Bear Stearns and the Seeds of Its Demise

Background

Bear Stearns was established in 1923 by Joseph Bear, Robert Stearns, and Harold Mayer with $500,000 in capital. The firm started out trading government bonds and ventured further into bond trading as it matured. Many of the top brass at Bear Stearns came out of the bond trading operations of the firm, where they masterfully learned the art of taking calculated risk on the trading desks. In 1993, Jimmy Cayne, a former scrap metal salesman, took over as CEO after working his way up through the company from the bond trading desks. He embodied the risk-taking culture of Bear Stearns, whom shunned the typical Wall Street brass.

During the 1990s, Bear Stearns ventured into asset management and started several hedge funds for institutional and high-net worth private clients. Two of those funds, were the High-Grade Structured Credit Strategies Master Fund (high-grade) and an offshoot the high-grade fund that offered “enhanced” returns, but modeled off the same strategy.

The Problem

Following the September 11, 2001 attacks and popping of the tech bubble, the Federal Reserve eased monetary policy and kept fed funds rate very low for an extended period of time to promote economic growth. The low interest rates stoked demand for mortgage loans, while tightening spreads in the corporate bond markets. As demand grew, riskier asset classes became highly in demand and the subprime mortgage market ramped up from a niche, fledgling part of the mortgage market into 15% of all mortgages originated from 2001 through 2007. The low interest rates also caused heavy demand for houses and thus, ever-increasing housing prices. As housing prices increased, the loose lending standards to subprime borrowers blurred the losses from the riskier lending because if a borrower defaulted, the lender could just turn around and sell the house close to the mortgage amount.

Rating agencies also played a role, by getting intimately involved in the origination process. The rating agencies would often rate some of the structured securities with the same rating as corporate bonds with default rates at only 10% of the level seen from corporate bonds. Combined with the strong financial incentive to get involved in this process and faulty risk-models, it led