How to Learn From the Bear Stearns Bailout

In spring, 2008, the Bush Administration directed the Federal Reserve to underwrite $30 billion dollars of shaky loans held by an investment bank, so that it would not declare bankruptcy. After the bailout, Bear Sterns was folded into JP Morgan Chase for $10 a share, less than a third of its value only two days before.The government had deemed that Bear Sterns was simply too big to fail. Whether you agree, there is much you can learn from this episode.

Difficulty: Moderately Easy

Instructions

1. Understand the position Bear Sterns held. It was one of the world’s largest global investment banks and the fifth largest in the United States. The institution held assets worth over $2.1 billion before its collapse and employed over 15,000 people. It was founded in 1923 and survived the 1929 stock market crash without laying off a single employee, but it could not get through the subprime mortgage meltdown. The company had invested too heavily in mortgage-backed securities and soon face a classic "run on the bank." Investors started pulling out their money (since FDIC protections don't extend to any funds you place in an investment bank) and the company was soon short of cash. Bear Sterns started looking for a buyer that would assume it's obligations, but no one stepped forward.

2. Grasp why the Federal Reserve intervened. Investment banks keep the economy running by raising money for initial public offerings, economic expansion and trading. The Fed jumped in because it was worried that a Bear Stearns failure could spark a run on other investment banks, creating a domino effect that could spark a major financial crisis. This doesn't mean your money will be safe if something like this happens at your investment bank. The Fed was loudly criticized for its response. In the future, if a bank is deemed expendable, it just might be allowed to fail.

3. Realize that other banks are at risk whenever home prices fall nationwide. Foreclosures increase and credit tightens. If you want to put some savings in an investment bank, steer clear of institutions that invest heavily in subprime mortgages.

4. If you have the option of investing in your employer’s stock program, don’t get overexposed. Treat it like another stock. At Bear Sterns, employees owned nearly a third of the company. At its peak, Bear Sterns was trading at $81. The stock ultimately sold for 12% of peak value.

5. A Bear Stearns failure could have caused a major credit crunch. To avoid being caught by one in the future, set up a line of credit at reasonable terms when you don’t need it and can negotiate your best deal.

Tips & Warnings

• This is an ongoing story so more could develop in the light of the recent criminal indictment of Bear Sterns Hedge Fund managers Realph Cioffi and Matthew Tannin. Both are accused of lying to investors.