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Bear Stearns – What Happened?

Updated on April 8, 2008

Bear Stearns – What Happened?

You have no doubt heard about the investment bank Bear Stearns, and their recent collapse. What led up to this, which caused the Federal Reserve to step in to try and restore some stability to the market?

Bear Stearns was established some 85 years ago, which means that it survived the stock market crash of 1929, and the subsequent Great Depression. It is an investment bank, but it is different to what you think of when you hear the word bank. It is better described as a securities dealer, and is soundly in the financial world, and not about to act as a High Street bank. In fact, it doesn’t even take deposits. Its business is to deal in securities, and for this it needs a tremendous amount of capital. In common with others in the industry, it doesn’t actually possess the capital, but is leveraged with borrowed money, and it isn’t unusual for the debt to equity, or borrowing to actual money, ratio to be as high as 30:1. In other words, it doesn’t have anywhere near enough money to meet its debts, if they are required to be paid, but survives and normally thrives by virtue of confidence.

It doesn’t take in the public’s money, as I said, but borrows from banks, which are usually eager to lend for the sake of getting interest paid to them for their profits. The problem that came about was that the banks didn’t want to lend money anymore, and in fact wanted their money paid back. Why would this be, and how had it changed? Bear Stearns made money by dealing in money and debt. They bought mortgage securities from mortgage brokers and mortgage banks, thereby providing capital to the mortgage industry. This is the very market in which there has been so much turmoil, with the sub-prime mortgages that have been brought into question.

A sub-prime mortgage is not as safe as a prime mortgage. It is “sub” because it is under the lending standards that are normally applied. This means it is more likely to go into default, and fail, resulting in a foreclosure on the property. With the housing bubble bursting in many areas, and house prices falling, there is concern that the property that secures the mortgage may not be valuable enough on the open market to even pay the loan back. Thus the withdrawal of confidence by the banks was in some ways justified, as they are responsible for the security of the money deposited with them, and have a duty to their investors.

This whole method of packaging mortgages can be traced back to the 70s and 80s. Traditionally, mortgages were the province of small local banks, which were in a position to examine each borrower’s situation personally. However, this relies on public investment in the bank to make funds available for lending, and the inflationary market at that time took many lenders out of the market – the short term interest rates rose, and the long term rates they were getting back on the loans didn’t allow them to increase rates enough to attract sufficient money.

The financial sector’s response to this was “securitization”. This meant a fundamental change in the mortgage function. Mortgage bankers only originated loans, which were sold on to a Wall Street broker. The broker combined all the loans into one entity, which was then a product that could be sold to investors. This specifically took away the safeguard of scrutiny. The loan originator was only interested in completing the paperwork satisfactorily to get his commission. The broker could not be responsible for each individual loan, and merely provided a means to gather investment, to get his profit. The upshot to all this was that loans were more aggressively marketed, to increase commissions, but no-one ultimately took responsibility for the quality of the borrowers. In fact, new products were invented, such as the “no documentation” loans, sometimes called “liar loans”, which specifically catered for the less financially worthy.

Ultimately, however, the failing in confidence led to the crash of Bear Stearns. Many other institutions are in the same financial position of being highly leveraged, as this is the standard way for the industry to operate. Household names such as Merrill Lynch and many others would be in trouble if all their debts were called in at one time, and this may have been the inspiration for the Federal Reserve to step in with financial support and encourage JPMorgan Chase to underwrite the liabilities. However, this has also been criticised as government interference in private business, which may subsequently backfire. To find out more about the financial side of business, you are encouraged to contact Stu Whisson of Insight Support, or to take their free course at www.insightsupport.com .

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