Topic Brief: Bear Stearns

Overview  

So, Bear Stearns… There’s a lot of messy economics surrounding this one, but it’s all over the news.  This brief is going to break it down into what you need to know and how to explain it without a lot of economic jargon. Here is the back story:  Bear Stearns is one of the world’s largest securities and brokerage firms.  In June of 2007, the firm found itself in financial trouble when the hedge funds and securities it held in the subprime mortgage market had lost nearly all of their value.  Over the coming months the firm posted a 61% net loss and severely damaged its credit.  In March of this year, the bank was on the verge of being insolvent.  On March 14, 2008, JP Morgan Chase and the Federal Reserve Bank of New York provided a loan to prevent Bear Stearns from insolvency, fearing the impact such an announcement would have on broader markets.  Two days later, the Fed helped subsidize a JP Morgan merger with Bear Sterns, allowing the stock to be traded at two dollars a share.  In a bid to boost investor and market confidence and gain support for their acquisition of the company, JP upped the share price to ten dollars on March 25.  This rise, combined with Morgan’s assertion that they will buy newly released Stearns stock, means the company will end up purchasing 39.5% of the company at an average of $65 a share.  This percentage, plus the influence of the current board, should give JP Morgan the influence it needs to gain control of the failed firm.

Key Terms and Figures

Bear Stearns:  One of the largest global investment banks and securities trading and brokerage firms in the world. The main business areas are capital markets, wealth management, and global clearing services.   In the last month their stock has fallen from approximately $100 a share to $2, before making a slight rebound to $11.

JP Morgan Chase: Third largest banking institution in the United States.  Has the largest hedge fund with over $34 billion in assists.  They used their economic clout–and spare resources– to buy out Bear Stearns.    By assuming the risk of the nearly insolvent firm, Chase is in the position to make a lot of money as long as they can return the company to its pre-2008 economic position.  Even if the company fails to stabilize, the fact that the bailout prevented a market panic made the buyout in their best interests.

Hedge Fund: A private investment fund that isn’t open to public investment.  In the US, these funds are able to avoid regulatory scrutiny as long as they are only open to accredited investment organizations.  As such, these firms use them for their riskier and more complex investments.  The allowance of risky investment techniques, such as short selling[1], allows these firms to maximize the potential profit from risk, and develop income outside – and beyond – the regulated accounts.

Securities:  These are tradable units representing some financial value.  Beyond what we commonly refer to as stocks, this also refers to currency speculation, futures markets, investment in debt, and includes investment on the potential returns of mortgages.  In the subprime crisis, those who had invested in the debt of mortgage holders expected to make a profit of the interest.  When many of these loans began to default, the agencies that had invested in them stood to lose large amounts of money.

Major Issues

Effect on Markets:  The long term effect of the collapse on the markets has been generally positive. Specifically, investors have seen the bail out as a symbol that the market is strong enough to help the failing investment firms – preventing a large scale market collapse.  Further, this news, combined with speculation that the housing collapse has begun to slow, has led many investors to posit that he impact of the subprime crisis has it rock bottom.  This optimism alone may be enough to bring markets surging back, as many analysts suggested that the collapse was as strongly rooted in declining confidence in banking as it was in the failures of some investments.  This positive influence has also increase market stability globally, as goes Wall Street so goes the world.

The Fed’s Role in the Bailout:  The Federal Reserve’s active role in the bailout of Bear Stearns is unprecedented in the financial history of the United States.   Specifically, the Fed helped negotiate the low buyout price to ensure that an outside firm – JP Morgan – would assume the risk of Bear Stearns and prevent a panic.  While this goal is admirable, some accuse the Fed of artificially lowering the price beyond needed values – a fact supported by the subsequent raise in the price – as a favor to specific business interests.  This claim is also supported by the fact that the Fed didn’t not inform Bear that it was going to provide $30 billion to increase liquidity – an announcement that would have given Bear a few more days to get their house in order.  Further, the Fed has given approval to a near 40% buyout without an investor vote, when traditional jurisprudence has set the limit at 20%.  What all of this represents is a more aggressive fed policy – that is willing to bend the rules – in defending the integrity of the banking system, and a potential commitment to assisting specific business interests.

Sample Questions

Did the Fed overstep its authority in the Bear Stearns bailout?
Will JP Morgan profit from its buyout of Bear Stearns?
Will the Stearns buyout be enough to restore investor confidence?
Should the US take greater steps to regulate hedge funds?
Have markets hit rock bottom?