Before Lehman: The Forgotten Crisis

It is 10 years after the collapse of the renowned investment bank Lehman Brothers sent shockwaves through the markets, marking the start of the financial crisis that went on to become a global economic crisis. These days, much is written about the Lehman bankruptcy, but everybody seems to have forgotten what happened six months earlier: the prelude and warning to what was coming. The smallest, but toughest bank of the Big 5, Bear Stearns, went down. It is a story of a once proud investment bank that, unlike most other big banks, was not a construction of mergers and acquisitions. It made its money all on itself by being tougher than the rest and taking risks where others wouldn’t. The collapse of the bank is also a lesson for anyone that is flying high. The higher you fly, the harder you fall. And coming down goes faster than going up.

"Everybody seems to have forgotten what happened six months before that: the prelude and warning to what was coming"

The rise

Until March 2008, there were 5 major broker-dealers on Wall Street: Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns. With 400 billion dollars in assets and 11 billion in capital, Bear was the smallest of the club. Lehman was a bit bigger,  but not much. Bear Stearns is a prime example of how the big guys on Wall Street thrived on subprime mortgages. Not just on investing in the mortgages itself, but the whole business around it, as well allowed the bank to make a fortune. The process from mortgage to investment is a highly lucrative business for specialized investment banks such as Bear Stearns. Commissions are earned for every security bought, sold, packaged, sliced and diced along the way from mortgage to MBS, CDO or pick your choice of the whole alphabet of derivatives. Besides, the investments themselves gave extremely high pay-offs for the level of perceived risk. The party went on for years and did not seem to come to an end. “As long as the music is playing, you’ve got to keep on dancing” is how former Citigroup chairman Chuck Prince called it. So that’s what everybody did. Since its foundation in 1923, Bear Stearns never reported a quarterly loss, until December 2007. It withstood the Great Depression without any layoffs. The bank made billions of dollars, and so did their top managers Jimmy Cayne and Alan Greenberg. Bear Stearns was unstoppable, it was flying sky high on derivative profits.

“As long as the music is playing, you’ve got to keep on dancing”

Trouble arising

The idea of derivatives is that the risk ends up with the party most able and willing to bear it. On paper it sounded good. You bundle different mortgages into a security and sell that security in different tranches bearing different levels of risk. Investors can, depending on their risk appetite, buy a tranch and thus be the ultimate financier of the mortgage. For example, a risk averse investor could buy the AAA-rated senior tranch of a security. When the security defaults, the holder of the senior tranch is the first to get his money back. On the other hand, holders of the high risk junior tranch obtain the highest yield, but are left holding the bag if the security defaults. This is how the system worked. The problem is that the loans that made up the security were not remotely as safe as believed, they were made up of subprime mortgages. This worked through in the securities, which ended up practically worthless. Where the theory suggested that the risk was safely spread throughout system, everybody was no heavily invested in financial “weapons of mass destruction” that were about to explode as people struggled to pay off their mortgage. For Bear Stearns, trouble arose in July 2007 with the collapse of its two High Grade funds run by Ralph Cioffi. His funds are extremely high leveraged, with one fund borrowing 100$ for every dollar in capital, which it invested mainly in subprime mortgage derivatives. This is extremely dangerous in case of only the slightest setback. When that setback occurred, Bear Stearns itself had to step in and guarantee all the funds loans. The bank never really recovered from this blowback as can be observed from its stock price. Where it swung around 155$ in July 2007, it fell to about 80$ in March 2008.

"On paper it sounded good"

The fall

What occurred next is a classic example of a bank run. On Thursday, the 13th of March 13 2008, rumors started that Bear was having liquidity problems. Whether this was actually true will probably never be known, but that conditions were worsening was clear. Acting on these rumors, investors started pulling out their money of the bank. Cash was flying out the door by billions and Bear was not able anymore to raise money in the market. That weekend it became clear it would not be able to open for business on Monday. With all other banks having their own problems, only one bank was able to come to the rescue: JP Morgan Chase. In a spectacular weekend, a shotgun marriage was brokered by the New York Fed and the bank was to be acquired for only 2 (!) dollars per share. This offer was later increased to 10 dollars to ensure the approval of the shareholders meeting, but the damage was done. A merger process that would in normal times take months, maybe even years, to complete was pulled off in a weekend. In a time span of 72 hours, one of Wall Street’s most prestigious investment bank went bankrupt as the first big casualty of the subprime mortgage game. The government forced Bear Stearns into the arms of JP Morgan Chase and prevented what would happen half a year later: a financial meltdown.  

"Cash was flying out the door by billions and Bear was not able anymore to raise money in the market"

Jimmy and Jamie

As if the collapse itself wasn’t tragic enough, the way it was handled by Bear’s top executive Jimmy Cayne was even more tragic. Cayne was the personification of Bear Stearns. Tough, arrogant and filthy rich. Would leave the bank at Thursday to start his weekend with a play of golf. And loved playing bridge. Actually, he loved it so much, that he found bridge to be of more importance than the bank. When the two Bear Stearns hedge funds collapsed in the summer of 2007, Cayne was playing bridge elsewhere. Any good CEO would have returned to headquarters immediately, but not Cayne. He was fiercely criticized for this action, but didn’t seem to have learned from it. When Bear Stearns was having an existential crisis in March 2008, Cayne was, guess what, playing bridge again! Unreachable, Cayne left his firm to die while playing bridge in Detroit. Then the neighbor came to the rescue: Jamie Dimon, CEO of JP Morgan Chase with a hands-on management style. This is the man that saved the world that weekend. He could not have been more different from Jimmy Cayne. Spends hours and hours at the office, likes to join every meeting he’s not invited to if he has nothing to do for the moment and always tries to do “the right thing”, as he calls it. So, when the government asked JP Morgan to buy Bear Stearns in a weekend, it was the right thing to do. Maybe not for JP Morgan, but for the country. Some people blame Dimon for destroying one of the most prestigious investment banks in the world by buying it for 2 dollar per share. But here is the thing: “We were not buying a house, we were buying a house on fire.” Fortunately for the financial world, they bought it anyway.

“We were not buying a house, we were buying a house on fire.”

The collapse should have been taken for a warning, but nobody really seemed to see the danger of another banking collapse. Yet, the Bear Stearns bankruptcy turned out to be just the prelude to what was coming. But just as it was quickly forgotten at the time, it is still forgotten 10 years after the financial crisis started.

Link 1 Link 2
Link 3 Link 4
Link 5 Link 6