FROM SYSTEMIC RISK TO MORAL HAZARD A Case Study Of Counterparty Credit Risk BEAR STEARNS
THE TIMELINE THE BACKDROP In the summer of 2007, two Bear Stearns hedge funds suffered heavy losses as a result of the subprime mortgage crisis Co-CEO CEO Warren Spector resigned after collapse of the two hedge funds, and remaining CEO C James Cayne was heavily criticized for being out of touch with the crisis In December, Bear Stearns reported its first ever quarterly loss CEO James Cayne retired under pressure, but stayed on as non-executive chairman. Alan Schwartz became president and chief executive In February, investors in Bear Stearns seized two of the firm s s failed hedge funds in an attempt to regain some of the losses in the previous summer s s collapse In early March, Carlyle Capital Corporation ( CCC( CCC ), a $22 billion hedge fund to which Bear Stearns was heavily exposed, suffered significant losses from exposure to mortgage backed securities CCC received substantial additional margin calls and default notices s from its lenders Trading of CCC shares was suspended in Amsterdam 2
THE TIMELINE (continued) THE WEEK THAT SHOOK WALL STREET Tuesday, March 11 The market is increasingly concerned about Bear s s liquidity Other investment banks are swamped with phone calls from clients looking to off-load trades with Bear Stearns Meanwhile, Federal Reserve officials announce a new program of lending l up to $200 billion of Treasury Bonds to investment banks for up to 28 days Treasuries would be exchanged under the program for hard-to to-value securities backed by home mortgages The first exchange was not scheduled to take place until March 272 Bear Stearns capital stands at $17 billion, which h management believes is sufficient 3
THE TIMELINE (continued) Wednesday, March 12 Carlyle Capital Corporation ration collapses Bear Stearns shares fall 17% as investors growg anxious about exposure to CCC Theories develop that t hedge funds with h short positions on Bear Stearns stock are spreading rumors about the firm s health in order to hasten its demise CEO Schwartz comments: Our balance sheet is not weakened at all. 4
THE TIMELINE (continued) Thursday, March 13 Customers continue to withdraw money from Bear Stear arns Bear Stearns reaches out to JPMorgan to discuss ways in which JPMorgan could help with Bear s liquid idity position Bear Stea earns cash has dwindled to just $2 billion By 7:30 a.m. Friday morning ning,, Bear Stearns must t repay billions ofo dollars of repurchase agreement borrowings With substantial repurchase agreement payments looming, Bear Stearns arns informs the Federal Reserve, Treasury and SEC in an early evening conference call that it has few options other than to declare bankruptcy the next morning New York Federal Reserve Bank President Timothy Geithner works late in to the night looking for potential suitors, but the short time frame proves unworkable 5
THE TIMELINE (continued) Friday, March 14 At 5 a.m., Mr. Geithner,, Treasury Secretary Henry Paulson, and Federal Reserve Chairman Ben Bernanke convene a conference call to debate whether Bear Stearns should be allowed to fail By 7 a.m., a decision was made to allow the Federal Reserve to lend l money to Bear Stearns, through JPMorgan, in order to assist Bear through its liquidity crisis At 9 a.m., Geithner and Paulson addressed a conference call of bond dealers and bankers to announce the loan, saying the dealer community had a a stake in the deal working out Markets were shaken by the news Stocks sank and rumors of pending failures by other broker-dealers circulated The run on Bear Stearns continued throughout the day 6
THE TIMELINE (continued) Saturday, March 15 Paulson is deluged by calls from bankers concerned that the run on Bear Stearns would spread to other financial institutions, regardless of the temporary funding from the Federal Reserve Paulson determines that a buy-out deal needs to be finished before Asian markets open late Sunday, New York time JPMorgan bankers and lawyers ascend on Bear Stearns to conduct diligence and determine whether a buy-out can be accomplished By Saturday evening, JPMorgan informs Bear Stearns that it is willing to buy the firm, subject to the conclusion of diligence, but no price is set 7
THE TIMELINE (continued) Sunday, March 16 The situation is tenuous yet again JPMorgan is uncomfortable with the level of diligence able to be conducted in such a short time-frame JPMorgan concludes that it will not buy Bear Stearns on its own, but only with help from the Federal Reserve The Federal Reserve agrees to lend $30 billion (later revised to $29 billion) to JPMorgan to complete its acquisition JPMorgan to borrow funds from the Federal Reserve discount window Funds to be re-loaned to Bear for 28 days Loan to be secured by collateral provided by Bear JPMorgan takes first $1 billion of collateral losses, Federal Reserve takes additional losses JPMorgan agrees to purchase up to 20% of Bear Stearns shares at $2 each (later revised to $10 each) Separately, Federal Reserve officials vote to extend emergency credit c to non-depository institutions (i.e.,( investment banks) Only the second time in history the Federal Reserve has agreed to open the discount window to non-depository institutions The first was in the Great Depression 8
KEY ISSUES AND TURNING POINT FOR BEAR STEARNS Extraordinary Market Conditions Defaults on subprime mortgage loans in 2006-2007 2007 were well beyond any previously experienced Subprime loans were pooled with prime loans in pools of collateral al for mortgage backed securities (MBS( MBS) MBS were further pooled into collateralized debt obligations, making g it very difficult to determine where losses were likely to occur As housing prices began to fall, even pools of collateral that looked l strong began to weaken Markets for these securities virtually closed down 9
KEY ISSUES AND TURNING POINT FOR BEAR STEARNS Reliance on Collateralized Borrowing Broker dealers like Bear Stearns rely primarily on short-term term repurchase agreements and other collateralized borrowing to fund operations With liquid securities as primary assets, capital maintained at broker-dealers is relatively lower In the extraordinary market conditions, however, Bear s s collateral could not be valued With the market unwilling to accept Bear s s collateral, its liquidity effectively evaporated Federal Reserve Discount Window Broker dealers can not access the Federal Reserve discount window w except under emergency conditions with specific Fed approval Federal Reserve officials approved the opening of the discount window w to broker dealers on Sunday, March 16, too late to save Bear Stearns Federal Reserve was reluctant to take this action given the moral hazard Only the second time in 70 years the Federal Reserve has taken this t extraordinary step in order to restore confidence in the financial system 10
PRIME BROKERS AND COMMERCIAL BANKS Prime Brokers Assets are primarily securities (rather than loans) Borrowings are typically collateralized by liquid securities Less capital required, as lenders and counterparties are protected ed by value of collateral Regulated by the Securities and Exchange Commission, not the Federal eral Reserve No access to Federal Reserve funding except on an emergency basis Commercial Banks Assets are primarily loans Loans are not typically used as collateral for borrowings Funding provided through balance sheet (i.e., unsecured borrowings) Customer deposits are Federally insured Regulated by the Federal Reserve Maintenance of Capital requirements Restrictions on types of business activities Restrictions on transactions with affiliates Access to funding from the Federal Reserve 11
TOO BIG TO FAIL? Interconnection of Financial Institutions Commercial Banks Investment Banks / Prime Brokers Hedge Funds Securities Lending and Trading Facilitated by Prime Brokers Like Bear Stearns Failure by Prime Brokers is uncommon Counterparties protected by access to liquid collateral Extraordinary market conditions, rather than the interconnection of financial institutions, prompted the Federal Reserve and Treasury to act Absent extraordinary conditions, Bear Stearns may have been allowed to fail 12
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