2008 Financial Crisis: Collapse of Bear Stearns and Lehman Brothers

Orcun Kahyaoglu

The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage firm, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession. Its main business areas, based on 2006 net revenue distributions, were capital markets (equities, fixed income, investment banking; just under 80%), wealth management (under 10%), and global clearing services (12%).

Lowenstein states in his book that Bear Stearns was involved in securitization and issued large amounts of asset-backed securities, which in the case of mortgages were pioneered by Lewis Ranieri, "the father of mortgage securities" (2010).

There are some major causes that made the Bear Stearns collapse. The rumors about running out of cash made people loosing confidence. Then, they want their money out which could cause the rumor to become true. But the securitization of subprime mortgages, which are called toxic assets, was the main cause of Bear Stearns to collapse. Bear borrowed too much to invest in these toxic assets and it should have found more lenders to loan money to Bear.

The moral hazard issue is again on its work in the financial markets. It is a term that is the encouragement to take risky or reckless action that arises when your losses are insured by someone else (Quiggin, 2008). If a company is bailed out, it may make the same mistakes again and if the company was allowed to fail, this may create a great systematic risk.

Tim Geithner learned that Bear had made credit default swap deals worth trillions of dollars all over Wall Street and around the world. Because Bear Stearns was so indebted to so many other people, their failure to repay their debts, or pay their debts, would cause a cascade of other failures, and it was frighteningly interconnected with other banks in Wall Street. Geithner saw that central bankers most fear from systemic risk. Bear Stearns, Geithner concluded, was “too big to fail.” A bankruptcy could undermine confidence in every major Wall Street firm.

 

Because of the issue of moral hazard, Lehman Brothers allowed to fail. Moral hazard concern of federal government surpassed systematic risk and they decided to not bailout. But the decision seemed to be wrong in the following days. Systematic risk become real and none of the banks lend to each other even if they know well the inter-bank lending is the bedrock of the banking system.

Mortgage crisis became a general credit crisis with frozen credit markets after the banks had stopped lending. Investors were shaken by Lehman’s bankruptcy. Commerce in America was grinding to a halt. The world’s largest insurance company AIG was down 70%. Geithner realized that if AIG went down, the consequences would be even worse than Lehman, so he argued for another bailout. He punished the banks that were parties in AIG’s toxic deals by making them take a financial hit. He made the parties have to take a discount on their insurance policy with AIG. As a result, government initiated a full-scale bailout of the U.S.’s financial system by taking stakes in the largest banks in U.S.

Lowenstein, R. (2010). The End Of Wall Street, Penguin, pp.xvii,22

Quiggin, J. (2008). Moral Hazard, Meet Adverse Selection. Retrieved from: http://crookedtimber.org/2008/09/19/moral-hazard-meet-adverse-selection/