1/31/2011

Bear Stearns and the Seeds of its Demise

Overview

• The Fall of Bear Stearns: A Time Line

• Background: A Simplified Structure of CDO
• What Forces Contributed to the Collapse of Bear’s Two Hedge
Funds?
• How Serious Were Bear’s Credit Problem?
• What Could Bear Stearns Have Done Differently to Address
the Credit Problem?

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The Fall of Bear Stearns

The Collapse of Bear’s Two Hedge Funds

• Early 2007: Fund performance started to deteriorate due to the

loss from CDO investment.
– Instead of reducing exposure, the Enhanced fund added to its bullish
bets by taking on even higher leverage.
– By the end of April 2007, the fund was down 23% year-to-date.
• Early June: liquidity dried up and margin calls piled up
• June 14: requested a 12-month freeze on new margin calls.
– Merrill Lynch and JP Morgan rejected the request.
• June 25: Bear loaned $3.2 billion to the funds – too late!
• July 31: filed for bankruptcy
– Valued at $1.6 billion at the end of 2006

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Deteriorating Investor Confidence

• Early August: CEO Cayne and CFO Molinaro held a

conference call to reassure investors.
– Increased maturity of the firm’s financing
– Strong cash holding of $11.4 billion
– No large exposures to mortgage-backed securities
• At odds with nearly $50 billion in MBS
• Mainly financed with overnight repos

• The meeting spurred investors’ fears rather than reassuring.

– Driving the broader market and Bear’s shares down
• A few days later, Warren Spector (copresident and COO)
resigned.
– Blamed for lax oversight of Bear’s hedge funds.

Additional Steps to Bolster Investor Confidence

• Sep 20, 2007: Bear announced a $2.5 billion share repurchase

– Signaling management’s belief that its shares were undervalued.
• Oct 5, 2007: Bear held a presentation to update investors on
the state of the firm.
– ―Things are getting better and liquidity had improved‖
– Bear ―would weather the storm and come out a stronger, more
diversified and a greater organization‖
– No plan for an equity infusion but would consider a strategic
partnership.
• Announced a joint venture with China’s CITIC Securities

• Same month: Bear laid off 300 employees to reduce costs.

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A Bleeding Bear

• Dec 20, 2007: Bear reported the first loss in its 84-year history.
– Quarterly loss: -$854 million of net income or -$6.90 per share
• Asset write-down:
– Wrote off $1.9 billion of losses on its loan portfolio
• Credit rating downgrade:
– Standard & Poor’s lowered Bear’s long-term senior debt from A+ to A
– Bear’s CDSs jumped from 108 bps to 176 bps.
• The executive committee decided to forgo bonuses.

Death Trigger Pulled

• Early March 2008: Credit spreads between agency bonds (issued by

Freddie Mac and Fannie Mae) started to widen again.
– Large exposure to agency bonds on its own.
– One of the creditors of a failed hedge fund (Carlyle Capital) that heavily
invested in agency bonds.
• March 11, 2008: Fed announced $200 billion Term Securities
Lending Facility.
– Allowing investment banks to swap agency and mortgage-related bonds for
treasury bonds for 28 days.
– Market interpreted this as a sign that Fed knew that some investment banks
were in trouble.
– Naturally, they pointed to the smallest, most leveraged investment bank
with large mortgage exposure: Bear Stearns.

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Death Trigger Pulled

• March 12, 2008: The media falsely released that Goldman

Sachs refused to enter a contractual relationship with Bear
Stearns.
– Contributed to the run on Bear by its hedge fund clients and other
counterparties.
– Bear’s liquidity situation worsened dramatically on the next day and
was suddenly unable to borrow from the repo market.
• Over the weekend, New York Fed helped broker a deal.
– JP Morgan would acquire Bear for $2 per share – later increased to $10.
• On Sunday night, Fed cut the discount rate from 3.5% to
3.25% and (for the first time) opened the discount window to
investment banks.

Background: A Simplified Structure of CDO

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Basics

• A Collateralized Debt Obligation (CDO) is a diversified set of

similar financial instruments where credit risk is allocated
differently among the various tranches making up the CDO.
• Underlying financial assets:
– Asset-backed securities
– Corporate bonds
– Bank loans
– Emerging market bonds
– Credit default swaps
– …

Creation of CDOs

• Step 1: Origination
– The lending bank (originator) extends loans to borrowers to finance the
purchases of certain assets and then pools these loans into a portfolio.
• E.g., a loan portfolio of subprime mortgages
– The loan portfolios are assets underlying the securitization process.
• Step 2: Transfer
– The originator transfer the assets to another legal entity: ―Special
Purpose Vehicle‖ (SPV)
– Through a ―true sale‖ of assets to the SPV
– Necessary for legal reasons:
• In case of defaults, CDO investors will possess the assets (collateral) and NOT hold
the originator responsible for repayment.

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Creation of CDOs

• Step 3: Distribution
– The SPV issues debt securities using the pooled assets as collateral.
– The securities are broken into different tranches – each with different
credit ratings and different interest rates
• Senior tranche: AAA
• Mezzanine tranche:
• Equity tranche: residual claim
– absorbing the eventual losses caused by a default of the underlying assets and receiving payments only
after all other tranches have been paid.

– The originator typically retains the equity tranche as a means of

aligning its interests with investors.

Creation of CDOs

Origination Transfer Distribution

Senior Notes
Originator SPV
Investors
Mezzanine
Notes
Loan Portfolio Loan Portfolio
Equities Originator

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The Magic Behind

Turning Junk Bonds into AAA Securities

• The default risk is not eliminated, but only redistributed across

the various tranches.
– Investors can participate in the profitability of the underlying assets at
the desired risk level.
• Consider a CDO collateralized on a pool of corporate loans:
– Even during economic recession, a given percentage of companies in
the pool will avoid financial distress and will pay down debts.
• A given % of the loan pool can be considered at very low risk → AAA rating
– In more favorable economic condition, a larger % of companies in the
pool will be able to pay down debts.
• A given % of the loan pool can be considered at low or reasonable risk → A rating
– …

Complexity of CDOs

• Each tranche has a default rate determined by the rating

agencies – could be problematic!
• CDOs are not fully standardized.
• To value different CDO tranches, a hedge fund manager must
– Set up a credit risk mathematical model;
– Simulate cash flows;
– Monitor the CDO Manager’s activity over time;
– Have a good understanding of the intricacies of CDOs.

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Complexity of CDOs: An Example

• HVB Asset Management Asia (HVBAM) has brought to market the first ever hybrid
collateralized debt obligation (CDO) managed by an Asian collateral manager. The deal, on
which HVB Asia (formerly known as HypoVereinsbank Asia) acted as lead manager and
underwriter, is backed by120 million of asset-backed securitization bonds and 880 million of
credit default swaps... Under the structure of the transaction, Artemus Strategic Asian Credit
Fund Limited—a special purpose vehicle registered in the Cayman Islands—issued 200
million of bonds to purchase the 120 million of cash bonds and deposit 80 million into the
guaranteed investment contract, provided by AIG Financial Products. In addition, the issuer
enters into credit default swap agreements with three counterparties (BNP Paribas, Deutsche
Bank and JPMorgan) with a notional value of 880 million. On each interest payment date, the
issuer, after payments of certain senior fees and expenses and the super senior swap premium,
will use the remaining interest collections from the GIC accounts, the cash ABS bonds, the
hedge agreements, and the CDS premiums from the CDS to pay investors in the CDO
transaction... The transaction was split into five tranches, including an unrated 20 million
junior piece to be retained by HVBAM. The 127 million of A-class notes have triple-A ratings
from Fitch, Moody’s and S&P, the 20 million B-notes were rated AA/Aa2/AA, the 20 million
C bonds were rated A/A2/A, while the 13 million of D notes have ratings of BBB/Baa2 and
BBB.

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What Forces Contributed to the Collapse of

Bear’s Two Hedge Funds?

Investment Strategies

• Step 1: Raised capital from investors and used it to buy CDOs

backed by AAA-rated subprime MBSs.

• Step 2: Leveraged up by borrowing from short-term repo

markets.

• Step 3: Purchased credit default swaps (CDSs) as insurance

against the risk of falling collateral values.

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Source of Return: Carried Interest

• Carried interest:
– Spread between the return on CDOs and the short-term borrowing costs
• Since its Oct 2003 inception, the High-Grade Fund benefited
from the low interest rate environment.
• The use of leverage further magnified the positive carried
interest.
• Annual return to investors between 10% to 12% till late 2006.

The Music Ends

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Declining Spreads

2003 2004 2005 2006 2007

CDO Return 7.70 7.30 7.50 8.40 8.60
Borrowing Cost: 1.37 2.19 4.09 5.35 5.17
LIBOR
Insurance Cost: 0.30 0.36 0.30 0.23 0.79
BSC 5-year swap rates
Carry 6.03 4.75 3.11 2.82 2.64

Ineffective Hedge

• In late 2006 and early 2007, the Bear funds had purchased
large amounts of CDOs, hedged by shorting the ABX index.
– ABX index was tied to subprime loans with various ratings.
• Until March, the loss in CDO value was largely offset by the
gain in short ABX positions.
• In March, the ABX index started to stabilize and the Enhanced
Fund was squeezed on two fronts:
– Falling CDO value
– ABX positions no longer making money

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Death Spiral: Leverage and Asset Illiquidity

• Through Jan 2007, the Bear funds had reported consistently

positive returns, yet by July, they were bankrupt.
• Three reasons contributing to such sudden death
– High leverage magnified the losses.
• Jan 2007: 17.2X ($699 million capital vs. $12 billion CDO investments)
• Feb 2007: 22.5X ($667 million capital vs. $15 billion CDO investments)
– Highly illiquid nature of CDOs
• In 2006, about 70% of assets were based on ―fair value‖.
• Determined by ―marking-to-model‖ as opposed to ―marking-to-market‖
• The majority of fund assets were valued based on managers’ own estimates.
– Strict borrowing terms.
• Failure to meet the margin call by liquidating assets allowed the creditors to
repossess their collateral quickly.

How Serious were Bear’s Credit Problems?

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Large Exposure to Mortgage-related Securities

• Contrary to management’s denial, Bear had an increasingly

large exposure to mortgage-related securities. (Exhibit 9)
– $46 billion in 2007 vs. $39.8 billion in 2006
– The majority of these securities were based on ―fair value‖.
• Bear Stearns had been very active in the securitization
activities.
– In addition to purchasing CDOs from other institutions, Bear created its
own CDO products.
– In 2006 and 2007, Bear retained an increasingly larger interest in these
securitizations.

Bear Stearn’s Securitization Activities

2007 2006
Total Securitizations 121.1 96.8
Retained Interests
AAA rated 5.1 3.0
Other Investment Grade 1.6 1.3
Non-investment Grade 1.3 1.3
Total Retained Interest 8.0 5.6

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Leverage Ratio

• Leverage for all major investment banks increased

significantly from 2006 to 2007.
• Bear Stearns and Morgan Stanley had the highest gross
leverage ratio – about 30%.
• After the 2007-2008 crisis, only Goldman Sachs and Morgan
Stanley survived as independent investment banks.
– Both actually became bank holding companies, which were required to
cap leverage at 10X capital.

What Could Have Bear Stearns Done Differently?

• Mismatch in maturity
• Equity capital injection
• Myopia on adequately modeling the value and assessing the
risk of CDOs when no market existed
• …

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