Mike Crowley

Profesor Sam Lee

2/21/21

FNCE 125

Individual Submission: Bear Stearns

As the new president of Bear Stearns, I am here to address​ the board of directors, all

members of top management, and major shareholders and creditors of Bear, regarding​ the

situation we are in and possible solutions to the problems our business lines are facing.

Bear Stearns main business lines:

Bear Stearns operating business lines consist of three main sectors: 1) Capital Markets, 2)

Global Clearing Services, and 3) Wealth Management. Included in Capital Markets are

brokerage services, market-making, proprietary trading in both equities and fixed income, and

Bear Stearns primary economic driver prior to 2007 being our fixed income business. Also

included in Capital Markets is investment banking services such as securities assurance and

advice on mergers and acquisitions. Bear Stearns Global Clearing Services business line consists

of our prime brokerage business where Bear provides trade execution, security clearing, custody,

and lending to hedge funds and broker-dealers. Lastly, Bear Stearns Wealth Management

business line includes their private client services group which serves high net worth individuals

and Bear Stearns Asset Management (BSAM), which manages hedge funds and other vehicles

for investment.
Bear Stearns Economic Engines: Contributions to revenue from 2004 to 2007 (in $ millions)

Above, the business lines are laid out and reveal annual revenue for Bear Stearns, with

fixed income being the largest contributor. Fixed Income up until this year has the largest

percentage of revenues compared to other lines and sublines. Fixed Income in 2004 made up

37% of Bear’s revenue and 25% in 2006. To assist Bear Stearns in their acquisition of mortgage

backed securities, Bear owned EMC Mortgages which was one of the most aggressive

originators. Bear is able to sell mortgaged backed securities to investors and then use that cash

to lend to prospective homeowners. From 2004 to 2007 Bear Stearns has been the leading

underwriter for mortgage-backed securities. The subprime mortgage backed securities that make

up our main source of income are known as Collateralized Debt Obligations (CDO) because they

pay an interest rate over the cost of borrowing.

In years past mortgage backed securities were considered a safe investment and had

strong credit ratings. Bear Stearns also seemed to face very little risk because we make our
profits mostly from fees for the services we offer as a percentage of the transaction price we can

avoid risk of owning securities.

The external shock and it’s direct effects on Bear’s business lines:

Housing prices in the United States appreciated drastically from 1998 to 2006. Subprime

mortgages were increasing in popularity as they allow less creditworthy borrowers easier access

to mortgage finance. From 2001 to 2005 the origination from subprime mortgages went from

$190 billion to $625 billion. 72% of the subprime mortgages were hybrid “adjustable rate

mortgages” (ARM) where the introductory rate was even lower than what a prime borrower

would receive. Then after 3 years at this rate, the teaser period would end and the loan rates

reset regularly. After the housing market peaked in 2005 it became clear by 2007 that default

and delinquency rates on subprime mortgages were increasing rapidly. We have begun facing

the effects of the reduced value of mortgage backed securities, as the credit ratings of numerous

securities plummets and investors are no longer interested in purchasing or holding our

securities. Income has steeply decreased from the sale of CDO’s Mortgage underwriting

business is no longer profitable. Many of our business lines are not directly affected by the shock

because they are separate from the housing market and mortgage backed securities however our

underwriting business collapsed.

Investors that held these securities faced the consequences of the illiquid trading market

and had to seek bids from the original commercial and investment banks (like Bear Stearns)

including those that bundled and sold these mortgaged backed securities. The banks lower the

price of these securities which led to greater uncertainty of their fundamental value. Through
this process Bear has been acquiring large inventories of these securities as investors rush to get

rid of their positions while the prices are manipulated downward. Bear has increased proprietary

trading and has placed the risk of these securities within the company. Bear has been able to

finance the buying back of securities by using short term repos with other firms. This is bringing

Bear down a dangerous path of having too much of our assets locked up in illiquid securities.

Another direct effect of the external shock felt by Bear occurred last month when two

hedge funds managed by Bear Stearns Asset Management collapsed. These hedge funds had to

file for bankruptcy because they had large inventories of mortgage backed securities financed

with leverage. When those securities reduced in value and demand along with our failure with

the Everquest IPO, investor confidence in our securities continued to decrease.

What is Bear Stearns' situation currently (Aug 2, 2007), and what poses the biggest threat?

What steps should Bear Stearns take to avert this potential threat?

As a company, Bear Stearns has continued to finance our company through overnight

repurchase agreements. US Government securities for example pose no threat because we can

turn and sell them anytime we need to liquidate our finances, but repos with money locked up in

mortgage backed securities pose the greatest potential threat to our company. We are risking the

further creation of a maturity mismatch linked between overnight repo collateralized by

mortgage backed securities that we are unable to sell instantaneously. We need to get ahead of

this issue before more speculation and dismay occurs regarding our securities and our repo

lenders potentially back out and refuse to resign our contracts. If this occurred, we would be left

with illiquid securities on our balance sheet possibly resulting in bankruptcy which would
negatively impact other business lines that aren’t even related to the issue at hand as investors

pull funding. A solution to this problem is to refinance these mortgaged backed security repo

agreements to have a later maturity date so that the market has time to stabilize along with our

securities. If we continue buying back our own securities as we believe they are undervalued we

need to finance them with the appropriate maturity even if it is more expensive. Another option

is to find a strategic partner to potentially undergo a merger acquisition. This would ideally help

eliminate the excess leverage currently held by Bear Stearns and bring extra liquidity to help free

up more assets. No matter what we decide to do we need to act quickly as our inaction can

have catastrophic consequences on multiple markets and the economy as a whole