Case 1

KEL378

©2008 by the Kellogg School of Management, Northwestern University. This case was prepared by Evan Meagher ’09, CFA, under the supervision of Professor David Stowell. Cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. To order copies or request permission to reproduce materials, call 800-545-7685 (or 617-783-7600 outside the United States or Canada) or e-mail [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 Kellogg School of Management.

DAVID STOWELL

Investment Banking in 2008 (A): Rise and Fall of the Bear

Posit: People think a bank might be financially shaky. Consequence: People start to withdraw their money. Result: Pretty soon it IS financially shaky. Conclusion: You can make banks fail.

—Sneakers (1992)

Gary Parr, deputy chairman of Lazard Frères & Co. and Kellogg class of 1980, could not believe his ears.

“You can’t mean that,” he said, reacting to the lowered bid given by Doug Braunstein, JP Morgan head of investment banking, for Parr’s client, legendary investment bank Bear Stearns. Less than eighteen months after trading at an all-time high of $172.61 a share, Bear now had little choice but to accept Morgan’s humiliating $2-per-share, Federal Reserve-sanctioned bailout offer. “I’ll have to get back to you.”1

Hanging up the phone, Parr leaned back and gave an exhausted sigh. Rumors had swirled around Bear ever since two of its hedge funds imploded as a result of the subprime housing crisis, but time and again, the scrappy Bear appeared to have weathered the storm. Parr’s efforts to find a capital infusion for the bank had resulted in lengthy discussions and marathon due diligence sessions, but one after another, potential investors had backed away, scared off in part by Bear’s sizable mortgage holdings at a time when every bank on Wall Street was reducing its positions and taking massive write-downs in the asset class. In the past week, those rumors had reached a fever pitch, with financial analysts openly questioning Bear’s ability to continue operations and its clients running for the exits. Now Sunday afternoon, it had already been a long weekend, and it would almost certainly be a long night, as the Fed-backed bailout of Bear would require onerous negotiations before Monday’s market open. By morning, the eighty-five-year-old investment bank, which had survived the Great Depression, the savings and loan crisis, and the dot-com implosion, would cease to exist as an independent firm. Pausing briefly before calling CEO Alan Schwartz and the rest of Bear’s board, Parr allowed himself a moment of reflection.

How had it all happened?

1 Kate Kelly, “Bear Stearns Neared Collapse Twice in Frenzied Last Days,” Wall Street Journal, May 29, 2008, http://online.wsj.com/article/SB121202057232127889.html (accessed July 17, 2008).

INVESTMENT BANKING IN 2008 (A) KEL378

2 KELLOGG SCHOOL OF MANAGEMENT

Bear Stearns

Founded with just $500,000 of capital in 1923 by Joseph Bear, Robert Stearns, and Harold Mayer, Bear Stearns needed to show its soon-to-be trademark tenacity and agility in the market merely to survive its first decade. Originally conceived as an equity trading house to take advantage of a roaring 1920s bull market, Bear instead relied upon its trading in government securities to last through the Great Depression, managing not only to avoid layoffs but also to continue paying employee bonuses. Despite the sagging national and global economy, Bear grew from its seven original employees to seventy-five by 1933, and began to expand with the acquisition of Chicago-based Stein, Brennan.2

The firm quickly developed a reputation as a maverick in the white-shoe culture of New York investment banking. Unlike more polished firms, who catered to the world’s most prestigious companies and earned most of their revenues from equity underwriting and advisory services, Bear had a cutthroat, renegade culture that stemmed from its dominant position in bond trading, where the slightest turn in the market can make the difference between a profitable trade and a losing one. CEO Salim “Cy” Lewis reinforced this trader’s culture after joining the company in 1938 as head of the firm’s institutional bond trading department, running the firm almost as a holding company of independent profit centers that frantically sought his approval. Imposing at six foot four, Lewis’s audacity, brash demeanor, and relentless work ethic set the tone at Bear until his death in 1978, when he suffered a stroke at his own retirement party at the Harmonie Club in New York City.3

In stark contrast to the WASP-y, cliquish atmosphere of its competitors, Bear set the standard for diversity among its employees, valuing initiative and tenacity over pedigree in its hiring. As Lewis’s successor, Alan “Ace” Greenberg, put it, “If somebody with an MBA degree applies for a job, we will certainly not hold it against them, but we are really looking for people with PSD degrees,” meaning poor, smart, and with a deep desire to become very rich.4

“It was unique,” said Muriel Siebert, founder of brokerage house Muriel Siebert & Co. “It didn’t matter what your last name was. They had a mixture of all kinds of people and they were there to make money.” Long before its clubbier competitors embraced hiring diversity, the scrappy, trading-focused Bear had cultivated a roster of Jewish, Irish, and Italian employees who lacked the Ivy League pedigrees required for positions at white-shoe firms such as Morgan Stanley or Lehman Brothers.

When it went public in 1985, the firm diversified its operations, becoming a full-service investment bank with divisions in investment banking, institutional equities, fixed-income securities, individual investor services, and mortgage-related products.5 Bear’s investment banking unit got off to a rough start, battered by the collapse of the mergers and acquisitions boom in the second half of the decade. The firm remained resilient, however, drawing inspiration from its leader on one of the worst trading days in history: October 19, 1987, or Black Monday.

2 Bear Stearns Companies, Inc., “Company History,” http://www.answers.com/topic/the-bear-stearns-companies-inc?cat=biz-fin (accessed July 11, 2008). 3 Kris Frieswick, “Journey Without Maps,” CFO Magazine, March 2005, http://www.cfo.com/article.cfm/3709778/1/c_3710920 (accessed July 11, 2008). 4 Max Nichols, “One of Our Most Remarkable Leaders,” Oklahoma City Journal Record, April 12, 2001, http://findarticles.com/p/ articles/mi_qn4182/is_20010412/ai_n10145162 (accessed July 11, 2008). 5 Bear Stearns, “Company History.”

KEL378 INVESTMENT BANKING IN 2008 (A)

KELLOGG SCHOOL OF MANAGEMENT 3

As the Dow Jones fell more than 500 points, Greenberg—who did not play golf—pantomimed a golf swing and announced to the assembled throng of traders that he would be taking the following day off.6

By the time James Cayne succeeded Greenberg as CEO in 1993, the firm found itself at the top of the equity underwriting league tables in Latin America and its research department had flourished. Its Early Look at the Market: Bear Stearns Morning View became one of the most widely read pieces of market intelligence.

Long Term Capital Management

Long Term Capital Management, or LTCM, was a hedge fund founded in 1994 by John Meriwether, the former head of Salomon Brothers’s domestic fixed-income arbitrage group. Meriwether had grown the arbitrage group to become Salomon’s most profitable group by 1991, when it was revealed that one of the traders under his purview had astonishingly submitted a false bid in a U.S. Treasury bond auction. Despite reporting the trade immediately to CEO John Gutfreund, the outcry from the scandal forced Meriwether to resign.7

Meriwether revived his career several years later with the founding of LTCM. Amidst the beginning of one of the greatest bull markets the global markets had ever seen, Meriwether assembled a team of some of the world’s most respected economic theorists to join other refugees from the arbitrage group at Salomon. The board of directors included Myron Scholes, a coauthor of the famous Black-Scholes formula used to price option contracts, and MIT Sloan professor Robert Merton, both of whom would later share the 1997 Nobel Prize for Economics. The firm’s impressive brain trust, collectively considered geniuses by most of the financial world, set out to raise a $1 billion fund by explaining to investors that their profoundly complex computer models allowed them to price securities according to risk more accurately than the rest of the market, in effect “vacuuming up nickels that others couldn’t see.” 8

One typical LTCM trade concerned the divergence in price between long-term U.S. Treasury bonds. Despite offering fundamentally the same (minimal) default risk, those issued more recently—known as “on-the-run” securities—traded more heavily than those “off-the-run” securities issued just months previously. Heavier trading meant greater liquidity, which in turn resulted in ever-so-slightly higher prices. As “on-the-run” securities become “off-the-run” upon the issuance of a new tranche of Treasury bonds, the price discrepancy generally disappears with time. LTCM sought to exploit that price convergence by shorting the more expensive “on-the- run” bond while purchasing the “off-the-run” security.

By early 1998 the intellectual firepower of its board members and the aggressive trading practices that had made the arbitrage group at Salomon so successful had allowed LTCM to flourish, growing its initial $1 billion of investor equity to $4.72 billion (Exhibit 1). However, the miniscule spreads earned on arbitrage trades could not provide the type of returns sought by hedge fund investors. In order to make transactions such as these worth their while, LTCM had to

6 Kate Kelly, “Fear, Rumors Touched Off Fatal Run on Bear Stearns,” Wall Street Journal, May 28, 2008, http://online.wsj.com/article/SB121193290927324603.html (accessed July 16, 2008). 7 Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York: Random House, 2000). 8 Ibid.

INVESTMENT BANKING IN 2008 (A) KEL378

4 KELLOGG SCHOOL OF MANAGEMENT

employ massive leverage in order to magnify its returns. Ultimately, the fund’s equity component sat atop more than $124.5 billion in borrowings for total assets of more than $129 billion. These borrowings were merely the tip of the iceberg; LTCM also held off-balance-sheet derivative positions with a notional value of more than $1.25 trillion.

The fund’s success began to pose its own problems. The market lacked sufficient capacity to absorb LTCM’s bloated size, as trades that had been profitable initially became impossible to conduct on a massive scale. Moreover, a flood of arbitrage imitators tightened the spreads on LTCM’s “bread-and-butter” trades even further. The pressure to continue delivering returns forced LTCM to find new arbitrage opportunities, and the fund diversified into areas where it could not pair its theoretical insights with trading experience. Soon LTCM had made large bets in Russia and in other emerging markets, on S&P futures, and in yield curve, junk bond, merger, and dual-listed securities arbitrage.

Combined with its style drift, the fund’s more than 26x leverage put LTCM in an increasingly precarious bubble, which was eventually burst by a combination of factors that forced the fund into a liquidity crisis. In contrast to Scholes’s comments about plucking invisible, riskless nickels from the sky, financial theorist Nassim Taleb later compared the fund’s aggressive risk-taking to “picking up pennies in front of a steamroller,” a steamroller that finally came in the form of 1998’s market panic. The departure of frequent LTCM counterparty Salomon Brothers from the arbitrage market that summer put downward pressure on many of the fund’s positions, and Russia’s default on its government-issued bonds threw international credit markets into a downward spiral. Panicked investors around the globe demonstrated a “flight to quality,” selling the risky securities in which LTCM traded and purchasing U.S. Treasury securities, further driving up their price and preventing a price convergence upon which the fund had bet so heavily.

None of LTCM’s sophisticated theoretical models had contemplated such an internationally correlated credit market collapse, and the fund began hemorrhaging money, losing nearly 20 percent of its equity in May and June alone. Day after day, every market in which LTCM traded turned against it. Its powerless brain trust watched in horror as its equity shrank to $600 million in early September without any reduction in borrowing, resulting in an unfathomable 200x leverage ratio. Sensing the fund’s liquidity crunch, Bear Stearns refused to continue acting as a clearinghouse for the fund’s trades, throwing LTCM into a panic. Without the short-term credit that enabled its entire trading operations, the fund could not continue and its longer-term securities grew more illiquid by the day.9

Obstinate in their refusal to unwind what they still considered profitable trades hammered by short-term market irrationality, LTCM’s partners refused a buyout offer of $250 million by Goldman Sachs, ING Barings, and Warren Buffet’s Berkshire Hathaway.10 However, LTCM’s role as a counterparty in thousands of derivatives trades that touched investment firms around the world threatened to provoke a wider collapse in international securities markets if the fund went under, so the U.S. Federal Reserve stepped in to maintain order. Wishing to avoid the precedent of a government bailout of a hedge fund and the moral hazard it could subsequently encourage, the Fed invited every major investment bank on Wall Street to an emergency meeting in New York and dictated the terms of the $3.625 billion bailout that would preserve market liquidity. The Fed convinced Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank,

9 Ibid. 10 Andrew Garfield et al., “Bear Stearns’ $500m Call Triggered LTCM Crisis,” London Independent, September 26, 1998, http://findarticles.com/p/articles/mi_qn4158/is_19980926/ai_n14183149 (accessed July 12, 2008).

KEL378 INVESTMENT BANKING IN 2008 (A)

KELLOGG SCHOOL OF MANAGEMENT 5

Goldman Sachs, Merrill Lynch, JP Morgan, Morgan Stanley, Salomon Smith Barney, and UBS— many of whom were investors in the fund—to contribute $300 million apiece, with $125 million coming from Société Générale and $100 million from Lehman Brothers and Paribas. Eventually the market crisis passed, and each bank managed to liquidate its position at a slight profit. Only one bank contacted by the Fed refused to join the syndicate and share the burden in the name of preserving market integrity.

That bank was Bear Stearns.

Bear’s dominant trading position in bonds and derivatives had won it the profitable business of acting as a settlement house for nearly all of LTCM’s trading in those markets. On September 22, 1998, just days before the Fed-organized bailout, Bear put the final nail in the LTCM coffin by calling in a short-term debt in the amount of $500 million in an attempt to limit its own exposure to the failing hedge fund, rendering it insolvent in the process. Ever the maverick in investment banking circles, Bear stubbornly refused to contribute to the eventual buyout, even in the face of a potentially apocalyptic market crash and despite the millions in profits it had earned as LTCM’s prime broker. In typical Bear fashion, Cayne ignored the howls from other banks that failure to preserve confidence in the markets through a bailout would bring them all down in flames, famously growling through a chewed cigar as the Fed solicited contributions for the emergency financing, “Don’t go alphabetically if you want this to work.”11

Market analysts were nearly unanimous in describing the lessons learned from LTCM’s implosion; in effect, the fund’s profound leverage had placed it in such a precarious position that it could not wait for its positions to turn profitable. While its trades were sound in principal, LTCM’s predicted price convergence was not realized until long after its equity had been wiped out completely. A less leveraged firm, they explained, might have realized lower profits than the 40 percent annual return LTCM had offered investors up until the 1998 crisis, but could have weathered the storm once the market turned against it. In the words of economist John Maynard Keynes, the market had remained irrational longer than LTCM could remain solvent. The crisis further illustrated the importance not merely of liquidity but of perception in the less regulated derivatives markets. Once LTCM’s ability to meet its obligations was called into question, its demise became inevitable, as it could no longer find counterparties with whom to trade and from whom it could borrow to continue operating.

The thornier question of the Fed’s role in bailing out an overly aggressive investment fund in the name of market stability remained unresolved, despite the Fed’s insistence on private funding for the actual buyout. Though impossible to foresee at the time, the issue would be revisited anew less than ten years later, and it would haunt Bear Stearns.

With negative publicity from Bear’s $38.5 million settlement with the SEC regarding charges that it had ignored fraudulent behavior by a client for whom it cleared trades and LTCM’s collapse behind it, Bear Stearns continued to grow under Cayne’s leadership, with its stock price appreciating some 600 percent from his assumption of control in 1993 until 2008. However, a rapid-fire sequence of negative events began to unfurl in the summer of 2007 that would push Bear into a liquidity crunch eerily similar to the one that felled LTCM.

11 Ibid.

INVESTMENT BANKING IN 2008 (A) KEL378

6 KELLOGG SCHOOL OF MANAGEMENT

The Credit Crisis

Beginning in the late 1990s, consistent appreciation in U.S. real estate values fueled a decade- long boom in the housing market. During this period, the mortgage business was revolutionized from its traditionally local focus with banks lending directly to homebuyers to a global industry with banks issuing mortgages and then selling them to a diverse pool of investors. Eager to add new products that provided underwriting fees, investment banks began “securitizing” the mortgages, slicing them into various securities differentiated on the basis of the geography of the underlying mortgages, the estimated default risk, and whether the purchaser of the security would receive the interest accruing on the mortgages or the payback of the principal. Investment banks then sold these securities to various investor groups depending on their preferences regarding risk, interest rate exposure, and myriad other factors. Issuance of these collateralized debt obligations, or CDOs, grew to a peak of $421.6 billion in 2006 and $266.9 billion in 1H 2007 in the United States alone (Exhibit 2).12 In the process, the structure of the mortgage industry changed (Exhibit 3).13

Previously, small, mostly regional banks had conducted mortgage lending using the funds deposited by their retail customers, which limited the total dollar amount any one bank could lend. More importantly, banks had to rely upon their own due diligence to make sure that mortgage terms remained reasonable—that the homebuyer had sufficient income and credit history to repay the loan, or that the appraisal on the property justified the amount lent. The surge of investor appetite for CDOs in the early 2000s allowed lenders to issue mortgages and then immediately securitize them through investment banks, who sold the various tranches of those securities in the mortgage bond market. One can easily recognize the sea change in incentives for lenders; without the loan resting on the bank’s balance sheet, the best way to boost profits was to originate more—rather than safer—mortgages before flipping them to investment banks, which reissued them through CDOs. Issuance ballooned.

However, the suddenly lucrative CDO market suffered from inherent limitations on the base of potential homebuyers. Moreover, with interest rates remaining historically low and stable for the better part of a decade, investors—particularly hedge fund investors, who entered the CDO market in earnest in 2004 and 200514—began seeking higher returns by taking on additional risk. The twin pressures of investors seeking higher returns and lenders trying to grow their market led to the boom in higher-risk mortgages to less creditworthy homebuyers, or “subprime” mortgages (Exhibit 4).

Officially referring to loans that did not meet the more stringent guidelines of Fannie Mae or Freddie Mac, subprime mortgages were geared toward riskier homebuyers with lower incomes and spottier credit histories. As a result, such mortgages frequently carried higher interest rates, increasing investor return but also the likelihood of homeowner default. One common subprime structure was the “2/28” adjustable rate mortgage (ARM), a floating rate loan that featured a low interest rate for the first two years before resetting to a significantly higher rate for the final twenty-eight years of the loan, often 500 or more basis points over LIBOR. The long historical trend in rising real estate values and the ready availability of credit in the market convinced many

12 Securities Industry and Financial Markets Association, “Global CDO Market Issuance Data,” http://www.sifma.org/research/pdf/ SIFMA_CDOIssuanceData2008.pdf (accessed July 11, 2008). 13 IMF Global Financial Stability Report, “Financial Market Turbulence: Causes, Consequences, and Policies,” 2007. 14 Peter Cockhill and James Bagnall, “Hedge Fund Managers Expand Into CDOs and Private Equity,” Hedgeweek, October 1, 2005, http://www.hedgeweek.com/articles/detail.jsp?content_id=12879 (accessed July 12, 2008).

KEL378 INVESTMENT BANKING IN 2008 (A)

KELLOGG SCHOOL OF MANAGEMENT 7

that they could refinance their mortgages before the ARM adjusted to the higher interest rate, allowing them in effect to gain significant equity in the home without significant cash outlay.

The sudden pullback in U.S. housing prices in the summer of 2006 changed all of that (Exhibit 5). With the collapse of housing markets in Arizona, California, Florida, and the northeast corridor of the United States, many owners found themselves holding negative equity, meaning the appraised value of the property was less than the mortgage debt outstanding on their loan (Exhibit 6). Foreclosures spiked, and suddenly wary lenders stopped issuing new loans almost entirely.

Bear Stearns Asset Management

Like many of its competitors, Bear Stearns saw the rise of the hedge fund industry during the 1990s and began managing its own funds with outside investor capital under the name Bear Stearns Asset Management (BSAM). Unlike its competitors, Bear hired all of its fund managers internally, with each manager specializing in a particular security or asset class. Objections by some Bear executives, such as co-president Alan Schwartz, that such concentration of risk could raise volatility were ignored, and the impressive returns posted by internal funds such as Ralph Cioffi’s High-Grade Structured Credit Strategies Fund quieted any concerns.

Cioffi’s fund invested in sophisticated credit derivatives backed by mortgage securities. When the housing bubble burst in 2006, Cioffi’s trades turned unprofitable, but like many successful Bear traders before him he redoubled his bets, raising a new Enhanced Leverage High- Grade Structured Credit Strategies Fund that would use 100x leverage (as compared to the 35x leverage employed by the original fund).15 The market continued to turn disastrously against the fund, which was soon stuck with billions of dollars worth of illiquid, unprofitable mortgages. In an attempt to salvage the situation and cut his losses, Cioffi launched a vehicle named Everquest Financial and sold its shares to the public. But when journalists at the Wall Street Journal revealed that Everquest’s primary assets were the “toxic waste” of money-losing mortgage securities, Bear had no choice but to cancel the public offering. With spectacular losses mounting daily, investors attempted to withdraw their remaining holdings. In order to free up cash for such redemptions, the fund had to liquidate assets at a loss, selling that only put additional downward pressure on its already underwater positions. Lenders to the fund began making margin calls and threatening to seize its $1.2 billion in collateral, leading to a hastily arranged conference with creditors in which Bear trader and co-president Warren Spector claimed that lenders from Merrill Lynch and JP Morgan Chase did not understand the fund’s operations and that Cioffi would turn it around.

In a less turbulent market it might have worked, but the subprime crisis had spent weeks on the front page of financial newspapers around the globe, and every bank on Wall Street was desperate to reduce its own exposure. Insulted and furious that Bear had refused to inject any of its own capital to save the funds, Steve Black, JP Morgan Chase head of investment banking, called Schwartz and said, “We’re defaulting you.”16

15 Bryan Burrough, “Bringing Down Bear Stearns,” Vanity Fair, August 2008, http://www.vanityfair.com/politics/features/2008/08/ bear_stearns200808 (accessed July 13, 2008). 16 Ibid.

INVESTMENT BANKING IN 2008 (A) KEL378

8 KELLOGG SCHOOL OF MANAGEMENT

The default and subsequent seizure of $400 million in collateral by Merrill Lynch proved highly damaging to Bear Stearns’s reputation across Wall Street. In a desperate attempt to save face under the scrutiny of the SEC, Cayne made the unprecedented move of using $1.6 billion of Bear’s own capital to prop up the hedge funds. The bailout later revealed deeper problems at the bank when a front-page Wall Street Journal article claimed that Cayne had been absent at the height of the scandal, off on a ten-day golf and bridge-playing vacation in Nashville without a cell phone or e-mail device. The article further alleged ongoing marijuana usage by Cayne, who denied the specific 2004 incident identified in the article but refused to make a blanket statement denying any such usage in the past.

By late July 2007 even Bear’s continued support could no longer prop up Cioffi’s two beleaguered funds, which paid back just $300 million of the credit its parent had extended. With their holdings virtually worthless, the funds had no choice but to file for bankruptcy protection. The following day, Cayne returned from Nashville and set about trying to calm shareholder fears that Bear was not standing on solid financial ground. Spector would not survive the weekend, with Cayne forcing him out in a sort of public bloodletting to show that things were once again under control. Ironically, his departure may have done more harm than good. After opening an August 3 conference call with a statement of assurance that the company had $11.4 billion in cash and was “taking the situation seriously,” Cayne turned the call over to chief financial officer Samuel Molinaro, Jr., and stepped out to speak with an attorney regarding Spector’s resignation. When the conversation turned to Q&A, an equity research analyst’s question posed to Cayne met with deafening silence. Cayne later returned to the room, but callers were not told this, contributing to the impression of Cayne as a disinterested, absentee CEO.17

The Calm Before the Storm

On November 14, just two weeks after the Journal story questioning Cayne’s commitment and leadership, Bear Stearns reported that it would write down $1.2 billion in mortgage-related losses. (The figure would later grow to $1.9 billion.) CFO Molinaro suggested that the worst had passed, and to outsiders, at least, the firm appeared to have narrowly escaped disaster.

Behind the scenes, however, Bear management had already begun searching for a white knight, hiring Gary Parr at Lazard to examine its options for a cash injection. Privately, Schwartz and Parr spoke with Kohlberg Kravis Roberts & Co. founder Henry Kravis, who had first learned the leveraged buyout market while a partner at Bear Stearns in the 1960s. Kravis sought entry into the profitable brokerage business at depressed prices, while Bear sought an injection of more than $2 billion in equity capital (for a reported 20 percent of the company) and the calming effect that a strong, respected personality like Kravis would have upon shareholders. Ultimately the deal fell apart, largely due to management’s fear that KKR’s significant equity stake and the presence of Kravis on the board would alienate the firm’s other private equity clientele, who often competed with KKR for deals. Throughout the fall Bear continued to search for potential acquirers, with private equity firm J. C. Flowers & Co., JP Morgan Chase, and Berkshire Hathaway CEO Warren Buffett all kicking the tires before ultimately passing. With the market watching intently to see if Bear shored up its financing, Cayne managed to close only a $1 billion

17 Kate Kelly, “Bear CEO’s Handling of Crisis Raises Issues,” Wall Street Journal, November 1, 2007, http://online.wsj.com/public/article_print/SB119387369474078336.html (accessed July 14, 2008).

KEL378 INVESTMENT BANKING IN 2008 (A)

KELLOGG SCHOOL OF MANAGEMENT 9

cross-investment with CITIC, the state-owned investment company of the People’s Republic of China.

Meanwhile, a battle raged within the firm, with factions pitted against each other on how to proceed with Bear’s mortgage holdings, which were still valued at $56 billion despite steady price declines. With traders insisting that any remaining mortgage positions be cut, head mortgage trader Tom Marano instituted a “chaos trade,” essentially a massive short on the ABX, a family of subprime indexes. They also shorted commercial mortgage indexes and the stocks of other financials with mortgage exposure, such as Wells Fargo and Countrywide Financial.

Bear’s executive and risk committees met in late September 2007 to review the trades, just after negotiations to sell a 10 percent stake in Bear to Allianz SE’s Pacific Investment Management Co. had failed. With Cayne recovering from an infection, all eyes turned to Greenberg, who had become increasingly active throughout the crisis. Uncomfortable with the size of Bear’s remaining mortgage holdings and the potential volatility of the chaos trade, the veteran trader insisted that the firm reduce its exposure. “We’ve got to cut!” he shouted, invoking the firm’s historical aggressiveness in trimming unprofitable positions.

Despite the fact that the hedges had returned close to half a billion dollars, Schwartz followed Greenberg’s advice, requesting trades to offset specific assets in Bear’s portfolio instead of the broader, more market-based chaos trade.

Morale sunk to demoralizing lows as fall turned to winter, with bankers squabbling over a greatly diminished bonus pool and top Bear executives clamoring for Cayne’s dismissal as CEO. Top performers at Bear demanded that Schwartz oust Cayne or else face a mass exodus. Matters worsened on December 20, when Bear posted the first quarterly loss since its founding some eighty-five years earlier. The next day it received an e-mail from colossal bond manager PIMCO indicating its discomfort with exposure to the financial sector and its desire to unwind billions of dollars worth of trades with Bear. An emergency conference call to Bear alumnus and PIMCO managing director William Powers convinced the fund to hold off on any such drastic moves at least until a meeting with Bear executives, but Powers’s admonition came through loud and clear: “You need to raise equity.”18

In an attempt to stem the tide of quality employees fleeing what appeared to be a sinking ship, Schwartz conversed with the board and received approval to ask for Cayne’s resignation, which he tendered on January 8. Cayne remained chairman of the board, with Schwartz stepping in as the new CEO. Schwartz immediately turned his sights to the Q1 numbers, desperate to ensure that Bear would post a quarterly profit and hopefully calm the growing uneasiness among its shareholders, employees, creditors, and counterparties in the market.

Run on the Bank

Bear’s $0.89 profit per share in the first quarter of 2008 did little to quiet the growing whispers of its financial instability (Exhibit 7). It seemed that every day another major investment bank reported mortgage-related losses, and for whatever reason, Bear’s name kept

18 Kate Kelly, “Lost Opportunities Haunt Final Days of Bear Stearns,” Wall Street Journal, May 27, 2008, http://online.wsj.com/article/SB121184521826521301.html (accessed July 16, 2008).

INVESTMENT BANKING IN 2008 (A) KEL378

10 KELLOGG SCHOOL OF MANAGEMENT

cropping up in discussions of the by-then infamous subprime crisis. Exacerbating Bear’s public relations problem, the SEC had launched an investigation into the collapse of the two BSAM hedge funds, and rumors of massive losses at three major hedge funds further rattled an already uneasy market. Nonetheless, Bear executives felt that the storm had passed, reasoning that its almost $21 billion in cash reserves had convinced the market of its long-term viability (Exhibit 8).

Instead, on Monday, March 10, 2008, Moody’s downgraded 163 tranches of mortgage- backed bonds issued by Bear across fifteen transactions.19 The credit rating agency had drawn sharp criticism in its role in the subprime meltdown from analysts who felt the company had overestimated the creditworthiness of mortgage-backed securities and failed to alert the market of the danger as the housing market turned. As a result, Moody’s was in the process of downgrading nearly all of its ratings, but as the afternoon wore on, Bear’s stock price seemed to be reacting far more negatively than competitor firms.

Wall Street’s drive toward ever more sophisticated communications devices had created an interconnected network of traders and bankers across the world. On most days, Internet chat and mobile e-mail devices relayed gossip about compensation, major employee departures, and even sports betting lines. On the morning of March 10, however, it was carrying one message to the exclusion of all others: Bear was having liquidity problems.

At noon, CNBC took the story public on Power Lunch. As Bear’s stock price fell more than 10 percent to $63, Ace Greenberg frantically placed calls to various executives, demanding that someone publicly deny any such problems. When contacted himself, Greenberg told a CNBC correspondent that the rumors were “totally ridiculous,” angering CFO Molinaro, who felt that denying the rumor would only legitimize it and trigger further panic selling, making prophesies of Bear’s illiquidity self-fulfilling.20 Just two hours later, however, Bear appeared to have dodged a bullet. News of New York governor Eliot Spitzer’s involvement in a high-class prostitution ring wiped any financial rumors off the front page, leading Bear executives to believe the worst was once again behind them.

Instead, the rumors exploded anew the next day, as many interpreted the Federal Reserve’s announcement of a new $200 billion lending program to help financial institutions through the credit crisis21 as aimed specifically toward Bear Stearns. The stock dipped as low as $55.42 before closing at $62.97 (Exhibit 9). Meanwhile, Bear executives faced a new crisis in the form of an explosion of novation requests, in which a party to a risky contract tries to eliminate its risky position by selling it to a third party. Credit Suisse, Deutsche Bank, and Goldman Sachs all reported a deluge of novation requests from firms trying to reduce their exposure to Bear’s credit risk. The speed and force of this explosion of novation requests meant that before Bear could act, both Goldman Sachs and Credit Suisse issued e-mails to their traders holding up any requests relating to Bear Stearns pending approval by their credit departments. Once again, the electronically linked gossip network of trading desks around the world dealt a blow to investor confidence in Bear’s stability, as a false rumor circulated that Credit Suisse’s memo had

19 Sue Chang, “Moody’s Downgrades Bear Stearns Alt-A Deals,” MarketWatch, March 10, 2008, http://www.marketwatch.com/news/ story/moodys-downgrades-bear-stearns-alt-deals/story.aspx?guid=%7B9989153A-B0F4-43B6-AE11-7B2DBE7E0B9C%7D (accessed July 19, 2008). 20 Burrough, “Bringing Down Bear Stearns.” 21 Chris Reese, “Bonds Extend Losses After Fed Announcement,” Reuters News, March 11, 2008, http://www.reuters.com/article/ bondsNews/idUSNYD00017820080311 (accessed July 16, 2008).

KEL378 INVESTMENT BANKING IN 2008 (A)

KELLOGG SCHOOL OF MANAGEMENT 11

forbidden its traders from engaging in any trades with Bear.22 The decrease in confidence in Bear’s liquidity could be quantified by the rise in the cost of credit default swaps on Bear’s debt. The price of such an instrument—which effectively acts as five years of insurance against a default on $10 million of Bear’s debt—spiked to more than $626,000 from less than $100,000 in October, indicating heavy betting by some firms that Bear would be unable to pay its liabilities.23

Internally, Bear debated whether to address the rumors publicly, ultimately deciding to arrange a Wednesday morning interview of Schwartz by CNBC correspondent David Faber. Not wanting to encourage rumors with a hasty departure, Schwartz did the interview live from Bear’s annual media conference in Palm Beach. Chosen because of his perceived friendliness to Bear, Faber nonetheless opened the interview with a devastating question that claimed direct knowledge of a trader whose credit department had temporarily held up a trade with Bear. Later during the interview Faber admitted that the trade had finally gone through, but he had called into question Bear’s fundamental capacity to operate as a trading firm. One veteran trader later commented, “You knew right at that moment that Bear Stearns was dead, right at the moment he asked that question. Once you raise that idea, that the firm can’t follow through on a trade, it’s over. Faber killed him. He just killed him.”

Despite sentiment at Bear that Schwartz had finally put the company’s best foot forward and refuted rumors of its illiquidity, hedge funds began pulling their accounts in earnest, bringing Bear’s reserves down to $15 billion. Additionally, repo lenders—whose overnight loans to investment banks must be renewed daily—began informing Bear that they would not renew the next morning, forcing the firm to find new sources of credit. Schwartz phoned Parr at Lazard, Molinaro reviewed Bear’s plans for an emergency sale in the event of a crisis, and one of the firm’s attorneys called the president of the Federal Reserve to explain Bear’s situation and implore him to accelerate the newly announced program that would allow investment banks to use mortgage securities as collateral for emergency loans from the Fed’s discount window, normally reserved for commercial banks (Exhibit 10).24

Bear executives struggled to placate an increasingly mutinous employee base. Bruce Lisman, head of equities, stood on his desk and implored traders to remain focused and weather the storm, pointing out Bear’s historical resilience. Greenberg once again pretended to swing a golf club on the trading floor, as if to suggest that Bear had survived far greater crises.

Regardless of their effect on employees, such assurances had no effect on the market. The trickle of withdrawals that had begun earlier in the week turned into an unstoppable torrent of cash flowing out the door on Thursday. Meanwhile, Bear’s stock continued its sustained nosedive, falling nearly 15 percent to an intraday low of $50.48 before rallying to close down 1.5 percent. At lunch, Schwartz assured a crowded meeting of Bear executives that the whirlwind rumors were simply market noise, only to find himself interrupted by Michael Minikes, senior managing director.

“Do you have any idea what is going on?” Minikes shouted. “Our cash is flying out the door! Our clients are leaving us!”25

22 Kelly, “Fear, Rumors Touched Off Fatal Run on Bear Stearns.” 23 Ibid. 24 Burrough, “Bringing Down Bear Stearns.” 25 Kelly, “Fear, Rumors Touched Off Fatal Run on Bear Stearns.”

INVESTMENT BANKING IN 2008 (A) KEL378

12 KELLOGG SCHOOL OF MANAGEMENT

Hedge fund clients jumped ship in droves. Renaissance Technologies withdrew approximately $5 billion in trading accounts, and D. E. Shaw followed suit with an equal amount. That evening, Bear executives assembled in a sixth-floor conference room to survey the carnage. In less than a week, the firm had burned through all but $5.9 billion of its $18.3 billion in reserves, and was still on the hook for $2.4 billion in short-term debt to Citigroup. With a panicked market making more withdrawals the next day almost certain, Schwartz accepted the inevitable need for additional financing and had Parr revisit merger discussions with JP Morgan CEO James Dimon that had stalled in the fall. Flabbergasted at the idea that an agreement could be reached that night, Dimon nonetheless agreed to send a team of bankers over to analyze Bear’s books.

Parr’s call interrupted Dimon’s fifty-second birthday celebration at a Greek restaurant just a few blocks away from Bear headquarters, where a phalanx of attorneys had begun preparing emergency bankruptcy filings and documents necessary for a variety of cash-injecting transactions. Facing almost certain insolvency in the next twenty-four hours, Schwartz hastily called an emergency board meeting late that night, with most board members dialing in remotely. Cayne missed most of the conversation while playing in a bridge tournament in Detroit.

Bear’s nearly four hundred subsidiaries would make a bankruptcy filing impossibly complicated, so Schwartz continued to cling to the hope for an emergency cash infusion to get Bear through Friday. As JP Morgan’s bankers pored over Bear’s positions, they balked at the firm’s precarious position and the continued size of its mortgage holdings, insisting that the Fed get involved in a bailout they considered far too risky to take on alone. Fed officials had been gathered down the hall for hours, and discussions continued into early Friday morning between the Fed and JP Morgan as Schwartz and Molinaro ate cold pizza, the decision now out of their hands.

Its role as a counterparty in trillions of dollars’ worth of derivatives contracts bore an eerie similarity to LTCM, and the Fed once again saw the potential for financial Armageddon if Bear were allowed to collapse of its own accord. An emergency liquidation of the firm’s assets would have put strong downward pressure on global securities prices, exacerbating an already chaotic market environment. Facing a hard deadline of credit markets’ open on Friday morning, the Fed and JP Morgan wrangled back and forth on how to save Bear. Working around the clock, they finally reached an agreement wherein JP Morgan would access the Fed’s discount window and in turn offer Bear a $30 billion credit line that, as dictated by a last-minute insertion by Morgan general counsel Steven Cutler, would be good for twenty-eight days. As the press release went public, Bear executives cheered; Bear would have almost a month to seek alternative financing.

Bear’s Last Weekend

Where Bear had seen a lifeline, however, the market saw instead a last desperate gasp for help. Incredulous Bear executives could only watch in horror as the firm’s capital continued to fly out of its coffers. On Friday morning Bear burned through the last of its reserves in a matter of hours. A midday conference call in which Schwartz confidently assured investors that the credit

KEL378 INVESTMENT BANKING IN 2008 (A)

KELLOGG SCHOOL OF MANAGEMENT 13

line would allow Bear to continue “business as usual” did little to stop the bleeding, and its stock lost almost half of its already depressed value, closing at $30 per share.26

All day Friday, Parr set about desperately trying to save his client, searching every corner of the financial world for potential investors or buyers of all or part of Bear. Given the severity of the situation, he could rule out nothing, from a sale of the lucrative prime brokerage operations to a merger or sale of the entire company. Ideally, he hoped to find what he termed a “validating investor,” a respected Wall Street name to join the board, adding immediate credibility and perhaps quiet the now deafening rumors of Bear’s imminent demise. Sadly, only a few such personalities with the reputation and war chest necessary to play the role of savior existed, and most of them had already passed on Bear.

Nonetheless, Schwartz left Bear headquarters on Friday evening relieved that the firm had lived to see the weekend and secured twenty-eight days of breathing room. During the ride home to Greenwich, an unexpected phone call from New York Federal Reserve President Timothy Geithner and Treasury Secretary Henry Paulson shattered that illusion. Paulson told a stunned Schwartz that the Fed’s line of credit would expire Sunday night, giving Bear forty-eight hours to find a buyer or file for bankruptcy. The demise of the twenty-eight-day clause remains a mystery; the speed necessary early Friday morning and the inclusion of the clause by Morgan’s general counsel suggest that Bear executives had misinterpreted it, although others believe that Paulson and Geithner had soured both on Bear’s prospects and on market perception of an emergency loan from the Fed as Friday wore on. Either way, the Fed had made up its mind, and a Saturday morning appeal from Schwartz failed to sway Geithner.

All day Saturday prospective buyers streamed through Bear’s headquarters to pick through the rubble as Parr attempted to orchestrate Bear’s last-minute salvation. Chaos reigned, with representatives from every major bank on Wall Street, J. C. Flowers, KKR, and countless others poring over Bear’s positions in an effort to determine the value of Bear’s massive illiquid holdings and how the Fed would help in financing. Some prospective buyers wanted just a piece of the dying bank, others the whole firm, with still others proposing more complicated multiple- step transactions that would slice Bear to ribbons. One by one, they dropped out, until J. C. Flowers made an offer for 90 percent of Bear for a total of up to $2.6 billion, but the offer was contingent on the private equity firm raising $20 billion from a bank consortium, and $20 billion in risky credit was unlikely to appear overnight.27

That left JP Morgan. Apparently the only bank willing to come to the rescue, Morgan had sent no fewer than three hundred bankers representing sixteen different product groups to Bear headquarters to value the firm. The sticking point, as with all the bidders, was Bear’s mortgage holdings. Even after a massive write-down, it was impossible to assign a value to such illiquid (and publicly maligned) securities with any degree of accuracy. Having forced the default of the BSAM hedge funds that started this mess less than a year earlier, Steve Black cautioned Schwartz and Parr not to focus on Friday’s $32 per share close and indicated that any Morgan bid could be between $8 and $12.28

On its final 10Q in March, Bear listed $399 billion in assets and $387 billion in liabilities, leaving just $12 billion in equity for a 32x leverage multiple. Bear initially estimated that this

26 Kelly, “Bear Stearns Neared Collapse Twice in Frenzied Last Days.” 27 Burrough, “Bringing Down Bear Stearns.” 28 Ibid.

INVESTMENT BANKING IN 2008 (A) KEL378

14 KELLOGG SCHOOL OF MANAGEMENT

included $120 billion of “risk-weighted” assets, those that might be subject to subsequent write- downs. As Morgan’s bankers worked around the clock trying to get to the bottom of Bear’s balance sheet, they came to estimate the figure at nearly $220 billion. That pessimistic outlook, combined with Sunday morning’s New York Times article reiterating Bear’s recent troubles, dulled Morgan’s appetite for jumping onto what appeared to be a sinking ship. Later, one Morgan banker shuddered, recalling the article. “That article certainly had an impact on my thinking. Just the reputational aspects of it, getting into bed with these people.”29

On Saturday morning Morgan backed out and Dimon told a shell-shocked Schwartz to pursue any other option available to him. The problem was, no such alternative existed. Knowing this, and the possibility that the liquidation of Bear could throw the world’s financial markets into chaos, Fed representatives immediately phoned Dimon. As it had in the LTCM case a decade ago, the Fed relied heavily on suasion, or “jawboning,” the longtime practice of attempting to influence market participants by appeals to reason rather than a declaration by fiat. For hours, Morgan’s and the Fed’s highest-ranking officials played a game of high-stakes poker, with each side bluffing and Bear’s future hanging in the balance. The Fed wanted to avoid unprecedented government participation in the bailout of a private investment firm, while Morgan wanted to avoid taking on any of the “toxic waste” in Bear’s mortgage holdings. “They kept saying, ‘We’re not going to do it,’ and we kept saying, ‘We really think you should do it,’” recalled one Fed official. “This went on for hours . . . They kept saying, ‘We can’t do this on our own.’”30 With the hours ticking away until Monday’s Australian markets would open at 6:00 p.m. New York time, both sides had to compromise.

On Sunday afternoon, Schwartz stepped out of a 1:00 emergency meeting of Bear’s board of directors to take the call from Dimon. The offer would come somewhere in the range of $4–5 per share.

Hearing the news from Schwartz, the Bear board erupted with rage. Dialing in from the same bridge tournament in Detroit, Cayne exploded, ranting furiously that the firm should file for bankruptcy protection under Chapter 11 rather than accept such a humiliating offer, which would reduce his 5.66 million shares—once worth nearly $1 billion—to less than $30 million in value. In reality, however, bankruptcy was impossible. As Parr explained, changes to the federal bankruptcy code in 2005 meant that a Chapter 11 filing would be tantamount to Bear falling on its sword, because regulators would have to seize Bear’s accounts, immediately ceasing the firm’s operations and forcing its liquidation. There would be no reorganization.

Even as Cayne raged against the $4 offer, the Fed’s concern over the appearance of a $30 billion loan to a failing investment bank while American homeowners faced foreclosures compelled Treasury Secretary Paulson to pour salt in Bear’s wounds. Officially, the Fed had remained hands-off in the LTCM bailout, relying on its powers of suasion to convince other banks to step up in the name of market stability. Just ten years later, they could find no takers. The speed of Bear’s collapse, the impossibility of conducting true due diligence in such a compressed time frame, and the incalculable risk of taking on Bear’s toxic mortgage holdings scared off every buyer and forced the Fed from an advisory role into a principal role in the bailout. Worried that a price deemed at all generous to Bear might subsequently encourage moral hazard—increased risky behavior by investment banks secure in the knowledge that in a worst- case scenario, disaster would be averted by a federal bailout—Paulson determined that the

29 Ibid. 30 Ibid.

KEL378 INVESTMENT BANKING IN 2008 (A)

KELLOGG SCHOOL OF MANAGEMENT 15

transaction, while rescuing the firm, also had to be punitive to Bear shareholders. He called Dimon, who reiterated the contemplated offer range.

“That sounds high to me,” Paulson told the JP Morgan chief. “I think this should be done at a very low price.” It was moments later that Braunstein called Parr. “The number’s $2.”

Under Delaware law, executives must act on behalf of both shareholders and creditors when a company enters the “zone of insolvency,” and Schwartz knew that Bear had rocketed through that zone over the past few days. Faced with bankruptcy or Morgan, Bear had no choice but to accept the embarrassingly low offer that represented a 97 percent discount off its $32 close on Friday evening. Schwartz convinced the weary Bear board that $2 would be “better than nothing,” and by 6:30 p.m., the deal was unanimously approved.

After eighty-five years in the market, Bear Stearns ceased to exist.

INVESTMENT BANKING IN 2008 (A) KEL378

16 KELLOGG SCHOOL OF MANAGEMENT

Exhibit 1: Value of $1 Invested in LTCM vs. S&P 500

Source: Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York: Random House, 2000).

KEL378 INVESTMENT BANKING IN 2008 (A)

KELLOGG SCHOOL OF MANAGEMENT 17

$-

$20.0

$40.0

$60.0

$80.0

$100.0

$120.0

$140.0

$160.0

Q1 '05 Q2 '05 Q3 '05 Q4 '05 Q1 '06 Q2 '06 Q3 '06 Q4 '06 Q1 '07 Q2 '07 Q3 '07 Q4 '07 Q1 '08

Exhibit 2: U.S. Quarterly CDO Issuance ($ in billions)

Source: Securities Industry and Financial Markets Association, “Global CDO Market Issuance Data,” http://www.sifma.org/research/pdf/ SIFMA_CDOIssuanceData2008.pdf (accessed July 11, 2008).

IN V

E ST

M E

N T

B A

N K

IN G

IN 2

00 8

(A )

K E

L 37

8

K EL

LO G

G S

C H

O O

L O

F M

A N

A G

EM EN

T 18

Ex hi

bi t 3

: M or

tg ag

e M

ar ke

t F lo

w s

an d

R is

k E

xp os

ur es

No

te s:

A B

S =

as se

t-b ac

ke d

se cu

rit y;

A B

C P

= a

ss et

-b ac

ke d

co m

m er

ci al

p ap

er ; C

D O

= c

ol la

te ra

liz ed

d eb

t o bl

ig at

io n;

C D

S =

c re

di t d

ef au

lt sw

ap ; S

IV =

s tru

ct ur

ed in

ve st

m en

t v eh

ic le

; S P

V =

s pe

ci al

pu

rp os

e ve

hi cl

e

S ou

rc e:

IM F

G lo

ba l F

in an

ci al

S ta

bi lit

y R

ep or

t, “F

in an

ci al

M ar

ke t T

ur bu

le nc

e: C

au se

s, C

on se

qu en

ce s,

a nd

P ol

ic ie

s, ” 2

00 7.

KEL378 INVESTMENT BANKING IN 2008 (A)

KELLOGG SCHOOL OF MANAGEMENT 19

0%

5%

10%

15%

20%

25%

$0

$100

$200

$300

$400

$500

$600

$700

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008  Q1

Subprime Issuance ($ in millions) Subprime Share of Market

Exhibit 4: Subprime Issuance and Share of Market

Source: Ellen Schloemer et al., “Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowners,” Center for Responsible Learning, December 2006, http://www.responsiblelending.org/pdfs/foreclosure-paper-report-2-17.pdf (accessed July 19, 2008).

INVESTMENT BANKING IN 2008 (A) KEL378

20 KELLOGG SCHOOL OF MANAGEMENT

0%

50%

100%

150%

200%

250%

2000 2001 2002 2003 2004 2005 2006 2007 2008

Exhibit 5: S&P/Case-Shiller Home Price Index (SPSC20R) Appreciation Since 2000

Source: Schloemer et al., “Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowners.”

KEL378 INVESTMENT BANKING IN 2008 (A)

KELLOGG SCHOOL OF MANAGEMENT 21

Exhibit 6: Four-Quarter Housing Price Changes by State (2Q 2007–1Q 2008)

Source: Office of Federal Housing Enterprise Oversight, “Decline in House Prices Accelerates in First Quarter,” May 22, 2008, http://www.ofheo.gov/media/hpi/1q08hpi.pdf (accessed July 19, 2008).

INVESTMENT BANKING IN 2008 (A) KEL378

22 KELLOGG SCHOOL OF MANAGEMENT

Exhibit 7: Condensed Consolidated Statements of Income, Three Months Ended (US$ in millions, except share and per share data) February 29, 2008 February 28, 2007 REVENUES Commissions 330 281 Principal transactions 515 1,342 Investment banking 230 350 Interest and dividends 2,198 2,657 Asset management and other income 154 168 Total revenues 3,427 4,798 Interest expense 1,948 2,316 Revenues, net of interest expense 1,479 2,482 NON-INTEREST EXPENSES Employee compensation and benefits 754 1,204 Floor brokerage, exchange, and clearance fees 79 56 Communications and technology 154 128 Occupancy 73 57 Advertising and market development 40 37 Professional fees 100 72 Other expenses 126 93 Total non-interest expenses 1,326 1,647 Income before provision for income taxes 153 835 Provision for income taxes 38 281 Net income 115 554 Preferred stock dividends 5 6 Net income applicable to common shares 110 548 Basic earnings per share $0.89 $4.23 Diluted earnings per share $0.86 $3.82 Weighted average common shares outstanding Basic 129,128,281 133,094,747 Diluted 138,539,248 149,722,654 Cash dividends declared per common share $ 0.32 $ 0.32

KEL378 INVESTMENT BANKING IN 2008 (A)

KELLOGG SCHOOL OF MANAGEMENT 23

Exhibit 8: Condensed Consolidated Balance Sheets, Three Months Ended (US$ in millions, except share and per share data) February 29, 2008 February 28, 2007 ASSETS Cash and cash equivalents 20,786 21,406 Cash and securities deposited with clearing organizations or segregated in compliance with federal regulations 14,910 12,890

Securities received as collateral 15,371 15,599 Collateralized agreements

Securities purchased under agreements to resell 26,888 27,878 Securities borrowed 87,143 82,245

Receivables Customers 41,990 41,115 Brokers, dealers, and others 10,854 11,622 Interest and dividends 488 785

Financial instruments owned, at fair value 118,201 122,518 Financial instruments owned and pledged as collateral, at fair value 22,903 15,724 Total financial instruments owned, at fair value 141,104 138,242 Assets of variable interest entities and mortgage loan special purpose entities 29,991 33,553

Net PP&E 608 605 Other assets 8,862 9,422 Total assets 398,995 395,362 LIABILITIES AND STOCKHOLDERS' EQUITY Unsecured short-term borrowings 8,538 11,643 Obligation to return securities received as collateral 15,371 15,599 Collateralized financings

Securities sold under agreements to repurchase 98,272 102,373 Securities loaned 4,874 3,935 Other secured borrowings 7,778 12,361

Payables Customers 91,632 83,204 Brokers, dealers, and others 5,642 4,101 Interest and dividends 853 1,301

Financial instruments sold, but not yet purchased, at fair value 51,544 43,807 Liabilities of variable interest entities and mortgage loan special purpose entities 26,739 30,605

Accrued employee compensation and benefits 360 1,651 Other liabilities and accrued expenses 3,743 4,451 Long-term borrowings (includes $9,018 and $8,500 at fair value as of February 29, 2008 and November 30, 2007, respectively) 71,753 68,538

Total liabilities 387,099 383,569

. . . . . .

INVESTMENT BANKING IN 2008 (A) KEL378

24 KELLOGG SCHOOL OF MANAGEMENT

Exhibit 8 (continued) February 29, 2008 February 28, 2007 STOCKHOLDERS' EQUITY Preferred stock 352 352 Common stock 185 185 Paid-in capital 5,619 4,986 Retained earnings 9,419 9,441 Employee stock compensation plans 2,164 2,478 Accumulated other comprehensive income (loss) 25 –8 Shares held in RSU trust –2,955 — Treasury stock, at cost –2,913 –5,641 Total stockholders' equity 11,896 11,793 Total liabilities and stockholders' equity 398,995 395,362

KEL378 INVESTMENT BANKING IN 2008 (A)

KELLOGG SCHOOL OF MANAGEMENT 25

0 

20 

40 

60 

80 

100 

120 

140 

160 

180 

200 

$0

$10

$20

$30

$40

$50

$60

$70

$80

$90

$100

2/1/2008 2/8/2008 2/15/2008 2/22/2008 2/29/2008 3/7/2008 3/14/2008

Tr ad in g  V ol um

e  (m

ill io ns  o f s ha re s)

Sh ar e  Pr ic e

Price Volume

Exhibit 9: Share Price and Trading Volume

Exhibit 10: Differences in Regulation—Commercial Banks vs. Investment Banks Commercial Banks Investment Banks General business model Accept deposits and lend them out in a

variety of products, provide financial services for individuals and businesses

Underwrite equity and debt offerings, trade stocks and bonds, provide advisory (e.g., M&A) services

Federally insured? Yes No (pre-2008) Primary source of assets at risk Depositors Shareholders Restrictions on leverage Significant—10% capital ratio

considered “well-capitalized” None

Primary oversight Federal Reserve Securities and Exchange Commission Restriction of activities Prohibited from investing in real estate

and commodities; new activities require Fed approval

None