Bear Stearns' collapse: leverage, subprime mortgages, and systemic risk

Bear Sterns Collapse, How it Happened and What it Caused

The fall of Bear Stearns -- Why the unthinkable occurred

Types of securities in which Bear Stearns was investing

Bear Stearns fund managers had purchased collateralized debt obligations on subprime, mortgage-backed securities, paying an interest rate over and above the cost of borrowing. They used their leverage to buy more than they could pay with their immediately available capital, expecting a high rate of return from these trades. Credit default swaps were used as insurance against risk ("Dissecting the Bear Sterns hedge collapse," Investopedia, 2009).

Amount of assets

"Bear was noted for its addiction to leverage even at a time when Wall Street, which runs on debt, was drunk on the stuff. Bear had $11.1 billion in tangible equity capital supporting $395 billion in assets, a leverage ratio of more than 35 to one. And its assets were less liquid than those of many of its competitors" (Boyd 2009).

How they collapsed

The subprime mortgage crisis began to manifest itself as more and more people began to default on their loans. Although the bubble was supposed to 'burst' in the real estate market eventually, Bear Stearns portfolio managers had not anticipated this, and had insufficient credit insurance to protect themselves against their losses. Their creditors on the leveraged investments demanded that Bear Stearns provide additional cash on their loans because the collateral (subprime bonds) was rapidly falling in value ("Dissecting the Bear Sterns hedge collapse," Investopedia, 2009). However, Bear did not have enough available cash to quell its investor's fears.

Who was affected and what happened in the markets

Both investors and employees were affected: "I worked eight years at a firm that promoted me from the back office to investment banking," said one managing director, "I had thousands of shares and thought I could afford to send my kids to private schools and college. It's all gone now." (Boyd 2008). On Wall Street as a whole, pain and suffering reigned: the Dow Jones fell by as much as 300 points at one point and eventually closed 194 points lower. The repercussions were felt around the world: In London, the FTSE 100 fell 150 points and the Japanese Nikkei fell 454 points (Stepek 2008)

Where Bear ended up.: Who bought them and what is their place in the market today

Bear Stearns was sold to J.P. Morgan Chase for $2 a share, under pressure from the Federal Reserve (Stepek 2008). Later, to forestall a class action lawsuit by shareholders in Bear, that sum was increased to $10 a share. The case of Bear is seen as notable because of the new influence of the federal government in the world of investment banking, after decades of nonintervention, as well as the fact that rumors as much as real illiquidity caused the death of Bear Sterns.