Posted on April 8, 2008 by David Laidlaw
Bear Stearns’ largest business involved packaging mortgage-backed securities and selling those bonds to investors. Weakness in the housing market has led to defaults and huge markdowns in the value of these mortgage-backed securities. Given these issues, Bear was not able to sell these bonds to the investment community. Therefore, Bear retained toxic assets on its balance sheet. The presence of these low-quality bonds then led to a “run” on the brokerage house.
The classic “run on a bank” (as depicted in the movie It’s a Wonderful Life starring Jimmy Stewart) occurs when a bank’s depositors rush to withdraw all of their funds fearing the institution is in financial trouble. Northern Rock in England experienced this recently and the government nationalized the bank to maintain solvency. In the case of Bear Stearns, many of Bear’s multi-billion dollar hedge fund clients that used the firm as a prime broker withdrew their accounts and began conducting business with other brokers. Other banks and brokerages also refused to trade with Bear fearing that Bear would not be able to stand behind the trade.
The combination of lost trading revenues and failure of other firms to buy their short-term securities caused all of Bear’s liquidity to vanish. On March 10th, Bear Stearns had $18 billion in cash and equivalents. Three days later, on March 13th, the brokerage only had $2 billion in cash on its balance sheet.
The Federal Reserve was monitoring the situation and did not want Bear Stearns’ imminent failure to cause a financial panic which would have spread to other brokerage firms such as Lehman Brothers. Therefore, the Federal Reserve engineered JP Morgan’s acquisition of Bear Stearns.
JP Morgan agreed to stand behind all of Bear’s existing obligations. In return, the Federal Reserve provided $30 billion in financing by agreeing to swap $30 billion in US Treasuries for $30 billion in low-quality mortgage-backed securities that were held on Bear’s ledgers. JP Morgan is only assuming $1 billion in liabilities on the $30 billion package while the government (and the taxpayers) is assuming the remaining $29 billion in risk.
Subsequent to the original $2 per share price, JP Morgan increased its offer to $10 per share to acquire enough shares to ensure that it obtained shareholder approval. Bear Stearns did not go bankrupt and the unknown repercussions were avoided. The equity holders of Bear also suffered for their risky investment with investors such as Joseph Lewis losing close to $1 billion.