would prove futile.
And on March 14, 2008, the Federal Reserve Bank of New York would agree to offer a $25 billion loan to Bear Stearns. Furthermore, th loan would become collateralized by the remaining assets of Bear Stearns that still held value to inject needed liquidity. Lastly, on March 16, 2008, JP Morgan bought Bear Stearns for $2 USD per share with a guarantee of $30 billion in mortgages from the Federal Reserve.
What is the origin of the crisis?
The Financial crisis is caused by the less constraints on the auditing of consumers from the bank. The story begins in 2001. In 2001, the financial crisis lasted eight months. The Fed Funds Rate dropped to 1.75%, reaching as low as 1% by the end of 2003, while the unemployment rate climbed to 6% in June 2003 by the effect of the financial crises as shown in FIG 1.
FIG 1: Unemployment rate in the year 1999-2006 (Top), and End of Year Fed Funds Rate from 1999-2008 (Bottom).
President George W. Bush was in the spot and revealed a series of policies of tax cuts to inspire the economy. This act lowered the interest rate of mortgages and had been the culprit for the blooming of house prices before 2007. However, the lowered interest rate may not explain the house price increases or said there are other reasons behind it. By the research of Jack Favilukis, house prices are highly fluctuated as the financial constraints change, but not the real interest rate; aggregate business cycle risk and economy wide shifts in financing constraints arouse the housing risk premium fluctuates where most likely the house prices lower following the relaxation of constraints.
By contrast, low and declining interest rates around 2003 played trivial roles in spawning the house prices as the foreign flows generated an endogenous offsetting increase in the house risk premium. As a result, the average house price increased from about 100K USD at the beginning of 2000 to about 140K USD at the beginning of 2007, and the household mortgages-to-GDP ratio increased from 0.45 to 0.74 as shown in FIG 2. In addition, more and more people join and loan money to purchase houses.
FIG 2: Real House Price (Left) and Household Mortgages-To-GDP ratio (Right) Plot. Furthermore, FHFA stands for all transaction house price index from the Federal Housing and Financing Agency.
As the house prices continued to rise after 2003, people were in a frenzy to speculate in real estate. In addition, some people began to borrow money to join the agitation. Furthermore, commercial banks sold the mortgages to investment banks and hedge funds like Bear Stearns and Lehman Brothers. Investment banks and hedge funds sold their mortgage-backed securities which bundled the similar mortgages weighted on distinct factors to their investors. Even if the borrower cannot afford the payment of the house, other mortgages still generated money for securities which let the security seem fruitful from a risk-neutral perspective.
Moody’s Corporation, a credit rating firm, rated this security as A2. To secure the plan, investors also found large insurance firms like AIG to secure the plan. Formerly, this model works considerably profitable. This security supported Bear Stearns to grow on benefit chronically as shown in Bear Stearns’ income statement:
Table 1: Bear Stearns’ Income Statement at 2005:
At first, banks still discreetly verified the credit of consumers. However, enduring growth of business forced banks to take less constraints to the consumers. The less constraints rooted the house prices to further promotion. In 2006, the bubble rose to its peak. House prices were not affordable for people and prices began to fall.
Moreover, the falling of house prices spurred up a chain reaction.
Many insurance firms and other financial service firms also bought the securities. Then, the loss from one security caused the loss of other securities which triggered the Financial Crises.
The fall of Bear Stearns
The trouble began in 2007. In addition, the two hedge funds of Bear Stearns, High-Grade Structured-Credit Strategies Fund and the Enhanced Leverage Fund, could not meet its obligations. As described in the previous part, the house prices began falling in 2006. The securities started to get hit. “The securities shall be risk-neutral but two hedge funds raise over high leverage,” said the Commission Chairman Phil Angelides.
Bear Stearns seemed to have an extraordinary level of risk involving high leverage, a concentration in mortgaged-backed securities and short-term funding of its operations. By the end of 2007, Bear Stearns was leveraged 38-to-one, when measured in terms of tangible assets versus tangible common equity.
The high leverage rate declares the knell of Bear Stearns.
One month before the collapse of Bear Stearns, deficient or undocumented loans totalled $12.5 billion, which is more than the total assets of Bear Stearns.
Furthermore, the two hedge funds were twinned with the loan’s maelstrom early on, as revealed by Alan C. Gleensberg(Bear’s former Chairman & CEO who built the firm from a market capitalization of $100m into the billions before his retirement in 2001), neither of those hedge funds came before the executive committee when they started to sink. The snowball began to grow but nobody in the bank had foreseen the crisis nearby.
The great success of Bear Stearns in the previous years had carried everyone in the bank away from the destination. The markets had already acknowledged the signs of crisis. By the study of Fabio Saracco across the years 1995 to 2010, the early warning signs were the economics emerging sweeps all around the world. The report reveals global economics’ shrinking at the end of 2006. Bear Stearns still have the chance to detect the signs standing by the vision of 2021. In the annual report of Bear Stearns in 2006, Bear had already brought out the credit risk discussion that the firm had already been exposed to and prepared to monitor.
But the crisis accelerated beyond the forecasting of the bank.
In the 2007 Q1 report of Bear Stearns, the committee began to stop business of the securities. But the crisis came like a Tornado, and smashed Bear. At the end of July 2007, the loss of security grew larger than the total of Bear Stearns’ Assets. The business empire of Bear Stearns tumbled down.
In conclusion, the research on the postmortem examination of the bankruptcy of Bear Stearns gave a characteristic example of how everyone in the story made the correct decision to destroy the market. Many companies are still using the same logic and even the same strategies momentarily such as Lukkin Coffey and Ant Financial Service Group. Lastly, the lesson of the Financial Crisis in 2008 and the bankruptcy of Bear Stearns may guide us to smooth through the latent risk.
Why Did The Fed Bailout Bear Stearns? Written by Ang Li
Why Did The Fed Bailout Bear Stearns? Edited by Jack Argiro, Calvin Ma, Jimei Shen, Jay Devon & Lika Mikhelashvili
References for Why Did The Fed Bailout Bear Stearns?
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Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended November 30, 2005. (2005, November 5). SECURITIES AND EXCHANGE COMMISSION. https://www.sec.gov/Archives/edgar/data/777001/000116923206000651/d66710_10-k.htm
Causes of the 2008 Global Financial Crisis. (2021, May 7). The Balance. https://www.thebalance.com/what-caused-2008-global-financial-crisis-3306176
Contributor, M. (2019, April 26). Mistakes made at Bear Stearns. Marketplace. https://www.marketplace.org/2010/06/01/mistakes
How George Bush Affected the Economy. (2021, April 24). The Balance. https://www.thebalance.com/bush-administration-economic-policies-3305556
Why Did The Fed Bailout Bear Stearns?
J.Favilukis, S.C.Ludvigson, S.V.Nieuwerburgh. (2017, February). The Macroeconomic Effects of Housing Wealth, Housing Finance, and Limited Risk Sharing in General Equilibrium. The University of Chicago Press Journals. https://www.journals.uchicago.edu/doi/10.1086/689606#_i37
Jobs And Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). (2021, January 1). Investopedia. https://www.investopedia.com/terms/j/jgtrra.asp
Lawder, D. R. Y. (2010, May 6). Bear Stearns’ Cayne concedes leverage was too high. U.S. https://www.reuters.com/article/us-financial-regulation-bearstearns-idUSTRE64420N20100505
Saracco, F. (2016, July 27). Detecting early signs of the 2007â2008 crisis in world trade. Scientific Reports. https://www.nature.com/articles/srep30286?error=cookies_not_supported&code=45a3440f-72eb-4443-b4c3-e52d9cfe8931
What caused the last housing boom? (2015, February 27). World Economic Forum. https://www.weforum.org/agenda/2015/02/what-caused-the-last-housing-boom/
Why Did The Fed Bailout Bear Stearns?