Investment Banking in 2008

Case Study: Investment Banking in 2008

(A)   and (B): The Rise and fall of the Bear

1. Failure Analysis:

Identify the major factors that contributed to Bear Stearns’s failure?  

Liquidity, negligence, greed, ethics, and leverage are the main factors identified on the case that contributed to Bear Stearn’s failure. However, for specificities sake, we will concentrate on the fact that Bear Stearns held a high volume of sophisticated funds backed by mortgage securities. These investments were highly leveraged turning to be unprofitable and illiquid once the housing bubble bursted in 2006. It is important to mention that the article stated that some of Bear’s executives alerted to the fact that such concentration of risk could raise volatility; however, they were ignored. Were Bear’s decision making executives really acting on behalf of the shareholders with the main interest of maximizing their wealth while bearing so much risk?

A major factor that contributed to the sudden fall of the Bear was cause by Moody’s decision of downgrading multiple tranches of mortgage backed bonds issued by The Bear Stearns Companies, Inc. The downgrade of these bonds was another red flag for investors that were already reacting to the other clear signs of a financial crisis. Many investors proceeded to secure their investments by selling their positions in the firm. The increased orders to sell Bear Stearn stocks, along with the constant flow of news and media reports questioning the stability and solvency of the firm, deteriorated Bear’s market value on a daily basis. At the end of fiscal 2007 Bear Stearns’ net equity position of only $11.1 billion supported $395 billion in assets which means a leverage ratio of 35.6 to 1. This highly leveraged balance sheet, consisting of many illiquid and potentially worthless assets, led to the rapid diminution of investor and lender confidence, which finally evaporated as Bear was forced to call the New York Federal Reserve to stave off the looming cascade of counterparty risk which would ensue from forced liquidation.

As investors continued to abandon their positions in the Bear Stearns Companies, Inc, the firm dramatically reported decreases in its equity reserves and, as a direct consequence of reduced equity, the leverage factors of the firm increased. As the firm’s leverage continued to increase, more and more investors continued to lose their trust in the firm’s performance and chances of overcoming the crisis. Therefore, the firm continued to lose market value to a point where the firm lost virtually all of its equity, therefore losing its solvency.