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What Went Wrong

What Went Wrong

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Published by Neeraj Kumar Ojha

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Published by: Neeraj Kumar Ojha on Feb 28, 2010
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April 2008Avant Garde:Monthly e-Newsletter of IIT Kanpur
What went wrong with Bear Stearns?
Neeraj Kumar OjhaThe month of March, 2008 saw some important happenings on Wall Street. On March 16
Wall Streetwas on the brink of systemic collapse when Bear Stearns, America’s fifth largest investment bank,averted the catastrophe of a bank failure. Thanks to Federal Reserve which rewrote its rule-book torescue Bear Stearns by lending $30 billion to the cash-strapped investment bank. The Fed alsoarranged a deal in which JPMorgan Chase agreed to buy Bear Stearns for $236m. Bear Stearn’sswanky headquarters alone is worth six times the value for which it was sold in the fire sale. Its sharevalue has plunged to $2 per share from $170 a year ago. The story doesn’t stop here. All the other biginvestment banks are under intense funding pressure. Merrill Lynch, which had to swallow enormousmortgage-related write-downs, is seen by some as vulnerable. Lehman Brothers, the fourth-largestWall Street bank, is also deep in mortgage-backed securities. By one estimate, banks will write off afurther $50 billion of degraded inventory this quarter.So what went wrong with Bear Stearns that it collapsed with a speed and severity no one could haveever imagined? For the critics of modern finance, it was nothing but the consequence of the laissez-faire philosophy which allows financial services to innovate and spread almost unchecked. Bankersand fund managers, guided by their short term gains of large salaries and bonuses, never thoughtabout the long term consequences of designing and developing complex financial instruments. Bear Stearns was exposed to the toxic mortgage market. It had been in trouble since two of its hedge fundscollapsed last summer. Regulators were frustrated that the bank was not working hard as compared toits peers to manage its funding. The worst came when its clients withdrew $17 billion in two days before the collapse. Bear Stearns’ mix of businesses was less diverse and it relied more heavily onovernight funding in repurchase (repo) markets. In repo market, dealers sell securities to investors andthen buy them back the next day for slightly more, with the difference being the interest. This vastmarket has come under strain in recent weeks and as doubts grew, Bear Stearns was in effect shut out.When banks are threatened with insolvency, it is often the government, with the deepest pockets of all, which makes good their losses. This time the Federal Reserve has put $30 billion of public moneyat risk to avoid crisis from spreading in the market. Bear Stearns is not a very big bank if it ismeasured by its asset value. But it is very active in the credit-default swaps (CDS) market. It iscounterparty to some $10 trillion of over-the-counter swap options. A CDS enables its buyer toseparate the risk of default from a bond's other features, such as its interest rate. Like insuranceagainst fire or theft, it protects investors against the risk of default. Now, if a big counterparty likeBear Stearns goes bust, the contracts (of which it is counterparty) would no longer be honoured and

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