Liquidity Risk management: Bear Stearns Liquidity crisis Case Study: The Liquidity Run cycle
When property values began to plummet in 2006-2007, subprime mortgage payers defaulted on their payments which initiated a chain reaction whereby there was a significant drop in the cash inflows from these mortgages which would have been used to pay off the obligations on the derivate instruments. With the decline in property value and the subsequent impact on mortgage payments the values of the mortgage backed derivative instruments also fell as investors tried to liquidate their positions in these instruments in a relatively illiquid market.
Bear Stearns Case Study: The beginning of the Name crisis
On 14th June 2007 Bears Stearns reported a decline of 10% in profits for the second quarter over the previous quarter’s profits to $486 million. On 18th June 2007 Merrill Lynch seized the $850 million of the collateral comprising of thinly traded CDOs, of one of hedge funds that were heavily invested in subprime mortgages due to increased margin calls and failure of payment of debt obligations by the hedge fund because of the depressed value and illiquid market of its assets. When Merrill Lynch went to liquidate these derivates, they were only able to do so fractionally (only $100 million worth could be auctioned) and that too at marked-down values because of the lack of market liquidity for these instruments.
This led to Bear Stearns pledging $3.2 billion in secured loans to bail out one of its subprime hedge funds, Bear Stearns High-Grade Structured Credit Fund on 22 June 2007 together with negotiating loans with other banks against its collateral to bail out another hedge fund, Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund. This was done in order to counter what the failure of these hedge funds would do to its reputation as well as how the asset values could be impacted if the collateral continued to be sold in the illiquid and depressed market.
On 17th July 2007 as a result of the continually declining value of the subprime mortgages and the resulting fall is asset values of the derivative securities, Bear Stearns revealed to its clients that the hedge funds had lost all or almost all of their value. Investors in the two hedge funds sued Bear Stearns for the collapse of the funds and sought arbitration claims saying that the bank had misled them about its exposure to these funds. In response the funds filed for bankruptcy protection on 1st August 2007 and the company froze the assets of a third fund. The amount lost was around $1.6 billion.
The co-president and the person responsible for the management of these funds, Warren Spector, who was much touted to succeed Bear Stearns chief executive James Cayne resigned on 5th August 2007 following the collapse of the funds. On August 6th, the bank reassured clients by letter that the company was financially sound with the necessary experience and expertise to deal with challenging markets. On 17th August 2007 Bear Stearns cut 240 jobs from the loan origination units of the bank.
On 20th September 2007, the bank reported a drop of 61% in profits for the quarter to $171 million. In early October 2007 Bear Stearns CEO and president informed the public that most of its businesses were beginning to recover. It cut an additional 300 jobs. On 22 October 2007, it received an injection into its funding when it entered a share-swap deal with CITIC, China’s largest state-owned securities firm. Under the deal CITIC would pay Bear Stearns $1 billion for a 6% share in it with an option to buy a further 3.9% of the investment bank and in return Bear Stearns would eventually pay a similar amount for a 2% share in CITIC.
On November 14 2007 its CFO Molinaro reported that it would write down its assets and book a 4th quarter loss. This resulted in a ratings downgraded by S&P 500 from A+ to A stating that the outlook was negative. End November 2007 it released news that it planned to further reduce its global workforce by 4% or 650 jobs. Early December 2007 Joe Lewis an influential shareholder increased his share in Bear Stearns on grounds that he believed the banks shares to be undervalued and that the bank was on its way to recovery.
The bank registered its first loss in its 85-year history in the 4th quarter of 2007 amounting to $854 million due to a write down of $1.9 billion of the value of its holdings of mortgage assets. Barclays bank sued Bear Stearns for allegedly misleading them about the performance of the two collapsed hedge funds which were pledged as collateral against a $400 million loan granted to Bear’s asset management division.
Top employees of the company said they’d skip their bonuses but they including the CEO Cayne sold their company’s stock together worth over $20 million in December 2007. James Cayne resigned as CEO in early January 2008 though remained as the bank’s non-executive chairman with a remaining 5% share in the bank. Moody’s Investors Service downgraded the ratings of 46 tranches issued by Bear Stearns in 2006 (including 24 to junk status) and an additional 11 tranches of Alt-A deals issued in 2007 were also place under review for possible down based on higher than expected rates of default and foreclosure.
Due to the news of the quarter’s losses, sales of stock by the top employees and downgrades of its derivative securities including a more general concern that the US economy would slip into a recession, Bears Stearns share price fell drastically by more than 20%. As a result of this fall it was reported in mid-February 2008 that CITIC the Chinese state owned lender had begun to renegotiate their share-swap agreement with the bank.
On March 7 2008, the Carlyle Capital Corporation, a hedge fund had suffered because of the subprime crisis had received substantial margin calls and default notices from its lenders. Due to this it had its shares suspended in Amsterdam. As the Carlyle Group was founded by Bear Stearns which also had a 15% shareholding in the Carlyle Capital Corporation many investors and clients viewed Bear Stearns as been heavily exposed to it. This fueled concerns regarding whether or not the investment bank had sufficient cash/ funds to do business. The cost of insuring $10 million worth of Bear Stearns credit default swap debt went from $ 350,000 to over $ 1 million. Borrowing costs for Bear Stearns began to rise sharply.
In response to this Bear issued a press release on 10th March 2008 stating that there were no grounds for any rumors regarding their lack of liquidity saying that it has $17 billion in cash. However, the fact that a public announcement has been made was read as a signal by many Wall Street experts, that the bank was in trouble. There were also reports that a major bank had refused to lend to Bear via a repo transaction a short term loan of $2 billion and therefore rumors persisted that the bank was losing confidence among its creditors.
On 11th March Bear continued to reassure it customers and investors that nothing was wrong with its liquidity position with CFO Molinaro announcing on CNBC that the rumors were false. However on the same day Goldman Sach’s credit derivative group told its clients via email that it would no longer step in on their behalf to executive derivative deals with Bear Stearns. Other banks too refused to provide further credit protection against Bear Stearns debt.
On 12th March 2008 the CEO Alan Schwartz made gave a televised assurance to investors that there was no liquidity crisis and that the first quarter of 2008 would likely turn a profit for the bank. However when the news regarding the Gold Sach’s email leaked into the market many more hedge funds and clients began withdrawing their funds from the bank. Banks were backing out of providing credit and Bear Stearns credit lines were dramatically reduced. Hedge funds, mutual funds and capital management companies stopped using Bear Stearns’ brokerage service for executing their trades.
On 13th March 2008 the Carlyle Capital Corporation hedge fund collapsed which resulted in a fall in the Bear Stearns share price of 17%. The CEO publicly continued to maintain that all was well and that the collapse of the hedge fund and subsequent fall in share value had not weakened the bank’s balance sheet. However liquidity had now dropped to $2 billion. Schwartz approached JP Morgan to negotiate a rescue package. In the meantime the bank contacted a major client to encourage them to publicly express their confidence in Bear. The client declined.
On 14th March 2008 Bear Stearns confirmed the news that they had secured short term funding amounting to $30 billion from JP Morgan, the clearing agent for its collateral, in order to stabilize its position, strengthen its liquidity and meet the demands of its lenders. The collateral pledged would be backed by the Federal Reserve Bank of New York against the risk of its decline. However this funding was not sufficient to quell fears by investors regarding Bear Stearns financial stability and share prices fell by more than 40% on the news. S&P and Moody’s slashed ratings on the bank to just above junk status with a warning that further downgrades were possible.
On 16th March 2008 JP Morgan announced that it had acquired Bear Stearns for $2 per share. By March 24th 2008 the offer was raised to $10 per share in order to appease Bear Stearns shareholders. This was eventually approved by them.
Also see: An alternate approach for calculating Economic Capital using accounting data – a case study using publicly available data from Goldman, Citi, JP Morgan, Wells Fargo and Barclays Bank PLC.