Bear Stearns and Its Culture of Risk - Case Study Example

Bear Stearns Case Study BY YOU YOUR SCHOOL INFO HERE HERE The role of culture in Bear Stearns’ demise Bear Stearns was said to have a cutthroat, renegade culture built on a strong competitive reputation (Stowell 2008). The culture has also been described as being a maverick culture, one that did not obey the same rules of other investment firms (Wolgemuth 2008). Working with clients that had very high amounts of wealth built this maverick culture. Successes of employees were rewarded very well and managers wanted to recruit people that were poor, smart and had a very strong desire to become rich (Zarroli 2008). This was not the norm for other investment banks that wanted people with academic degrees. This transaction-based culture that rewarded risk-taking and an organisational culture that wanted, first, to make a lot of money drove a culture that was willing to gamble. A competitor, JP Morgan, was more conservative, less willing to take risks, and bureaucratic (Wolgemuth). This competitor had a strong management control system where employees were often told what to do and expected to obey. At JP Morgan, employees had much autonomy and were not used to working under top-down management systems. Lack of management control in a very independent culture created an environment where employees at Bear Stearns were making chancy decisions and conducting business relationships their own way. JP Morgan, with more conservative culture, is still in business today. Companies that do not have strong ethical values or build a culture of ethics tend to recruit people that are more willing to act unethically (Sahlman 2009). This was proven at Lehman Brothers, another investment firm that collapsed. Lehman Brothers had the same type of reckless culture where high risk investments that brought much return on investment were rewarded by management (Harress and Caulderwood 2013). Bear Stearns and its culture of risk and gamble was more attractive in the market than its competition. Bear Stearns employees willing to invest in risky investments that provided higher reward than more conventional investments made the firm more desirable to customers seeking fast and large wealth growth. Goldman Sachs, as an example, had a culture of total business protection and built a culture of risk avoidance. This competitor wanted to avoid investments that had short term high payoffs. Instead, Goldman tended to be focused on long-term investments that were less uncertain (Sahlman). Therefore, customers that wanted fast wealth turned toward the more daring culture of Bear Stearns. However, this culture at Bear Stearns began tying the business’ assets into investments that were not sustainable. This led to the demise of the business in the long-term. How Bear Stearns could have avoided its fate In the early 2000s, it was becoming common practice of banks and investment firms to give customers adjustable rate mortgages. These were subprime mortgages that were given to high-risk customers that did not have regular access to standard, fixed loans due to their credit status problems (UDHUD 2013). One type of mortgage was the Option Adjustable Rate Mortgage. This mortgage was a negative amortisation loan where payments that are not equal to accrued interest on the loan had unpaid amounts of interest added to the total principal balance. For example, if a loan was £1500 per month and the loan had an overdue amount of £2000, the £500 different is re-added to the complete loan balance (Fabozzi 2006). The problem is that every month the loan is recalculated and the loan gets a new principle balance that leads to consumers needing to make higher payments on the next invoice. Bear Stearns was active in this practice. By the year 2006, Bear Stearns was holding over $13 trillion USD in derivatives, which many were from credit default swaps that were meant to protect against mortgage loan defaults. These high risk and adjustable mortgages given to customers were defaulting regularly. As a result, Bear Stearns had a leverage ratio of 35:1 with illiquid derivatives and assets related to high risk mortgages, making a liquidity problem. The company should have avoided providing high risk and adjustable rate loans to consumers with bad credit. Credit default swaps are insured in a way that is more favourable for the buyer and not the seller (Deutsche Bank 2009). These swaps are usually bundled with a value of between £10 and £20 million each. A new method of attempting to secure the mortgage lender using derivatives and a lack of regulations (during this time period) that did not force companies to set aside financial reserves to cover the swap (Frielink 2008) led to the downfall of this company. In the summer of 2007, realising its illiquidity problem, should not have negotiated with other banks to loan money against its failing hedge funds. Merrill Lynch bout $850 million of hedge fund collateral that gave the business a bad market reputation and created fear of liquidation of its collateralized debt obligations. This led to a massive markdown of other assets as investors panicked. Bear Stearns should have went to the government immediately for a bail out agreement that would have probably made investors more comfortable about the liquid position. Instead, many asset portfolios suffered for this poor strategy. The week of March 10, 2008, when Bear Stearns signed a merger agreement with JP Morgan Chase, was a mistake. This agreement had a stock swap contract of only seven percent of Bear Stearns’ total worth. The firm should have negotiated a larger bailout contract with the Federal Reserve as this stock swap contract with JP Morgan Chase created a lack of investor confidence. No companies due to the media exposure would enter any collateralized agreements with the company further. Market perceptions of liquidity It is absolutely more important for the investment bank than traditional manufacturing and distribution companies. These businesses usually have just a small basket of investment strategies (stocks and bonds) to build capital. Investment companies diversify their portfolios in order to be competitive in many markets (CDOs, other derivatives, futures, options and more). Many of these investment types are high value, like the credit default swap, and are not always backed with real financial capital, but are high risk. Today, with new regulations, investment banks must now put away reserves to cover potential losses. Because of this, it means a firm cannot consider these reserves to be available capital when exposed to high risk investment strategies. A manufacturing company is not exposed to this multi-level risk. Therefore, it is easier for the manufacturing or distribution company to come up with solutions if an investment becomes illiquid. They can sell actual assets (real estate or equipment), as one example. Investment firms, however, are very rely on investors to build capital. Using CDOs and mortgage-backed securities as an example, because of their high value and volume, investment firms might have to sell nearly 100 percent of their total assets to cover potential losses. This happened with Lehman Brothers in 2008 (Anderson and Dash 2008). A manufacturing company can restructure its operations to control costs or even get loans when having a good credit rating to make sure it is in a liquid position. Derivatives or other investment strategies have many inter-dependent aspects, such as multi-party contracts to secure the investment, which means that when the investment strategy fails, it has a trickle-down effect on other portfolio investments. Investment banks are also very important for creating a stable domestic economy. This means they have much more publicity about transparency. Having many, many different investors means that negative publicity can create a lack of confidence that drives down stock value, investment value, and willingness of partners (such as other investment banks) to enter into agreements that makes the firm even more financially troubled. Basically, a manufacturing firm has less risk exposure than an investment bank and when confidence disappears with investors, the bank can collapse easily. Addressing perceptions of illiquidity The Chairman of the U.S. Securities and Exchange Commission stated clearly that the collapse of the firm was a result of reduced investor confidence and not a lack of available financial capital (Cox 2008). In 2007, Bear Stearns stated its assets were $350 billion USD and there is no research evidence that these were false statements and reporting. In 2007, Bear Stearns began negotiating with other banks to rescue failing hedge funds related to subprime mortgages (Creswell and Bajaj 2007). At the time, the collateralized debt obligations (CDOs) held by Bear Stearns had a very high credit rating of AAA (Siew and Yoon 2007). Banks such as Goldman Sachs and Bank of America were rushing to close out their positions in the CDOs offered by Bear Stearns. High publicity of these pull-outs created a situation where the CDOs needed to be marked down in order to divest them to investors. Bear Stearns’ own manager, Matthew Tannin, delivered an email which was publicised when Tannin was indicted for securities fraud. The email stated: “The subprime market looks pretty damn ugly...the subprime market is toast. If the CDOs report is anywhere close to accurate, we should close these funds now. If AAA bonds are systemically downgraded, then there is simply no way for us to make money – ever” (Dealbook 2008, p.1). Senior executives at Bear Stearns and the governance board should have quickly moved to separate itself from this manager. With real assets and capital available (which was confirmed by SEC Chairman Cox), Bear Stearns could have eased concerns and confidence problems by stating the firm did not share this belief with a manager who was arrested for fraud allegations. A run on the bank was caused by this publicity and exposure of emails from internal managers stating fret and concern about the illiquidity problem if CDOs were marked down. Executives at Bear Stearns should have held several press conferences showing the investment world and society that these CDOs had an AAA rating and had been high-performing. Waiting too long to come public to condemn Tannin and letting media rumours run for weeks is what led to markdowns as no investors or banks wanted a relationship with Bear Stearns CDOs. The “pure-play” investment bank It would not be fair to say that Bear Stearns’ failure undermined the pure play investment bank concept. Pure play means a company that has a single business focus, like Coca-Cola that sells beverages in comparison to PepsiCo that also markets snacks. Pure play strategy is designed to lower the cost of capital and maintain a good debt-to-equity ratio. Netflix is a company with a pure play strategy since it only deals with movies and video content rather than diversifying. Bear Stearns would be considered pure play since it was not geographically diversified. Only a small portion of total revenues were created outside of the United States. Merrill Lynch, as one example of a non-pure play bank, has 33 percent of its revenues from international diversified activities. Bear Stearns focused mostly on investment activities, such as fixed income, asset management, equities and investment banking; a single focus. The pure play business must make sure its return on capital is higher than the total cost of capital. Using the capital asset pricing formula, the pure play company better controls its cost of capital with a single focus. Bear Stearns had, prior to 2007, had a success record for large rates of return on its investment strategies that were much higher than cost of capital. Prior to 2007, the company was not over-leveraged since such derivatives as the credit default swap or collateralized debt obligations were high performing and the company did not have to issue debt to support these investments. It was market conditions, fear and investor/commercial speculation that began to create less market value for these (and other) investment strategies which impacted the choice by which Bear Stearns built its business model. Bear Stearns would likely be in business today if the media and investor fears had not created problems with derivative value and demand for these investments. Bear Stearns went from a basic leveraged firm to a highly over-leveraged firm as a result and the cost of capital increased massive as a result. Other pure play investment banks with a single focus find success by not diversifying to the point where they are over-exposed to much risk and can have a positive debt-to-equity ratio and low cost of capital (Welch 2010). The potential role of the Federal Reserve in securities’ markets The role of the Federal Reserve in an economy is to manage the national supply of money, stabilise inflation and deflation rates, regulate interest rates, supervise banking institutions, and provide loans to banks as a last resort in the event of a coming collapse (Epstein and Martin 2003). The Federal Reserve is a banking authority that is supposed to work within a free market economy. This economy supports a lack of government regulation in controlling prices on products and gives businesses independence from government control. This type of economy is one where the capital market is driven by market conditions (demand, supply and pricing). The securities market works on the basis of supply and demand and where prices are determined by market conditions. The Federal Reserve should not be a regulating force or a bail-out entity when there are problems in the securities market. Companies that are issuing securities should be held accountable to guarantee ethical securities trading and make sure that real assets are backing the securities financial asset. During the Great Depression of 1929, people gave a run on banks when panicking about their financial wealth. This is why the Reserve was created to make sure this does not happen and provides liquidity if it should. Today, media creates situations of panic and the Federal Reserve should not be a source of capital for investment banks (offering securities) when there are other options (such as taking debt) to get out of such a situation. The Securities and Exchange Commission is created to regulate the securities market in the U.S. and other nations with a securities market. These have the assets available for enforcement and the authority to do so. The Federal Reserve was not put into action to start providing capital to struggling banks that were using unethical actions for offering illiquid securities. The SEC can make sure that companies are following securities trading laws and punish those who cause problems in this market. If the Federal Reserve were to make a practice of offering loans to struggling banks that were about to collapse due to securities fraud or poor securities strategy, it would set a trend that banks would come to the Reserve whenever they had capital problems. The Federal Reserve has limited assets and operates on a budget like any other business or bank and many obligations for regulating banking activities. It is not realistic to have the Federal Reserve play any role in the securities market where the Federal Reserve has many liabilities and uncertain asset growth in treasuries to create a budget that works for the entire nation. To have authority in the securities market, it would also be necessary for the Federal Reserve to be given regulatory authority to make sure businesses obey laws related to securities trading and issuing. This could be difficult sharing this authority with the SEC to coordinate controls and punishments when securities traders do not use fair and ethical practices. Securities traders would probably want the Federal Reserve to give the banks loans whenever market situations were causing pricing issues with securities. Too many companies that were seeking Federal Reserve loans would strain the organisation’s ability to provide support to retail and commercial banks and consumers with deposits might suffer if a situation like the 2008 recession occurred again. References Anderson, J. and Dash, E. (2008). For Lehman, more cuts and anxiety, New York Times. [online] Available at: http://www.nytimes.com/2008/08/29/business/29wall.html?em&_r=0 (accessed 11 December 2014). Cox, C. (2008). Sound practices for managing liquidity in banking organizations, U.S. Securities and Exchange Commission. [online] Available at: www.sec.gov/press/2008/2008-48_letter.pdf (accessed 10 December 2014). Creswell, J. and Bajaj, V. (2007). $3.2 billion move by Bear Stearns to rescue fund, The New York Times. [online] Available at: http://www.nytimes.com/2007/06/23/business/23bond.html?_r=0 (accessed 9 December 2014). Dealbook. (2008). Behind the scenes of Bear’s Fund Meltdown. [online] Available at: http://dealbook.nytimes.com/2008/06/19/behind-the-scenes-of-bears-fund-implosion/comment-page-1/?_php=true&_type=blogs&_r=0 (accessed 7 December 2014). Deutsche Bank. (2009). Credit default swaps: heading towards a more stable system. [online] Available at: http://www.dbresearch.com/PROD/DBR_INTERNET_EN-PROD/PROD0000000000252032.pdf (accessed 10 December 2014). Epstein, L. and Martin, P. (2003). The complete idiot’s guide to the Federal Reserve. Alpha Books. Fabozzi, F.J. (2006). Handbook of Mortgage Backed Securities, 6th ed. McGraw-Hill. Frielink, K. (2008). Credit default swaps and insurance issues under Dutch Caribbean Law. [online] Available at: http://www.curacao-law.com/2008/06/17/credit-default-swaps-and-insurance-issues-under-dutch-caribbean-law/ (accessed 11 December 2014). Haress, C. and Caulderwood, K. (2013). The death of Lehman Brothers: what went wrong, who paid the price, and who remain unscathed through the eyes of former vice president, International Business Times. [online] Available at: http://www.ibtimes.com/death-lehman-brothers-what-went-wrong-who-paid-price-who-remained-unscathed-through-eyes-former-vice (accessed 9 December 2014). Sahlman, W.A. (2009). Management and the financial crisis: we have met the enemy and he is us, Harvard Business School. [online] Available at: http://www.hbs.edu/faculty/Publication%20Files/10-033.pdf (accessed 10 December 2014). Siew, W. and Yoon, A. (2007). Bear Stearns CDO liquidation sparks contagion fears, Reuters. [online] Available at: http://www.reuters.com/article/2007/06/22/businesspro-usa-credit-bearstearns-cdo-d-idUSN2136425520070622 (accessed 9 December 2014). Stowell, D. (2008). Investment banking in 2008 (A): rise and fall of the bear, Kellogg School of Management. UDHUD. (2013). Subprime lending, U.S. Department of Housing and Urban Development. [online] Available at: http://portal.hud.gov/hudportal/HUD?src=/program_offices/fair_housing_equal_opp/lending/subprime (accessed 7 December 2014). Welch, I. (2010). A bad measure of leverage: the financial debt-to-asset ratio, in R. Berger (ed.), Strategy and ownership structure as determinants of financial management: an empirical investigation. Rainer Hampp. Wolgemuth, L. (2008). JP Morgan and Bear Stearns: a culture challenge, US News and World Report. [online] Available at: http://money.usnews.com/money/careers/articles/2008/03/31/jpmorgan-and-bear-stearns-a-culture-challenge (accessed 8 December 2014). Zarroli, J. (2008). Little sympathy for Bear Stearns, National Public Radio. [online] Available at: http://www.npr.org/templates/story/story.php?storyId=88690002 (accessed 9 December 2014). Read More