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!