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LOUVAIN SCHOOL OF MANAGEMENT

LOUVAIN SCHOOL OF MANAGEMENT LLSMS2009 - RISK MANAGEMENT OF FINANCIAL INSTITUTIONS 1 CASE STUDY : TIP

LLSMS2009 - RISK MANAGEMENT OF FINANCIAL INSTITUTIONS

1 ST CASE STUDY :

TIP OF THE ICEBERG JP MORGAN BEAR STEARNS

Professor : HENRARD Luc

Students : DE BROUWER Rodolphe LOTOKO DIESE Aristote MAKANGU MPEMBELE Axel NAUWELAERTS Pierre

ACADEMIC YEAR 2016-2017

1.

INTRODUCTION

On 16 March 2008, JP Morgan, the largest bank in the United States, acquired the fifth-largest U.S. investment bank in the beginning of that year, namely Bear Stearns. The purchase, in the amount of $10 per share, has been possible thanks to significant government assistance. Indeed, the hope was to avert a far-reaching spread of damage into the larger financial world. Thus, in this paper, we are going to analyze these two companies, specially their behaviors that led tem in these difficult positions.

  • 2. HOW WOULD YOU EVALUATE THE RISK MANAGEMENT CULTURE WITHIN BEAR STEARNS ?

In 2007, Bear Stearns was one of the biggest investment banks in the world. Some specialists used to place BS second in the securities industry behind Lehman Brothers but ahead Goldman Sachs and one of the Most Admired Companies according to Fortune Magazine. Despite this very good reputation, we all saw the BS’s fall in March 2008. So, we have to ask ourselves one question: what is the origin of the fall of BS? According to the article, namely "The Tip of the Iceberg, 2009", the risk management was one of the causes. This will be developed below.

First of all, the American government represented by US. Treasury Secretary Henri Paulson, N.Y. Fed represented by the President Timothy Geitfmer and Fed Chairman Benjamin Bemanke tried to help BS by putting pressure on JP Morgan Chase to acquire BS when the price was approximately $2 per share. Thus, we can already suppose that the risk management has not been perfect.

Furthermore, if we want to understand the BS’s collapse, we have to put ourselves in the situation of 2008. Indeed, it is very easy to be critical after the facts and consequences. But if we were in the situation of former CEO Alan "Ace" Greenberg and the board in general, two trends/attitudes worried them. Firstly, they tried to take some risks in order to develop BS but, in an other hand, they bought some securities in order to secure enterprise’s capital. But, before 2008, they gave more importance into BS’s development and did not see the crisis. It was a big mistake, especially because they had highly regarded risk management skills.

“Bear's activities were financed with a mix of long term debt, equity, and financing collateralized

with securities from Bear's inventory. Bear's trading business required the investment bank to constantly hold an inventory of securities; these securities were used as collateral for short term

borrowing agreements known as repurchase agreements (repos).“(The Tip of the Iceberg, page 3,

2009).

Thus, we

have

to think like

ten years ago,

with information they had about

securities, macroeconomic environment etc. But also with the vision of Bear Stearns executives and not only with the vision we have today.

Moreover, we noticed a non-optimal strategy from Bear Stearns, because the major key of their success was fixed income compound by mortgages and mortgages-backed securities and we all know that it is not optimal for a firm to be undiversified.

“Bear's economic engine was its fixed income business. In 2005 and 2006 respectively, Bear's fixed income business contributed $3.0 billion and $3.62 billion in revenues, compared to $1.04 billion and $1.33 billion from investment banking, $S38 million and $1.38 billion from equities, $372 million and $523 million from asset management, and $261 million and $234 million from prime brokerage. Mortgages and mortgage-backed securities comprised most of the fixed income business. (The Tip of the Iceberg, page 3, 2009).

But, in August 2006, Bear Sterns executives magnified the exposure to mortgages- backed securities. Then, they saw the return’s collapse and had to find a solution as soon as possible. The solution was the IPO from Everquest, but their investors were too hungry, so the IPO was canceled and after that, BS’s losses were stronger. Here, we can notice two risks taken by BS: the first one is the exposure to mortgages and the second one was the IPO from Everquest. The idea was not bad, because the two decisions could improve the firm’s situation but, unfortunately, there was an opposite effect. It is one of the reasons we could not say their risk management was good.

“Investor appetite for Everquest was limited and IPO was canceled While the success of such an

endeavor could have temporarily sustained the Bear funds, its failure had the opposite effect. The funds' investors, spooked by the IPO's failure and by the funds' rapidly accelerating losses, began to

ask for their money back.” (The Tip of the Iceberg, page 11, 2009). In addition, the CEO Alan “Ace” Greenberg left the enterprise and Alan Schwartz, a respected investment banker, was the substitute. This time, the decision could reassure investors or improve BS’s finances, but the fall went on.

"Schwartz, however, was reluctant to unload billions of dollars’ worth of bonds at prices that seemed to be unreasonably low and possibly not reflective of their true value […] While Bear had the opportunity to take action in autumn 2007, none of these steps we’re taken." (The Tip of the Iceberg, page 12, 2009).

To conclude, the risk management was not efficient mainly because of executives greedy, they known that their management was a bit risky but they continued to manage BS in order to make more profit. So the risk management was not very good and management of executives did not work very well. Then, they were in a situation in which

there is no come back and they had to sell their enterprise to JP Morgan Chase. They

couldn’t save the investment bank anymore.

3. HOW WOULD YOU EVALUATE THE RISK MANAGEMENT CULTURE WITHIN JP MORGAN CHASE ?

In that question, we are going to understand the global management and the business of JP Morgan Chase. Once executed, we have developed relationships with the different kinds of risks 1 that we have seen in the course.

First of all, JP Morgan Chase, which is one of the oldest financial institutions in the United States, was born from multiple bank mergers. Moreover, in addition to being now a leading global financial services company, JP Morgan Chase has lots of operations all around the world. Indeed, they became a leader in financial services for consumers, asset management, investment and commercial banking and financial transaction processing.

In 2004, JP Morgan Chase acquired Bank One, recruiting in this way the president of the company, named Jamie Dimon, a charismatic financial. Immediately, Jamie had the autority to manage things on a day to day basis and began to impose his management culture on his new firm. Indeed, in order to begin the merger integration, Jamie and his team soon slashed costs, invested in infrastructure and technology and improved business processes, which is a good risk management culture against operating risks. For example, during its corporate life, JP Morgan Chase could have been experiencing an increase of its costs 2 , hence the good risk management from Jamie Dimon.

Moreover, Jamie Dimon had a particular approach concerning the access management. Indeed, he established a policy of transparency between the different parties

1 Operating risk, Financial risk and Insurance Liability risk. 2 That kind of risk is called "Business risk", which is part of Operating risk.

in the entire firm, especially in the senior team. In other words, each line and each level of business have acces to the same Executive Management Report, which is a set of market share data, risk metrics, financials results and "to do" items. In practical terms, everyone has the same information. The fact that everyone can keeping an eye on all the information is beneficial for the risk management, mainly for operational risks. Therefore, fraud, unintentional errors, man-made shocks and legal risks may be prevented or corrected. All of this is reinforced by discussions and honesty in his team collaboration because he did not rely on PowerPoint presentations. According to him, meetings between each business head allows to go immediately on what is wrong inside the company. Finally, Jamies used

the same

method with the Operating Committee.

Indeed, he keeps the same idea and specifies that heated discussions as well as mistakes were welcomed. According to him, making mistakes means they are trying hard, but he

differentiated the good and the bad ones.

Then, concerning the measures taken against the financial risks, the Dimon's financial approach were very thoughtful. Indeed, at year end 2007, JP Morgan Chase had

$1.4 trillion in financial liabilities, which were well splitted: one part as deposit, a very stable source of funding and another part came from a combination of repos and borrowings in the “federal funds” market. Moreover, the strategy chosen by Dimon and his team was to implementing a "fortress balance sheet", with liquidity and capital levels taking into account requirements maintained by major competitors in addition to regulatory

requirements. (The Tip of the Iceberg, page 6, 2009). In fact, four pillars composed that strategy: large amounts of cash capital, term financing, stress testing to update of any large and unpredictable losses, and liquidity reserves for assets. Another Jamie's requirement, concerning his risk management culture, especially against financial risks, was that each line of business had to be qualified for an "A" credit rating. Furthermore, the managers had to paid attention to use more common equity rather than preferred stock. Indeed, preferred stocks give lots of advantages as, for example, receiving fixed dividend payments, even when a company determines there are insufficient revenues, and that therefore, the common shareholders cannot receive any dividend payment. Thus, we can say that this strategy gave high priority to the use of conservative accounting within rules.

Furthermore, in 2007, just before the crisis, the mix between the attitude of transparency and sharing, and the idea of “fortress balance sheet" was quite good to face the torment preparing. Following a risk evaluation and many discussions, he took the conscientious decision to avoid some parts of the burgeoning business in CDOs and SIV.

“We got subprime mostly right because of discipline around the company risk meetings. Individual pieces of JMPC saw things happening in their slice of the pie that all added up” (The Tip of the

Iceberg, 2009).

Finally, Jamie Dimon and his team gave a high priority to execution beyond acquisitions. We can say their strategy works well. Indeed, they wait until focusing on execution kills the market and after that, they pick up leftovers. Last but not least, JP Morgan Chase benefitted of a market leadership position thanks to the finalization of Bank One's integration in the society. As a result, JP Morgan Chase has experienced a significant growth in earnings, namely $6.3 billion to $15.4 billion.

To conclude, we can say that the risk management culture of JP Morgan Chase was absolutely appropriate in the moment. Indeed, due to his strong balance sheet, which results from good risk strategy, resulting from its capital, liquidity and market strategy positions across products areas 3 , JP Morgan Chase was totally ready to fight the financial crisis and purchase assets from ailing competitors.

4. WHAT SHOULD/COULD THE TOP MANAGEMENT OF BEAR STEARNS HAVE DONE IN ORDER TO AVOID THE COLLAPSE OF THE COMPANY ?

"Paul Friedman, a former Bear Stearns executive one day said: ”Bear Stearns was the smallest of the major investment banks, and I do not believe that obtaining more long-term secured financing or making any other changes in Bear Stearns' funding strategies would have enabled the firm to overcome these unprecedented market forces or withstand the liquidity crisis that the firm experienced in March 2008". He even added during a testimony in front of the Financial Crisis Inquiry Commission that the loss of confidence was prompted by false rumors about Bear Stearns liquidity position.

Talking about what the Top Management could have done, we have to come back with the core of what the top management should do at any firms: instilling a particular corporate culture and ensuring the survival of its business model. We cannot deny that those factors have not had any effect on Bear collapse. Indeed, the culture that is set by the top management may play a role on a business success and its evolution within the competitive landscape. Bearn Stearns wasn’t the typical

3 Notice that there are more diversified that the ones of Bear Stearns.

white shoe, Ivy League style investment bank, Bear Stearns was the scrappy kid from around the block: more on the aggressive and greedy style. Bear Stearns was the renegade of Wall Street and proud of it. Such culture may foster risky behavior within the firm.

Furthermore, Bear Stearns business model was flawed from the beginning as it was too concentrated on mortgage, fixed income and short-term lending from others. This lack of diversification can bring high return but exposes you in time of bear market.

Bear also had a vulnerable capital structure. When the housing market began to collapse, all the flaws revealed. This market was built on subprime loan for less- credit worthy borrowers with high probability of default. When rating agencies started to downgrade the credit rating of securities related with mortgage-exposure, things started to go wrong. And of course, scrappy Bear has not done well enough to protect itself from such event risk.

Bear exposed itself as well to reputation risk, the management did not communicate well enough and failed to build trust. And then, Bear Stearns started having some liquidity problems, the maverick bank with his poor reputation led investors to pull assets from the firm. It would have been possible to stop that if Bear management would have communicated with the aim of transparency and reassuring its stakeholders. As we have put it, this would have built trust and given a sense of honesty from this renegade bank. Bear funding and risk model was not the best as well. The firm relied too much on short-term lending with others by putting all his egg in only one basket.

To answer the question about if the top management do something differently, we answer yes. In the events of the crisis, the lack of open communication and the willingness to go all in against the odds accelerated the collapse. The corporate culture instilled a culture of risk. A key thing that the top management could have done differently is first of all to build a solid risk model and to provide trust to his shareholders. Dodging the LTCM bailout.

5.

WHAT

WAS

THE

IMPACT

MORGAN CHASE ?

OF

THIS

ACQUISITION

ON

JP

Firstly, there were a lot of risks and opportunities for JP Morgan when they wanted to acquire Bear Stearns. The many risks that took JPMC with this acquisition explain the price they paid for it. Indeed, they only paid 1,5 billion dollars for a company that was valuated at the time at 11 billion $. JPMC was given a gift by the government, maybe a poisoned one but a gift anyway. They bought the fifth largest investment bank and its Midtown Manhattan office building worth 1.2 billion for like an eighth of its value. So the reason why JPMC paid such a little price is that they needed a big security margin to complete the merger and to act as a backstop for any transactions that was made with BS. They also had the negotiating power because the 2 only way out for BS were bankruptcy or being bought and also because the government was encouraging JPMC. With that kind of bargain, it would not be complicated to make this acquisition a profitable one.

Specialists and politicians explained that one of the biggest opportunities for JPMC was to

improve their prime brokerage business because it was one of the most important BS’s specialties. Though many of BS’s clients were fleeing just before the purchase because its

partner did not trust it anymore. So JPMC have lost several BS’s customers when they established the purchase. Then they focused on retaining clients of this division in order to make this acquisition more profitable. At that time JPMC was buying a burning house and they had to complete the acquisition as soon as possible in order to use their channel and the ones of BS to extend their businesses across Europe and Asia. Another cause for which they had to close the deal quickly was to build synergies on the common department they

had. Thanks to this acquisition and the synergies JPMC was supposed to generate nothing less than a billion $ in after-tax earnings during the 12 to 18 following months. Despite those enthusiastic previsions JPMC had to reduce its investment banking staff of around 15% in

2008.

With the acquisition of BS, JPMC exposed itself to all kind of lawsuits against the subprime

mortgage division and risks from its derivatives business from BS. In 2012 the New York’s

chief prosecutor filed civil complaint against JPMC for extensive fraud by Bear Stearns

during the sale of mortgage-back securities. Indeed Bear Stearns was one of the largest actor in the packaging and reselling of subprime mortgage-backer securities. And in this matter, one of the most active retail mortgage lenders was Washington Mutual. So JPMC took all the outstanding legal exposures by buying BS and Washington Mutuals.

Furthermore, the financial market were full of bad mortgages because BS’s analysts had not

enough time to asses the quality of mortgages. By acquiring Bs , JPMC acquired also the bad mortgages. This lack of solid due diligence put JPMC under scrutiny and after they had to pay 13 billion of settlement. In other words, the government accused JPMC and the companies it bought to discharge bad mortgages that affected the mortgage backed

securities investors and U.S. taxpayers due to their lax practices. The huge irony in this history is that the firms which were relatively clean in the pre-crisis exposed themselves and their shareholders to huge potential losses by buying off their competitors.

JPMC knew the risks it was taking when it bought those two companies. It was advised by some of the most talented lawyers on earth. So JPMC knew that it could face some lawsuits and pay huge fines. JPMC’s advisers could maybe not imagine a fine of 13 billion. Because it represented “only” 5 months of income for JPMC in 2012. It’s a huge amount of many even for JPMC, though certainly nothing approaching a death blow. It is clear that JPMC hoped for a much cheaper price for settling the cases.

In conclusion, as its CEO said “ We got some great things with Bear Stearns- some businesses, their buildings, some great people and some terrible things.

6. BIBLIOGRAPHY

  • Berstresser, D.B, Clayton, R., Lane, D. (2009). The Tip of the Iceberg: JP Morgan Chase and Bear Stearns. Cambridge: Harvard Business School Publishing.

  • Embrechts, P., Frey, R., & Mc Neil, A.J. (2005). Quantitative Risk Management: Concepts, Techniques and Tools. Princeton: Princeton University Press.

  • Henrard, L. (2016). The Risk Management of Financial Institutions. Document non publié, Université Catholique de Louvain, Louvain-la-Neuve.

ACADEMIC YEAR 2016-2017

  • Investopedia. (2014). What is the difference between preferred stock and common stock. Online http://www.investopedia.com/ask/answers/182.asp, consulted the 9 October 2016.

  • Wikipedia. (2016). JPMorgan Chase. Online https://fr.wikipedia.org/wiki/JPMorgan_Chase, consulted the 9 October 2016.

  • Wikipedia. (2016). Risque opérationnel (établissement financier). Online https://fr.wikipedia.org/wiki/Risque_op%C3%A9rationnel_(%C3%A9tablissem ent_financier), consulted the 9 October 2016.