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UV1064 Oct. 22, 2008

This case was prepared by Susan Chaplinsky, Professor of Business Administration. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright  2008 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to [email protected]. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation.

BEAR STEARNS AND THE SEEDS OF ITS DEMISE

“I just simply have not been able to come up with anything, even with the benefit of hindsight, that would have made a difference.”

—Alan D. Schwartz1

John Corso hung up the phone on January 15, 2008. He had been talking with Michael Minikes, a senior executive at Bear Stearns (Bear). This was Minikes’s second call in a matter of weeks. The first call had come in late December, shortly after Bear had disclosed a $1.9 billion write-off of bad loans. This time, Minikes had wanted to discuss Alan Schwartz’s promotion to CEO following James E. “Jimmy” Cayne’s resignation the previous week. Minikes reassured him that the firm was in good hands and was expecting better results this quarter. Corso understood the subtext of the call. During the past year, Bear had experienced a series of wounds—some self-inflicted and some not—and rumors persisted about the firm’s ability to survive the current credit crisis because of its large exposure to mortgage-backed securities. Corso was the manager of an $800 million hedge fund that held its brokerage account at Bear.2 Though he himself had little exposure to the mortgage market, his long–short fund kept sizable cash balances at the firm. Corso had a longstanding relationship with Cayne and Bear going back many years. When certain regulatory issues had been raised about his fund in 2001, Bear had stood by him. Loyalty and admiration for Bear’s grittiness had kept him a client so far. But with mounting pressures on the firm, he wondered if now might not be the time to move his business from Bear. History of Bear Stearns The Bear Stearns Companies Inc. was a publicly listed holding company that, through its subsidiaries, was principally engaged in investment banking, sales and trading, and asset

1 Senate Banking Committee, Testimony by Alan D. Schwartz, April 3, 2008. 2 As of November 30, 2007, Bear held approximately $86 billion in customer margin and $88 billion in

customer short balances in its prime brokerage business.

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management. In 2007, it was the fifth-largest U.S. investment bank with nearly $400 billion in assets and more than 14,000 employees worldwide. That represented astonishing growth, relative to the $500,000 in capital that Joseph Bear, Robert Stearns, and Harold Mayer had founded the firm with in 1923. The young Bear Stearns prospered in the fast-paced markets of the Roaring Twenties—it began trading in government securities and soon became a leader in this area. Throughout its history, Bear developed a culture of risk-taking that grew out of its trading operations. Over the years, Bear’s top management rose from the trading floor. In 1933, Salim L. “Cy” Lewis, a former runner for Salomon Brothers, was hired to direct Bear’s new institutional bond trading department. Lewis, who later became chairman, built Bear into a large, influential firm. Alan “Ace” Greenberg, who succeeded Lewis as chairman, started as a clerk at the firm in 1949, at age 21. He moved up rapidly within the company; by 1953, he was running the risk arbitrage desk, and by 1957, he was trading for the firm. When he became chairman in 1978, Greenberg had earned a reputation as one of the shrewdest traders on Wall Street.3

More than anyone, Greenberg defined and shaped the persona of Bear through the traders

he hired. He shunned the “frat boys” from the best families and schools that other top Wall Street firms stocked up on in favor of the “bridge and tunnel” crowd.

The Bear, as old-timers still called it, cared about one thing and one thing only: making money. Brooklyn, Queens, or Poughkeepsie; City College, Hofstra, or Ohio State; Jew or Gentile—it didn’t matter where you came from; if you could make money on the trading floor, Bear Stearns was the place for you.4

Bear was where Kohlberg met Kravis and Roberts and where Sandy Weill started after graduating college. Greenberg coined a name for his hires: PSDs, for poor, smart, and a deep desire to get rich.

Greenberg’s protégé, Jimmy Cayne, took over as Bear’s CEO in 1993, while Greenberg

retained the title of chairman. In contrast to Greenberg, whose executive style was known to be impulsive, Cayne took a more cautious approach and avoided big risks. Together, Cayne and Greenberg were thought to make a powerful and well-balanced team. Yet Cayne remained the quintessential PSD. He was a cigar-chomping kid from Chicago’s South Side, who in his early years sold scrap metal for his father-in-law. After a divorce, he found himself driving a taxi while pursuing his beloved pastime, playing bridge. It was at a bridge table where Greenberg met Cayne and famously told him, “If you can sell scrap metal, you can sell bonds.”5 Cayne found his calling on the trading floor, moving huge amounts of New York City municipal bonds during the city’s financial crisis of the 1970s. He became the embodiment of Bear, a go-it-alone maverick, impervious to what Wall Street thought—so long as Bear made money.

3 “Bear Stearns Companies, Inc.,” FundingUniverse.com, http://www.fundinguniverse.com/company-histories/

Bear-Stearns-Companies-Inc-Company-History.html (accessed September 29, 2008). 4 Bryan Burrough, “Bringing Down Bear Stearns,” Vanity Fair (August 2008). 5 Burrough.

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The last member of Bear’s management team, Alan Schwartz, was the exception. Schwartz was a member of Duke’s varsity baseball team and a top student. After an injury to his arm, he turned from baseball to investment banking and joined Bear’s research department in 1976. His background was not in trading, but in corporate finance, especially in acquisitions of media and entertainment companies. He became head of investment banking in 1985 and then copresident in 2001. Unlike his rough-around-the-edges predecessors, Schwartz was described as a “smooth operator.” When advising Michael Eisner on Disney’s acquisition of Capital Cities/ABC, Inc., in 1996, he told him, “Stay cool. Stay calm. Don’t overreact.”6 Bear Stearns’s Asset Management: Hedge Funds

During the booming 1990s, when most of Wall Street grew rich trading stocks, Cayne

kept Bear focused primarily on bonds and trading. Eventually Bear, like most on Wall Street, branched into asset management. Bear Stearns Asset Management (BSAM) provided asset management services to institutional clients and high-net-worth individuals across all major asset classes including money markets, fixed income, currencies, and equities. BSAM also provided investment services to the company’s proprietary and third-party hedge funds. Unlike some firms, Bear promoted its own traders rather than outsiders to run BSAM’s funds, and each fund specialized in a specific type of security rather than a diversified mix of securities.

In 2003, Bear tapped Ralph Cioffi to run one of its new hedge funds, the High-Grade Structured Credit Strategies Master Fund (“High-Grade”). Until the events of 2007, Cioffi was a Bear star. He graduated in 1978 with a business degree from Vermont’s Saint Michael’s College and joined the firm in 1985 as a bond salesman. By 1989, he was head of the Fixed Income sales group. At that point, he considered leaving to launch his own hedge fund, but the firm convinced him to stay and lead the firm’s charge into structured finance.7

The fund may have touted its sophisticated investment strategies, but in truth its strategy

was simple and formulaic in nature: Step 1: The High-Grade fund raised capital from investors and used it to buy collateralized debt obligations (CDOs) which were backed by AAA-rated subprime, mortgage-backed securities (MBSs).

Step 2: Through the use of leverage, the fund bought more CDOs than it could have with its own capital. Because CDOs paid an interest rate higher than the cost of borrowing, every incremental unit of leverage added to the fund’s total expected return.

Step 3: The fund purchased credit default swaps (CDSs) as insurance against movements in the credit market because the use of leverage increased the fund’s

6 “You Can Just Call Alan D. Schwartz ‘Mr. Smooth,’” New York Magazine online Daily Intel, January 9, 2008,

http://nymag.com/daily/intel/2008/01/you_can_just_call_alan_d_schwa.html (accessed September 29, 2008). 7 Matthew Goldstein and David Henry, “Bear Stearns’ Bad Bet,” BusinessWeek (October 11, 2007).

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overall risk. CDSs were expected to pay off when credit concerns caused the bonds’ value to fall, effectively hedging some of the risk of falling collateral values. Due to the high rates of return possible on AAA-rated subprime MBSs, after deducting

the cost of the debt to purchase the subprime MBSs and the cost of credit insurance, the fund was left with a positive rate of return, or “positive carry” as it was termed in the hedge fund industry.8

The High-Grade fund was marketed to investors as a “conservative” investment because

its portfolio included low-risk, high-rated securities, and it was managed by experts in mortgage- backed securities. It attracted wealthy individuals, pension funds, and other entities that sought a safe yet profitable investment. These investors were motivated, especially in 2003 and 2004, by a search for yield due to historically low interest rates (Exhibit 1). In the aftermath of September 11, 2001, the U.S. Federal Reserve had moved aggressively to cut interest rates to stave off a recession. During 2003, interest rates declined to 1%, implying near-zero or negative real rates of interest. This low interest rate environment spurred increases in mortgage refinancing, new mortgages, and substantial increases in house prices. With house prices increasing, mortgage- backed securities seemingly offered both safety and yield.

For most of its existence, the High-Grade fund was profitable, posting positive gains in

every month and a cumulative return of nearly 50% through January 2007. But as the housing market began to cool in 2006, its returns began to even out. In August 2006, Cioffi opened a second fund called the High-Grade Structured Credit Strategies Enhanced Master Fund (“Enhanced”). Investors were told that the Enhanced fund would generate greater profits than the High-Grade fund, but have only limited additional risk, in part because the fund would invest an even higher proportion of its assets in low-risk securities. The increased profits would result from greater use of leverage. The Roots of the Problem9

Over the past decade, the traditional business of banks—loan making—had undergone a major transformation. Banks that had once granted mortgages and loans and kept them on their books, in recent years, moved to an “originate and distribute” model in which banks granted mortgages and loans, repackaged them, and sold them to other financial investors. Investment banks had also transformed their businesses, moving away from advising and conducting fee- oriented transactions for clients to a greater focus on “principal transactions,” wherein their own or shareholders’ funds were invested in securities or other activities. Increasingly, investment

8 This example is drawn from information found in “Dissecting the Bear Stearns Hedge Fund Collapse,”

Investopedia.com, http://www.investopedia.com/articles/07/bear-stearns-collapse.asp (accessed September 29, 2008).

9 This section was developed from Markus Brunnermeier, “Deciphering the 2007–08 Liquidity and Credit Crisis,” Journal of Economic Perspectives (2008, forthcoming).

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banks’ profits and compensation were based on the results of these investments and their proprietary trading. Securitization

After originating a mortgage or loan, a bank could either keep it and insure itself by

buying a CDS or sell it outright. Instead of selling or protecting individual loans, banks typically first pooled the assets to create portfolios of mortgages, loans, corporate bonds, or other assets. These assets were typically transferred to a special purpose vehicle (SPV), whose function was to collect the principal and interest from the underlying assets and convey them to the holders of the structured products or asset backed securities (ABSs).

The formation of portfolios had two purposes. The pooling of assets helped to diversify

risk, and tranching (dividing the cash flows from the portfolios into separate claims) allowed securities to be tailored to meet the preferences of different investors. The safest tranche of a structured product paid a relatively low interest rate, because it was the first to be paid out of the cash flows to the SPV. The top tranche was also safer to the extent that the underlying assets were less correlated. Holders of the most junior tranche—or equity tranche—were paid only after all other tranches had been paid. The mezzanine tranches were in between. Because the senior tranches got paid first, the junior tranches of ABSs resembled a leveraged position in the underlying cash flows. The tranches were sold to pension funds, hedge funds, structured investment vehicles (SIVs), and other investors, while the equity tranche was usually (but not always) held by the issuing bank to ensure monitoring of the loans.

Asset-backed securities went by many names. CDOs were the most common form. Each

CDO consisted of several tranches of an underlying portfolio of debt, such as corporate bonds or mortgages.10 CDOs were typically floating-rate instruments benchmarked to LIBOR or U.S. Treasury rates to protect their value from changing interest rates. Almost all CDOs were sold as private placements, and therefore there was little transparency about their ongoing value. Exhibit 2 shows the growth in structured products by the type of collateral. CDO issue volume had grown from less than $25 billion annually when they were introduced in the mid-1990s, to more than half a trillion dollars annually in 2006 and 2007.

The main advantages of securitization were that it allowed risk to be shifted to those who could bear it most efficiently and it was spread widely among market participants. The main disadvantage of securitization was that the transfer of credit risk distanced the borrowers from the lenders. The banks’ incentive to carefully approve loan applications, and their incentive to monitor (and even to collect) the loans was weakened considerably. Because a substantial portion of credit risk was soon passed on to other financial institutions, banks held the full risk of the loans for only a few months. The reduced incentives to monitor, spurred by securitization, led

10 If the tranches were derived from a portfolio of loans, they were also referred to as collateralized loan

obligations (CLOs) and if from mortgages, they were called collateralized mortgage obligations (CMOs). CDOs of a pool of CDOs were referred to as “CDO squared.”

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to an erosion of lending standards and to excesses in lending. Mortgage brokers offered teaser rates, no-documentation mortgages, and NINJA (“no income, no job or assets”) loans. These mortgages were granted on the assumption that house prices would rise, making background checks unnecessary, since the lender could always refinance against the value of the house.

Subprime mortgages accounted for about 15% of all mortgages in 2001–2007.11 The

outstanding value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007. Exhibit 3 shows the credit standards associated with subprime loans from 2001 to 2007 and Exhibit 4 shows their associated delinquency rates through May 2007. The delinquency rates of adjustable-rate subprime mortgages rose to 16% in October 2007 and 21% in January 2008.12 Exhibit 5 shows the trend in housing values from 1995 to 2007. Role of Rating Agencies

Structured products were attractive to investors who sought the safety of high ratings and took the ratings at face value. There were differences in the ratings of structured products and corporate bonds. First, while ratings agencies charged a fee to rate either a corporate bond or a structured product, the fees were generally three times higher for CDOs. To rate a CDO issue, Standard & Poor’s charged as much as 12 basis points of the total value of the issue compared with up to 4.25 basis points for a corporate bond rating. The rating agencies claimed the higher fees were justified because the structures of CDOs were more complex.13 Structured products were also an important contributor to the growth in revenues and earnings of the three major credit rating agencies, Moody’s, Standard & Poor’s, and Fitch.14

Second, rating agencies participated at every level of packaging a CDO. Issuers of CDOs

worked closely with rating agencies to determine the “tranching attachment points,” or rating cutoffs for the tranches. Unlike the passive process of rating corporate debt, rating agencies advised CDO assemblers how to maximize the size of the top (highest rated) tranches to garner the most profit from the CDO. CDO tranches were always sliced in such a way to just result in an AAA rating (“rating at the edge”).

Third, the rating agencies rated the structure of the CDO, but did not investigate the

underlying credit quality of the assets that made up the CDO. They did not, for example, have access to individual loan files or verify the information provided in loan applications. “We aren’t

11 Subprime mortgages were the lowest-quality loans and Alternative-A mortgages were granted to borrowers

who were not quite prime borrowers, but had better credit than subprime borrowers. Subprime borrowers were generally defined as individuals with limited income or having FICO credit scores below 620 on a scale that ranged from 300 to 850. “Hybrid” mortgages initially had fixed rates that later converted to adjustable rates. Common subprime hybrids included “2-28 loans,” which offered a low initial fixed interest rate for 2 years after which the loan reset to a higher adjustable rate for the remaining 28 years of the loan.

12 “U.S. Foreclosure Activity Increases 75 Percent in 2007,” realitytrac.com January 29, 2008. 13 Richard Tomlinson and David Evans, “The Ratings Charade,” Bloomberg.com, July 2007. 14 Moody’s reported revenue of $1.52 billion in 2006 for credit rating. Structured finance accounted for 44% of

the revenues, or $667 million, compared with $485 million from company credit ratings.

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loan officers,” said Claire Robinson, head of asset-backed finance for Moody’s. “Our expertise is as statisticians on an aggregate basis. We want to know, of 1,000 individuals, based on historical performance, what percent will pay their loans?”15

The credit agencies stress-tested the structure of CDOs using Monte Carlo simulations

that were based in part on past default history and lending practices. Several assumptions drove this analysis. First, real estate markets were thought to be largely uncorrelated across the country. That is, a national market did not exist for real estate and thus, loan defaults in California, for example, would be largely uncorrelated with loan defaults in New York. Second, defaults were predicted based on an analysis of past underwriting standards with respect to mortgage lending. To the extent that lending standards had become less stringent over time, the models would fail to anticipate the increase in default rates that might arise as a consequence of this.

Investment-grade CDOs typically returned 25% more than the average yield on a

similarly rated corporate bond.16 But the higher return on CDOs ultimately derived from riskier assets (subprime mortgages) that were structured to give the higher rating. Moody’s reported that Baa-rated corporate bonds had average five-year default rates of 2.2%, whereas Baa-rated CDOs had five-year default rates of 24%.17 The differences in default rates on instruments of the same rating clearly demonstrated that the ratings on CDOs were not comparable to corporate bonds. Yet few in the market appeared to appreciate the difference.

Mismatch in Maturity Structure Because investors generally preferred assets with shorter-term maturities, banks created

off-balance-sheet vehicles that shortened the maturity of long-term structured products. Most of these off-balance-sheet vehicles were in the form of conduits or structured investment vehicles (SIVs).18 The aim of SIVs was to generate a spread between the yield on the asset portfolio and the cost of funding by managing the credit, market, and liquidity risks. Moody’s reported as of September 2007 that the total nominal value of assets under SIV management was $400 billion. SIVs invested in illiquid long-maturity assets and financed them with asset-backed commercial paper (ABCP) or medium-term notes (MTN). These instruments had an average maturity that ranged from 90 days to just over one year. ABCP was backed by the underlying assets, allowing the owner to seize and sell the collateral asset in case of default. Due to the growth of these activities, ABCP became the most popular form of commercial paper as of 2006 (Exhibit 6).

15 Roger Lowenstein, “Triple-A Failure,” New York Times Magazine (April 27, 2008). 16 One reason for the higher yields on CDOs was that their collateral was just sufficient to achieve an AAA-

rating compared with corporate debt where the collateral frequently exceeded the minimum needed for that rating. 17 Tomlinson and Evans. 18 Another motivation for SIV structures was that moving loans into off-balance-sheet vehicles and granting a

credit line to ensure an AAA-rating allowed commercial banks to save on regulatory capital. The Basel I accord imposed an 8% capital charge on banks for holding loans on their balance sheets, whereas the capital charge for contractual credit lines was much lower (Brunnermeier, 2008).

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Along with the growth in SIVs, investment banks financed a larger portion of their balance sheets with short-term collateralized lending in the form of repurchase agreements, or “repos.” In a repo contract, a firm borrowed funds by selling a collateral asset today and promising to repurchase it at a later date. Importantly, the growth in repo financing as a fraction of investment banks’ total assets was mostly due to an increase in overnight repos. Almost 25% of total assets were financed by overnight repos in 2007, an increase from 12.5% in 2000. Investment banks’ increasing reliance on overnight financing required them to roll over a substantial amount of their funding on a daily basis.19

The trend to invest in long-term assets and borrow short-term increasingly exposed

financial institutions to liquidity risk, because the ABCP or repo market might suddenly dry up. Should this happen, banks would be forced to sell assets or draw on backup lines of credit (supplied by other financial institutions). The financial system therefore bore the liquidity risk of this maturity transformation. Moreover, because banks were large purchasers of structured products themselves, a substantial amount of credit risk never left the financial system.

Growth of Credit Default Swaps

A CDS was a contract between two counterparties, whereby the buyer made periodic

payments to the seller in exchange for the right to a payoff in case of default. A CDS was insurance that could be used by a debt holder to hedge or to protect against default.20 CDSs could be used to manage credit risk without necessitating the sale of the underlying bonds. But because there was no requirement to actually hold the bonds, a CDS could also be used to speculate. For example, if a company faced financial difficulty, the company’s bonds would likely trade at a discount, and $1 million in bonds might be purchased by an investor for $900,000. If the company was able to repay its debt, the investor would receive a $1 million and make a profit of $100,000. Alternatively, one could enter into a CDS with another investor by selling credit protection and receive a premium of $100,000. If the company did not default, the investor would make a $100,000 profit without having invested in anything.

A seller in a CDS effectively had an unfunded exposure to the underlying cash bond or

“reference entity,” (e.g., firm, SPV, SIV), with a value equal to the notional amount of the CDS contract. Like the bonds themselves, CDSs could be bought and sold. The cost to purchase the swap from another party fluctuated as the perceived credit quality of the underlying company changed. Swap prices typically declined when creditworthiness improved, and rose when it worsened.21 But these pricing differences were amplified in CDSs compared with bonds, making CDSs attractive to those wishing to speculate on changes in an entity’s credit quality.

19 Brunnermeier, 2008. 20 A CDS was an insurance product but was called a “swap” to avoid the regulation associated with insurance. 21 Suppose a company had CDSs currently trading at 250 basis points (premium). This implied that the cost to

insure $10 million of its debt was $250,000 per annum (face value × premium). If the same CDS was later trading at 300 basis points, it indicated that the market believed the company had greater risk of default on its obligations.

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In many instances, the amount of CDSs outstanding for an individual company greatly exceeded the bonds or underlying collateral value. A company could have, for example, $1 billion of debt outstanding and $10 billion of CDS contracts outstanding. If the company were to default, and the recovery rate was 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. But the loss to CDS sellers would be $6 billion. As CDSs were bought and sold, it became difficult for the original purchaser of the insurance to locate the party responsible to pay the insurance and therefore judge the creditworthiness of the counterparty (Exhibit 7). When concerns about the creditworthiness of CDS counterparties rose, purchasers who bought CDSs for insurance were forced to increase their capital or reduce their exposure to credit risk by other means.

Since 2001, the CDS market had experienced explosive growth—most of it occurring

after 2005—and by mid-2007, the total notional amount of CDSs outstanding was more than $45 trillion. That was roughly twice the size of the U.S. stock market (valued at $21.9 trillion) and far exceeded the $7.1 trillion mortgage market and $4.4 trillion U.S. Treasuries market. By year-end 2007, the notional amount of CDSs outstanding had grown to $62.2 trillion, a 37% increase from midyear.22

Ultimately, the emergence and growth of these structured products and credit derivatives

substantially increased the liquidity risk of the financial sector. Yet the growth continued seemingly unabated. Why? Citigroup’s former CEO, Chuck Prince, provided a succinct answer by referring to Keynes’s analogy between bubbles and musical chairs: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”23 Said differently, so long as investors were willing to buy structured products, banks found it more profitable to follow the trend and dance. No single bank had an incentive to buck the trend and sit down before the music ended. Nevertheless, by late 2006, there was a growing sense that a day of reckoning was coming, at which point everybody would rush to sell high-risk bonds and reverse positions in credit derivatives.

22 International Swaps and Derivatives Association (ISDA). The gross notional amount of CDSs outstanding

was a measure of activity, not a measure of value at risk because it did not factor in netting and collateral values. Because CDSs were privately negotiated derivatives, ISDA data were obtained from a survey of approximately 90 firms. Bear reported approximately $11 trillion of gross notional amount of CDSs outstanding in November 2007.

23 As quoted in Brunnermeier (2008).

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The Music Ends The first warning sign came on November 28, 2006, when Moody’s issued a report

warning that the percentage of subprime loans without documentation was rising. This was followed on December 7, 2006, with the news that Ownit Mortgage Solutions, the eleventh- largest issuer of subprime mortgages, had shuttered its doors. In February 2007, New Century Financial Corporation, the number-two lender in the subprime market, announced the restatement of earnings for the first three quarters of 2006 to account for larger losses on its loan portfolio. Within a month, it was cut off from additional financing by its creditors.24 The news began as a trickle—but it was becoming increasingly evident that the number of defaults and losses on subprime mortgage were growing at an alarming rate.

Things started to go wrong for Ralph Cioffi and the Bear funds in early 2007. The funds

had purchased large amounts of CDOs in late 2006 and January 2007. At the same time, the funds were shorting the ABX index, which was tied to subprime loans (Exhibit 8).25 Until March, it was a winning trade. In February, as news about subprime mortgages worsened, CDO assets dropped in price. The market value of assets in the Enhanced fund fell 14.4%, which was offset by a 13.5% gain on the ABX index, which declined that month. The High-Grade fund assets were marked down 4.4% in February, but it remained profitable because its short positions on the ABX earned 5.3%.26

Then in March, the ABX index started to stabilize and Cioffi’s funds got squeezed on two

fronts: Its CDO bonds were falling in value and its ABX positions were no longer making money. The Enhanced fund’s losses were magnified by the large amount of borrowing it used to finance its investments. As of January 31, 2007, it had $699 million in investor capital, but had more than $12 billion in investments. A month later, its investor capital had dropped to $667 million, but investments in CDOs had increased to $15 billion. Over the course of a few months, the fund had added to its bullish bets and doubled down on its bearish bets. By the end of April, the fund was down 23% year-to-date.27

In early June, word began circulating that Cioffi’s funds were in need of cash and might not be able to make margin calls.28 Investors attempted to seek redemptions and lenders to repossess their collateral on loans. Part of the concern stemmed from the lack of transparency about the funds’ assets. Given the illiquid nature of CDOs, there was no easily determined value for the assets. In 2004, 25% of the High-Grade fund’s assets were based on “fair value”—two years later, more than 70% of its assets—$616 million—were calculated on this basis. For the Enhanced fund, 63% of its assets in 2006—$589 million—were “fair valued.” “Fair value” was

24 For a listing of significant events that took place in the credit crisis, see Stuart Turnbull, “The Credit Crisis of

07,” (working paper, University of Houston, Bauer College of Business, November 9, 2007). 25 ABX Indices, The New U.S. Asset Backed Credit Default Swap Benchmark Indices, January 2006,

http://www.markit.com. 26 Kate Kelly and Serena Ng, “Behind Bear Stearns Bid to Prop Up Troubled Funds—Loan of $3.2 Billion Caps

Days of Drama; Subprime-Sector Fear, Wall Street Journal, June 25, 2007. 27 Kelly and Ng. 28 A margin call was triggered when lenders requested additional cash or collateral on a loan.

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determined by a process of “marking-to-model” as opposed to marking-to-market. In effect, this meant that the value of a majority of the funds’ net assets was estimated by its managers.29

On June 14, 2007, Cioffi met with a group of creditors and asked them to cancel their

default notices and accept a 12-month freeze on new margin calls. Representatives from Merrill Lynch and J.P. Morgan, which were owed roughly $850 million and $500 million, respectively, and had at least one outstanding default notice balked at the nervy request and took possession of their collateral. On June 25, in an attempt to preserve its reputation and stave off further margin calls, Bear loaned $3.2 billion to the funds. It was to no avail. In July, Bear acknowledged to investors that “there is effectively no value left” in the Enhanced fund and “very little value left” in the High-Grade fund. To their dismay, investors learned that the two funds—which had an estimated aggregate value of $1.6 billion in capital at the end of 2006—were essentially worthless. On July 31, 2007, the funds filed for bankruptcy. The Markets Melt Down In August 2007, the credit crisis came to a full boil. Almost daily there were announcements of hedge fund closings and loan write-offs. Inside Bear Stearns, the firm believed the crisis had passed, albeit at some cost. In early August, Cayne and CFO Sam Molinaro Jr. held a conference call to reassure investors and articulate the steps Bear was taking to shore up its financial position. The firm had increased the maturity of some of its financing, adding a new longer-term borrowing agreement. Molinaro emphasized the firm’s strong cash holdings of $11.4 billion. At the same time, he described the market conditions as being among the most challenging he had ever seen. Cayne told investors that the firm did not have large exposures to mortgage-backed securities. That seemed at odds with the nearly $50 billion in mortgage-related securities Bear held, the majority of which were financed with overnight repos (Exhibit 9). Rather than reassuring investors, the meeting spurred investors’ fears, driving the broader market and Bear’s shares down with it.

A few days later, Bear announced the resignation of Warren Spector, copresident and COO of the firm. Spector had helped launch Bear Stearns Asset Management and was responsible for overseeing the firm’s trading in stocks and bonds. Spector, reportedly surprised at the turn of events, believed Bear was beginning to get a handle on its problems in the subprime area. But Cayne had lost faith in Spector, blaming him for lax oversight of the hedge funds. Upon Spector’s resignation, Schwartz was promoted to president.

In response to the deteriorating conditions, U.S. Federal Reserve Chairman Ben Bernanke

reversed course from his position in May—when he had stated, “we do not expect significant spillovers from the subprime market to the rest of the economy or the financial system”—to provide liquidity to the financial system.30 On August 9 and 10, the Fed intervened to supply $62

29 Matthew Goldstein and David Henry, “Bear Stearns Bad Bet,” BusinessWeek (October 11, 2007). 30 Ben Bernanke speech to Federal Reserve Bank of Chicago’s 43rd Annual Conference on Bank Structure and

Competition, Chicago, Illinois, May 17, 2007.

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billion of additional funds to the banking system. On August 16, the Fed reported that the total commercial paper (CP) outstanding fell more than $90 billion over the previous week. The lack of demand for CP made it difficult for borrowers to roll over debt. This drop was most pronounced for ABCP (Exhibit 6). These actions did little to calm the markets, and on September 18, the Fed lowered its target federal funds rate 50 basis points to 4.75%, and later that fall, it was cut another 25 basis points. The Fed cited concerns that “the tightening of credit conditions had the potential to intensify the housing correction and to restrain economic growth.”31

Throughout the fall, Bear took additional steps to bolster investor confidence. On

September 20, 2007, it announced a new $2.5 billion share repurchase program to signal management’s belief that its shares were undervalued. Apparently this view was shared by Joseph Lewis, who in September announced the purchase of a 7% stake in Bear for $860 million. The British billionaire had made his fortune investing in turnaround companies.

On October 5, 2007, Schwartz and Cayne held a presentation to update investors on the

state of the firm. Schwartz declared that “things are getting better and that liquidity had improved” in light of the Fed’s decision to lower its benchmark interest rate. At the same presentation, Cayne emphasized his confidence that Bear “would weather the storm and come out a stronger, more diversified and a greater organization.” He added that the firm was not looking for an equity infusion and would only consider a potential partner that “brings along geographic, strategic value to us.”32 Within a few weeks, Bear announced a joint venture with China’s CITIC Securities. Each firm would invest $1 billion in the other to pursue the growing market for financial services in China. Although the deal was a positive development for the firm, it did not provide an equity infusion; it would take months for the deal to close. During the same month, the firm announced the layoff of some 300 employees in an attempt to reduce costs.

On November 1, 2007, a page-one article appeared in the Wall Street Journal,

documenting Cayne’s long absences for bridge or golf tournaments and questioning his oversight when critical decisions were made during the summer’s hedge fund crisis. A number of Cayne’s longtime associates defended him and pointed to his highly successful record over 14 years. Other investors, such as Bruce Sherman, CEO of Private Capital Management and Bear Stearns’s fourth-largest shareholder, were less forgiving and advocated for a change.33

On December 20, 2007, Bear reported the first loss in its 84-year history. For the quarter

ended November 30, the firm reported –$854 million of net income or –$6.90 per share compared with $563 million or $4.00 per share a year ago. The firm also wrote off $1.9 billion of losses on its loan portfolio. Following the write-down, Standard & Poor’s lowered the company’s long-term senior debt rating from A+ to A. S&P believed its mortgage-related

31 Board of Governors of the Federal Reserve System, press release, September 18, 2007,

http://www.federalreserve.gov/newsevents/press/monetary/20070918a.htm (accessed October 6, 2008). 32 “Bear Stearns Denies Need to Seek Cash from Outside,” New York Times, October 5, 2007. 33 Kate Kelly, “The Fall of Bear Stearns: Lost Opportunities Haunt Final Days of Bear Stearns—Executives

Bickered Over Raising Cash, Cutting Mortgages,” Wall Street Journal, May 27, 2008.

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exposure was manageable, but was concerned that the company’s concentration in fixed income might hinder future revenue generation. In response to the disappointing earnings and ratings downgrade, Bear’s CDSs jumped from 108 basis points at the end of October to 176 basis points at the end of December 2007 (Exhibit 10). In light of the poor results, the executive committee decided to forgo bonuses. The income statement, balance sheet, and leverage and capital adequacy ratios of Bear Stearns are shown in Exhibits 11, 12, and 13.

Although the firm’s stock price had briefly rallied in October, it fell throughout the next

two months, ending the year at $88 per share (Exhibit 14). The Decision

As much as Corso had admired Cayne’s stewardship of Bear Stearns through the years, his resignation and the promotion of Schwartz had not come as a surprise. Having known Cayne for many years—–he had not changed, but the world had.34 He knew little about Schwartz except that he had never shown much interest in the firm’s trading activities, which were now at the center of its current problems. Throughout the fall, he had watched the steps management had taken and was uncertain about how successful they had been in resolving its credit problems. Perceptions and appearances were important on Wall Street—to take action might confirm the firm’s problems; to fail to act left the firm in the same potentially precarious position. Instead of managing the situation, Bear Stearns, a firm whose culture and fortunes were made trading and surmounting risk, seemed stymied by it. As Corso weighed his decision about his brokerage assets, one thought kept running through his mind—should a run develop on the bank, no one would want to be the last person in line at the teller’s window.

34 William D. Cohan, “The Rise and Fall of Jimmy Cayne,” Fortune (August 25, 2008).

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Exhibit 1

BEAR STEARNS AND THE SEEDS OF ITS DEMISE

Interest Rate Movements: 2000–07

Source: The U.S. Federal Reserve.

For the exclusive use of O. Oztekin, 2017.

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-1

U V

10 64

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Exhibit 3

BEAR STEARNS AND THE SEEDS OF ITS DEMISE

Loan Characteristics of the First-Lien Subprime Loans

2001 2002 2003 2004 2005 2006 2007 Size Number of loans (thousands) 452 737 1,258 1,911 2,274 1,772 316 Average loan size (thousands of dollars) 126 145 164 180 200 212 220 Mortgage Type Fixed-rate mortgages (FRM) (%) 33.2 29.0 33.6 23.8 18.6 19.9 27.5 Adjustable-rate mortgages (ARM) (%) 0.4 0.4 0.3 0.3 0.4 0.4 0.2 Hybrid mortgages (%) 59.9 68.2 65.3 75.8 76.8 54.5 43.8 Balloon mortgages (%) 6.5 2.5 0.8 0.2 4.2 25.2 28.5 Loan Purpose Purchase (%) 29.7 29.3 30.1 35.8 41.3 42.4 29.6 Refinancing (cash out) (%) 58.4 57.4 57.7 56.5 52.4 51.4 59.0 Refinancing (no cash out) (%) 11.2 12.9 11.8 7.7 6.3 6.2 11.4 Credit Characteristics (Means) FICO score 601.2 608.9 618.1 618.3 620.9 618.1 613.2 Combined loan-to-value ratio (%) 79.4 80.1 82.0 83.6 84.9 85.9 82.8 Debt-to-income ratio (%) 38.0 38.5 38.9 39.4 40.2 41.1 41.4 Documentation required (%) 76.5 70.4 67.8 66.4 63.4 62.3 66.7 Costs Mortgage rate 9.70 8.70 7.70 7.30 7.50 8.40 8.60 Spread on ARM/hybrid mortgages 6.40 6.60 6.30 6.10 5.90 6.10 6.00 Comparative Rates (%) AAA-Rated—Corporate 7.08 6.49 5.67 5.63 5.24 5.59 5.56 BBB-Rated—Corporate 7.95 7.80 6.77 6.39 6.06 6.48 6.48 LIBOR—1-year 3.74 2.17 1.37 2.19 4.09 5.35 5.17 Source: Y. Demyanyk and O. Van Hemert, “Understanding the Subprime Mortgage Crisis,” (working paper, Federal Reserve Bank of St. Louis, August 19, 2008). Information on comparative interest rates is from the Federal Reserve.

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-17- UV1064

Exhibit 4

BEAR STEARNSAND THE SEEDS OF ITS DEMISE

Mortgage Delinquency Rates (2001–07)

Source: U.S. Federal Reserve, based on First American Loan Performance data.

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-18- UV1064

Exhibit 5

BEAR STEARNS AND THE SEEDS OF ITS DEMISE

Home Price Values for Composite of U.S. Metropolitan Regions and Largest U.S. Cities (1995–2007)

The “Composite 10” included the metropolitan regions of Boston; Chicago; Denver, Colorado; Los Angeles; Las Vegas, Nevada; Miami, New York; San Diego, California; San Francisco; and Washington, D.C. The S&P/Case-Shiller Home Price Indices measured the residential housing market, tracking changes in the value of the residential real estate market. To be eligible to be included in the indices, a house had to be a single-family dwelling. Condominiums and co-ops were specifically excluded. Houses included in the indices also had to have two or more recorded arms-length sale transactions. As a result, new construction was excluded.

Source: Case writer created chart using data from S&P/Case-Shiller Home Price Indices.

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Exhibit 6

BEAR STEARNS AND THE SEEDS OF ITS DEMISE

The Commercial Paper Market: January 2003–December 2007

Note: ABCP was outstanding asset-backed commercial paper and Non-ABCP was unsecured financial, nonfinancial, and other commercial paper. Source: Case writer created chart using data from the Federal Reserve.

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-2

U V

10 64

xh ib

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-21- UV1064

Exhibit 8

BEAR STEARNS AND THE SEEDS OF ITS DEMISE

The ABX Home Equity (HE) Indices: June 30, 2000–December 31, 2007

The ABX.HE was a tradable synthetic index of CDSs on U.S. subprime asset-backed securities. The value of each index was 100 at initiation. The index was created from 20 deals of the largest subprime home equity ABS programs over a rolling six-month period. The ABX had separate indices based on the rating of the underlying subprime securities, ranging from AAA to BBB-minus. A decline in the ABX suggested that the securities had become more risky and that the value of CDSs had fallen. Source: Case writer created chart using data from ABX Indices, http://www.markit.com.

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-22- UV1064

Exhibit 9

BEAR STEARNS AND THE SEEDS OF ITS DEMISE

Bear Stearns’s Mortgage-Related Instruments at Fair Value (in millions of U.S. dollars)

2007 2006 Financial Instruments Owned, at Fair Value U.S. government and agency $12,920 $10,842 Other sovereign governments 672 1,372 Corporate equity and convertible debt 32,454 28,893 Corporate debt and other 26,330 32,551 Mortgages, mortgage- and asset-backed 46,141 39,893 Derivative financial instruments 19,725 11,617

$138,242 $125,168 Financial Instruments Sold, But Not Yet Purchased, at Fair Value U.S. government and agency $4,563 $11,724 Other sovereign governments 2,473 1,275 Corporate equity and convertible debt 18,843 12,623 Corporate debt and other 4,373 4,451 Mortgages, mortgage- and asset-backed 63 319 Derivative financial instruments 13,492 11,865

$43,807 $42,257 “Financial instruments sold, but not yet purchased,” are obligations of the company to purchase the specified financial instrument at the then current market price. These transactions resulted in off-balance-sheet risk as the company’s ultimate obligation to repurchase such securities might exceed the amount recognized in the Consolidated Statement of Financial Condition.

The Valuation of Financial Instruments was reported on a basis consistent with SFAS No. 157, “Fair Value Measurements.” As defined in SFAS No. 157, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Financial assets and liabilities carried at fair value were classified and disclosed in one of the following three categories: Level 1: Inputs based on quoted market prices for identical assets or liabilities in active markets. Level 2: Observable market based inputs or unobservable inputs that were corroborated by market data. Level 3: Unobservable inputs that were not corroborated by market data. CDOs fell in Level 3. Certain complex financial instruments and other investments have significant data inputs that cannot be validated by reference to readily observable data. These instruments are typically illiquid, long dated or unique in nature and therefore engender considerable judgment by traders and their management who, as dealers in many of these instruments, have the appropriate knowledge to estimate data inputs that are less readily observable. For certain instruments, extrapolation or other methods are applied to observed market or other data to estimate assumptions that are not observable. Source: SEC, The Bear Stearns Companies Inc. 2007 Annual Report.

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-23- UV1064

Exhibit 10

BEAR STEARNS AND THE SEEDS OF ITS DEMISE

Bear Stearns’s Five-Year Credit Default Swap Rates: January 2004–December 2007

Note: Five-year swap rates were the price of default insurance for a five-year period. Premium for Bear Stearns’s CDS were not available before 2003. Thereafter, annual CDS rates for Bear Stearns’s debt averaged 30 bps in 2003, 36 bps in 2004, 30 bps in 2005, 23 bps in 2006, and 79 bps in 2007. Source: Case writer created chart using data from Merrill Lynch.

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-24- UV1064

Exhibit 11

BEAR STEARNS AND THE SEEDS OF ITS DEMISE

Consolidated Statements of Income (in millions of U.S. dollars, except share and per-share data)

Fiscal Years Ended November 30, 2007 2006 2005

REVENUES Commissions $1,269 $1,163 $1,200 Principal transactions 1,323 4,995 3,836 Investment banking 1,380 1,334 1,037 Interest and dividends 11,556 8,536 5,107 Asset management and other income 623 523 372

Total revenues 16,151 16,551 11,552 Interest expense 10,206 7,324 4,141

Revenues, net of interest expense $5,945 $9,227 $7,411 NONINTEREST EXPENSES Employee compensation and benefits $3,425 $4,343 $3,553 Floor brokerage, exchange and clearance fees 279 227 222 Communications and technology 578 479 402 Occupancy 264 198 168 Advertising and market development 179 147 127 Professional fees 362 280 229 Impairment of goodwill and specialist rights 227 Other expenses 438 406 503

Total noninterest expenses 5,752 6,080 5,204 Income before provision for income taxes 193 3,147 2,207 (Benefit from)/provision for income taxes (40) 1,093 745

Net income $233 $2,054 $1,462 Preferred stock dividends (21) (21) (24)

Net income applicable to common shares $212 $2,033 $1,438 Basic earnings per share $1.68 $15.79 $11.42 Diluted earnings per share $1.52 $14.27 $10.31 Weighted average common shares outstanding: Basic (in millions) 130.2 131.7 130.3 Diluted (in millions) 146.4 148.6 147.5

Source: SEC, The Bear Stearns Companies Inc. 2007 Annual Report.

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-25- UV1064

Exhibit 12

BEAR STEARNS AND THE SEEDS OF ITS DEMISE

Consolidated Statement of Financial Condition (in millions of U.S. dollars, except share data)

Fiscal Years Ended November 30, 2007 2006 ASSETS Cash and cash equivalents $21,406 $4,595 Cash and securities deposited, clearing or segregated by federal regulations 12,890 8,804 Securities received as collateral 15,599 19,648

Collateralized agreements: securities purchased under agreements to resell 27,878 38,838 Collateralized agreements: securities borrowed 82,245 80,523

Receivables to customers, brokers and dealers, and interest and dividends 53,522 36,346 Financial instruments owned, at fair value 122,518 109,200 Financial instruments owned and pledged as collateral, at fair value 15,724 15,968 Total financial instruments owned, at fair value 138,242 125,168 Assets of variable interest entities and mortgage loan special purpose entities 33,553 30,245 Net property, equipment and leasehold improvements 605 480 Other assets 9,422 5,786

Total assets $395,362 $350,433

LIABILITIES AND STOCKHOLDERS’ EQUITY Unsecured short-term borrowings 11,643 25,787 Obligation to return securities received as collateral 15,599 19,648

Collateralized financings: securities sold under agreements to repurchase 102,373 69,750 Collateralized financings: securities loaned 3,935 11,451

Other secured borrowings 12,361 3,275 Payables to customers, brokers and dealers, and interest and dividends: 88,606 77,509 Financial instruments sold, but not yet purchased, at fair value 43,807 42,257 Liabilities of variable interest entities and mortgage loan special purpose entities 30,605 29,080 Accrued employee compensation and benefits 1,651 2,895 Other liabilities and accrued expenses 4,451 2,082 Long-term borrowings 68,538 54,570

Total liabilities $383,569 $338,304 STOCKHOLDERS’ EQUITY Preferred stock 352 359 Common stock, $1.00 par value 185 185 Paid-in capital 4,986 4,579 Retained earnings 9,441 9,385 Employee stock compensation plans 2,478 2,066 Accumulated other comprehensive (loss) income (8) -- Treasury stock, at cost: (5,641) (4,445)

Total stockholders’ equity $11,793 $12,129 Total liabilities and stockholders’ equity $395,362 $350,433

Source: SEC, The Bear Stearns Companies Inc. 2007 Annual Report.

For the exclusive use of O. Oztekin, 2017.

This document is authorized for use only by Ozde Oztekin in 2017.

-26- UV1064

Exhibit 13

BEAR STEARNS AND THE SEEDS OF ITS DEMISE

Leverage and Capital Adequacy (in millions of U.S. dollars, except ratios)

Fiscal Years Ended November 30, 2007 2006 Total assets $395,362 $350,433

Less: Cash and securities deposited with clearing organizations or segregated in compliance with federal regulations 12,890 8,804

Less: Securities purchased under agreements to resell 27,878 38,838 Less: Securities received as collateral 15,599 19,648 Less: Securities borrowed 82,245 80,523 Less: Receivables from customers 41,115 29,482 Less: Assets of variable interest entities and Mortgage loan special purpose entities, net 30,605 29,080 Less: Goodwill & intangible assets 952 383

Subtotal 184,078 143,675 Add: Financial instruments sold, but not yet purchased 43,807 42,257 Less: Derivative financial instruments 13,492 11,865

Net adjusted assets $214,393 $174,067 Stockholders’ equity

Common equity 11,441 11,770 Preferred stock 352 359 Stock-based compensation 0 816

Total stockholders’ equity 11,793 12,945 Add: Trust preferred equity 263 263

Subtotal - leverage equity 12,056 13,208 Less: Goodwill & intangible assets 952 383

Tangible equity capital $11,104 $12,825 Gross leverage ratio 32.8× 26.5× Net adjusted leverage ratio 19.3× 13.6×

Gross Leverage Ratios of Bear Stearns’ Peers

Years Ended December 31,

Bear Stearns

Goldman Sachs

Lehman Brothers

Merrill Lynch

Morgan Stanley

2003 28.4 18.7 23.7 17.9 24.2 2004 28.5 21.2 23.9 20.7 27.5 2005 27.1 25.2 24.4 19.1 30.8 2006 28.9 23.4 26.2 21.6 31.7 2007 33.5 26.2 30.7 31.9 33.4

Source: SEC Filings, The Bear Stearns Companies Inc. 2007 Annual Report, and Compustat.

For the exclusive use of O. Oztekin, 2017.

This document is authorized for use only by Ozde Oztekin in 2017.

-27- UV1064

Exhibit 14

BEAR STEARNS AND THE SEEDS OF ITS DEMISE

Monthly Performance of Bear Stearns’s Stock, XLF, and S&P 500 Index: 2001–2007

Note: XLF is an exchange-traded fund of financial service companies. Source: Case writer created chart using data from CRSP.

$88

For the exclusive use of O. Oztekin, 2017.

This document is authorized for use only by Ozde Oztekin in 2017.