Now that we have a background on the Subprime Financial Crisis and some of the key factors at play from our first two series on the subject, the next logical step is to look at what happened to Bear Stearns. In this series we will look at how this happened, why the Fed stepped in and the debate surrounding that intervention, the deal with JP Morgan and the debate surrounding this, and finally some things to look out for going forward.

As most of you probably know by now Bear Stearns, pending shareholder approval, has been sold to JP Morgan for the price of $2 a share or $236.2 Million, a stunning fall for the US’s 5th largest Investment Bank which has traded as high as $159.36. Although a terribly sad event for Bear Stearns employees who owned 30% of the stock, and the firms other shareholders, this is a historic event with many implications which we as traders and investors should understand.

First let’s look at just how this could have happened. We have already been over the background of the Subprime financial crisis which played a major role in Bear’s demise so if you have not been through that 3 part mini series, you can find it in the subprime crisis learning center at InformedTrades.com. As we learned in that mini course these pools of mortgages which are now defaulting at a higher rate than was expected by the market are at the center of the problem.

With this in mind the first thing that it is important to understand is that Bear Stearns was a major player in this area not only in packaging the loans up to be sold or securitizing them as it is called, but also in holding them on their books as an asset just as a hedge fund or other investor would.

While many banks which are now having trouble also had a lot of exposure to these pools of mortgages, the difference with Bear Stearns was in how large a percentage of their business this was. As Bear Stearns was not as well diversified as many of the other banks, when the mortgage securitization business faltered so did a much larger part of Bear Stern’s business in comparison to most other banks.

As we also learned about in our first series on the subprime crisis, the way that banks like Bear Stearns were profiting from these pools of longer term mortgage debt is buy using the credibility of their balance sheets to borrow money at low short term interest rates and then buy these longer term pools of debt which paid a higher rate of interest, earning the difference between the low interest rates they were paying to borrow money and the relatively higher interest rates they were earning from the pools of debt.

Because they borrow this money short term to fund long term obligations, they need to roll these loans over periodically or in other words when the short term loan expires they need to renew it to continue to fund their purchase of these longer term pools of debt. If the banks that are lending them money on the short term feel that their balance sheet or liquidity position is not as stable or high as they once were, then they will potentially no longer lend the bank the money needed to finance the short term loans. This puts the bank in a position where if they cannot find other sources of capital they have to default on their debt obligations and go bankrupt.

So essentially just like we used to have run’s on the bank where people would get scared a depository bank was going to fail and pull all their money out, the same thing has happened here. The only difference is Bear Stearns is an investment bank so instead of individuals pulling their funds it is financial institutions

Now that we understand the basics of what happened to Bear Stearns the next question that many people are asking is why did the Federal Reserve step in and intervene in the market. In order to understand this we need to first understand a little bit more about how an investment bank like Bear Stearns operates, and how intertwined they are into the global financial system. This will be the topic of our next lesson.

For more great information on the subprime crisis please visit our extensive free subprime learning section at InformedTrades.com and have a great day!

Hey David, I just wanted to tell you if it wasn't for your videos I think I would have dropped out of Finance as a major. Your videos are SOO helpful you have no idea, I am sure I am not the only one who can say that.
I have a presentation on the Fall of Bear Stearns, and your video pretty much helped. I had a question about my presentation: How would you divide the power point slides? It is only a 5 min presentation and I was thinking on dividing it into Introduction (overview of Bear Stearns and briefly discuss what happened), a little background about the housing market and the mortgage crisis, what actually happened to BSC, JPMorgan and the Fed, WHY the Feds helped and finally what is the future of Bear Stearns.
Again, it's only 5 minutes so I don't know what suggestions you might have.
Your videos are by far a blessing and the one thing I needed for this semester, I appreciate it.

Best,
Dan

Hi Dan,

Thanks for the note I am glad that you are finding the videos helpful and appreciate the encouragement.

I think you are on the right track with your presentation. Here are some bullet points for you:


- Subprime loans and how they were securitized and then sold off and how the problems started arising in the market.

- What this meant for the financial markets in terms of the banks not trusting each other and therefore making the cost of borrowing higher and further excaserbating the problem.

- How Bear was a major player in Subprime as well as something which is known as prime brokerage.

- How everyone was on edge so all that it took was rumors to cause a mad rush for the exits at bear by their clients.

- Why the fed decided to step in and why JP Morgan was the only buyer with a chance at doing the deal.

I did not actually get to the last point in my videos but the short version is that the Fed stated that a deal had to be completed over the weekend and that the firm that was taking on Bear's liabilities must be regulated under the Fed in order to recieve the feds assistance with the deal. So this basically knocked out all the investment banks like Goldman Sachs that do not have commercial banking divisions. Secondly JP Morgan was one of the only banks that was not very active in subprime so they were not hit nearly as hard as the other bank. So basically they were the only firm that really had the balance sheet to pull a deal of this size off in such a short period of time.

Going to be tough to get all that into 5 minutes but as you are speaking to finance students you should be able to cut a lot of the basics out that I go over in my vidoes.

If there are any questions that I can help you with along the way feel free to post them.

Best Regards,
Dave

1) When Bear Sterns fell, i read that the Fed flooded the US economy with fresh money. Where does the money go? How does this help?

2) Few months back Ron Paul said "Fed is printing more money to keep the interest rate low". How does interest rate go low with more money? Are the two questions related?
(Source : YouTube - CNBC: Ron Paul's question makes Ben Bernake's voice quiver - 00:58)

All i understand is, with more money in the system, inflation climbs still further!!

Dave,

The following website runs model based on our input, which may help readers to understand the impact of interest rate on Economy

Virtual Economy 2002 Medium Input Page

Hi Inapcha,

Glad to hear from you.

Thanks for the link here that is a pretty interesting tool to play with. I am also in the process of reviewing the video you linked to in one of my other posts which I am also finding very interesting.

Best Regards,
Dave

__________________
Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.

Hi inapcha,

My apologies for the delay in reply I had missed this post earlier.

If you visit my free basics of trading video course at the link below, you will find under module 8 several lessons that give the answers to these questions:

InformedTrades : Learn Trading. Trading Education. | - Basics of Trading Course

Start with the lesson on "physical policy and the business cycle" and then and let me know if the videos that follow do not answer your questions.

Best Regards,
Dave

__________________
Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.