Bear Stearns Collapse: The Fed-Backed JPMorgan Rescue of 2008

On the afternoon of Sunday 16 March 2008, a line of Bear Stearns managing directors queued outside the firm's Madison Avenue headquarters to be told that the stock they had spent their careers accumulating was now worth two dollars a share. A week earlier it had traded at seventy. A year earlier it had touched one hundred and seventy-two. By Friday 14 March, Bear had been forced to accept an emergency overnight loan from the Federal Reserve, routed through JPMorgan Chase, because its cash balance had dropped from eighteen billion dollars on Monday morning to roughly two billion by Thursday evening. No American investment bank of Bear's size had failed since 1929, and no Federal Reserve board had invoked Section 13(3) of the Federal Reserve Act since 1936. Both dominoes fell inside a single weekend.

Bear Stearns did not lose money in the conventional sense. It ran out of counterparties willing to lend to it overnight — and a modern broker-dealer that cannot roll its repo book cannot open on Monday. The firm's death was, in Henry Paulson's phrase, a bank run conducted entirely over Bloomberg terminals (Paulson, 2010). The ten days between 6 and 16 March 2008 turned out to be the dress rehearsal for Lehman Brothers in September, and the single most important case study in how fast the modern shadow banking system can come apart.

An 85-year-old firm and the paper it had come to own

Bear Stearns was founded in 1923 by Joseph Bear, Robert Stearns, and Harold Mayer with $500,000 of capital, one of a cohort of Jewish-owned partnerships locked out of the WASP franchises that dominated Wall Street. It survived the 1929 crash without firing a single employee, a point the firm retold in every annual report. By the late 1990s it had built a reputation for two things: ferocious fixed-income trading and a cheerful lack of deference to industry convention. In 1998, Bear was the only major Wall Street firm that refused to contribute to the bailout of Long-Term Capital Management, a decision chairman Jimmy Cayne defended publicly and which other chief executives on that rescue call — as documented in the oral history of the Long-Term Capital Management collapse — never forgave (Cohan, 2009).

By 2006 Bear had become one of the largest originators, packagers, and warehousers of US residential mortgage-backed securities. Its fixed-income division, run by Warren Spector, accounted for more than two-thirds of firm profits. Two internal hedge funds run under the Bear Stearns Asset Management umbrella — the High-Grade Structured Credit Strategies Fund and, later, the Enhanced Leverage fund — held tens of billions of dollars of subprime collateralised debt obligations purchased with levered repo funding. In the second quarter of 2007, both funds began to lose money in a straight line. By July 2007 they were worth essentially zero.

The High-Grade fund had started the year reporting 1.5 percent monthly returns. Merrill Lynch, as the senior creditor, seized $850 million of collateral and tried to auction it, discovering that no bid would clear. Bear eventually provided a $3.2 billion loan to the High-Grade fund in an effort to stop a fire sale (Sorkin, 2009). The Enhanced Leverage fund was left to die. Investors lost every dollar. Cayne, playing in a bridge tournament in Nashville, could not be reached by his own risk committee for most of the weekend the funds blew up.

The two fund failures were the first visible tremor of what would later be called the subprime crisis, and the first clear signal to wholesale counterparties that Bear Stearns had concentration risk in a market whose price discovery had stopped working. As Ben Bernanke later wrote, what differentiated the 2007 phase from 2008 was that in 2007 "only the people who owned the paper lost money; in 2008 the people who had lent to the people who owned the paper started to lose as well" (Bernanke, 2015).

From Cayne to Schwartz

In January 2008 Bear's board asked Jimmy Cayne to step aside as chief executive. His public image — a serial bridge champion who took recreational marijuana, who had left the office during the July 2007 fund crisis, whose main defence of his own management was that he had "never been fired from anything" — had become an active liability for a firm whose counterparties were watching its headline risk daily. Alan Schwartz, a career investment banker who had run the firm's media franchise, replaced him on 8 January 2008.

Schwartz inherited a balance sheet that ran to roughly $395 billion of assets against $11 billion of tangible common equity — a leverage ratio close to 36:1. Roughly $50 billion of those assets were illiquid mortgage securities and whole loans. Funding was provided, in the main, by an overnight repo book of around $75 billion, rolled every morning against collateral that included the mortgage paper itself. The cash reserve sat at $18 billion on Friday 7 March 2008.

The FinChart: a share price chronology

The ten days

The Thursday evening collapse of the cash balance is the detail that matters. Bear Stearns was not insolvent in a mark-to-model sense on Wednesday. It was insolvent on Thursday because its repo counterparties — money market funds, European banks, Fidelity, Federated — began to refuse to roll overnight financing against mortgage collateral whose price nobody could name. Bill Dudley, then running the New York Fed's markets desk, later testified that by midnight on Thursday his team calculated Bear had enough cash to open Friday morning but not Friday afternoon (Bernanke, 2015).

Section 13(3) and the invention of Maiden Lane I

Section 13(3) of the Federal Reserve Act, added in 1932, permits the Federal Reserve to lend to "any individual, partnership, or corporation" in "unusual and exigent circumstances" with the unanimous consent of the Board of Governors. It had last been used in 1936 to lend to a leather manufacturer. On the evening of Thursday 13 March 2008, Tim Geithner called Bernanke at home and described the facility he needed to build by sunrise. Bernanke asked, "Is this legal?" Geithner replied, "If it's not, we have bigger problems."

The first structure — a 28-day loan from the Fed to JPMorgan, which then passed it through to Bear — lasted exactly one day. Over the weekend it was replaced by a different vehicle: a Delaware special-purpose entity funded by a $28.82 billion senior loan from the New York Fed and a $1.15 billion subordinated loan from JPMorgan. The entity, named after the street that runs along the south side of the New York Fed, bought a ring-fenced pool of Bear's mortgage securities at their 14 March marks. BlackRock Solutions was retained to manage the wind-down. Maiden Lane I would not fully repay the Fed until 2012; the final loss to taxpayers was approximately $1.2 billion on a portfolio whose notional once exceeded $30 billion.

The moral-hazard argument over Bear began within hours. Paul Volcker, speaking at the Economic Club of New York on 8 April 2008, told the audience the Fed had gone "to the very edge of its lawful and implied powers" (Volcker, 2008). William Poole, then president of the St Louis Fed, voted against the rescue internally. Bernanke's own defence rested on the observation that Bear was counterparty to some five thousand other financial firms and that an uncontrolled Chapter 11 filing on Monday morning would have frozen the tri-party repo market — a system that at the time settled around $2.8 trillion of overnight funding every day.

The Lehman precedent, foreshadowed

The rescue of Bear created the central assumption that broke six months later. Dick Fuld, running Lehman Brothers, read the 16 March deal as a confirmation that the Fed would not allow another major broker-dealer to file. Hank Paulson, by his own account, grew more convinced over the summer of 2008 that the moral-hazard bill had to be paid — that the market needed, in his words, to see that a firm could be allowed to fail (Paulson, 2010). Those two beliefs collided on the weekend of 13–14 September 2008, when Lehman was permitted to file for Chapter 11 protection. The full chain from Bear's fall to Lehman's filing is traced in our article on the 2008 financial crisis and how the system broke.

Bear's collapse also sat at the front of a chain of bank runs that had already started nine months earlier on the other side of the Atlantic, when Northern Rock became the first British bank run in 150 years. In both cases the funding shock ran ahead of the credit shock — depositors and repo lenders stopped rolling funding before mark-to-market losses had been recognised on the asset side.

What the primary sources say

Three contemporaneous accounts remain canonical. Andrew Ross Sorkin's reconstruction is based on interviews with almost every named participant in the deal (Sorkin, 2009). William Cohan's book reads as a forensic autopsy of a culture whose main institutional memory was of always being the firm that traded against the consensus (Cohan, 2009). Bernanke's memoir is the most technical of the three and contains the clearest surviving description of the liquidity mathematics that led the Fed to conclude that a disorderly failure was the single worst option on the table (Bernanke, 2015).

A direct quotation captures the mood inside the building. Paul Friedman, a senior managing director in fixed-income operations, told Sorkin that by Thursday afternoon "it felt like a science experiment. We watched the cash go out, and we could not get anyone to tell us why" (Sorkin, 2009, p. 59). Another captures the view from JPMorgan. Jamie Dimon, on a Sunday afternoon conference call with his own board, said the deal was "a good business at a price that reflected the risks, the principal risk being that we might have to spend the next decade unwinding this" (Cohan, 2009, p. 83). Hank Paulson, on a Monday call with the Journal, described the rescue in a single line: "We did what we had to do to prevent a financial meltdown" (Paulson, 2010, p. 122).

What Bear's death changed

The ten days rewrote the operating manual for US financial regulation. The Fed began extending its Primary Dealer Credit Facility to non-bank broker-dealers for the first time, a facility created explicitly because Bear had been unable to borrow overnight on the collateral it held. The Treasury opened an internal working group on investment-bank resolution regimes — work that would later feed into Title II of the Dodd-Frank Act. Goldman Sachs and Morgan Stanley converted into bank holding companies in September 2008, an act of institutional self-preservation that ended the era of the independent American broker-dealer as a corporate form.

Inside Bear itself, roughly seven thousand of fourteen thousand employees were made redundant over the twelve months that followed the deal. Cayne, who had owned around one percent of the firm at its peak, saw a paper stake of roughly one billion dollars reduce to $61 million at the final $10 deal price. JPMorgan, for its part, acquired the Madison Avenue building, the prime brokerage platform, and the energy-trading desk at a price that Dimon told analysts in the April 2008 earnings call was "probably the best real-estate deal we've ever done, even ignoring the rest of it."

The deeper change was epistemological. For the first time since the Great Depression, the Federal Reserve had used a public balance sheet to absorb the trading book of a private broker-dealer. The post-war separation between bank rescues, which were acknowledged and expected, and broker-dealer rescues, which were considered impossible, had ended. Every subsequent policy choice of 2008 — AIG's loan facility, the money-market guarantee programme, the Capital Purchase Programme, TARP — was made in a context where that line no longer existed.

On the Sunday night of 16 March, a Bear Stearns trader named Sam Molinaro, the chief financial officer, left a voicemail for a colleague that circulated inside the firm for weeks. The message was six words long: "It is over. Go to sleep."