Bear Stearns Collapse

The Bear Stearns collapse of March 2008 was the first major casualty of the financial crisis. The investment bank, which had survived the Great Depression and numerous market crises, was crippled by enormous losses on mortgage-backed securities. Unable to meet liquidity demands and with its stock price in freefall, Bear Stearns was sold to JPMorgan Chase in an emergency transaction orchestrated by the Federal Reserve. It was a harbinger of worse to come.

The warning signs

Bear Stearns had grown throughout the 2000s as a major player in mortgage securitization and trading. The firm had accumulated enormous positions in mortgage-backed securities and related derivatives. As the housing market began to soften in 2006–2007, Bear’s positions became increasingly problematic.

In July 2007, two hedge funds managed by Bear Stearns collapsed due to mortgage-backed security losses. The hedge funds had been highly leveraged; their losses raised questions about Bear’s own exposure and risk management. By early 2008, it was clear that Bear had massive mark-to-market losses.

The liquidity crisis

In March 2008, as mortgage-backed securities became nearly untradeable and mark-to-market losses mounted, Bear Stearns faced a liquidity crisis. Customers and counterparties, spooked by the firm’s losses, began to withdraw deposits and pull credit lines. Repo lenders (who provided short-term financing secured by collateral) began to demand higher rates or to refuse to lend at all, or demanded superior collateral.

By March 10, 2008, Bear Stearns’ liquidity was critical. The firm had only enough cash to operate for a few days. A bankruptcy seemed imminent.

The emergency sale

Recognizing the systemic implications of a Bear bankruptcy, the Federal Reserve, working with JPMorgan Chase and the Treasury, organized an emergency sale. On March 16, 2008, Bear Stearns was sold to JPMorgan Chase for $2 per share — a devastating loss for shareholders (the stock had traded for $160 a year earlier) but necessary to prevent a bankruptcy.

The Federal Reserve provided a $30 billion loan to JPMorgan to absorb some of Bear’s losses. The Fed also made clear that it was willing to provide emergency liquidity to investment banks to prevent further defaults.

The signal

The Bear Stearns rescue was intended to stabilize markets by preventing a catastrophic bankruptcy. But it also sent a signal: the federal government and the Fed were willing to rescue large financial institutions to prevent systemic crises.

However, the signal was ambiguous. Some interpreted it as reassurance that the government would prevent major failures. Others interpreted it as evidence that the financial system was in dire straits and that worse crises were coming.

The aftermath: Lehman and beyond

Six months after Bear Stearns’ forced sale, Lehman Brothers — a much larger investment bank — was allowed to fail. The contrast raised questions: why rescue Bear Stearns but not Lehman? Some argued that the Fed had exhausted its forbearance; others argued that the decision not to rescue Lehman was a mistake.

Legacy: The cost of interconnectedness

Bear Stearns’ collapse and rescue demonstrated the interconnectedness of modern financial institutions. A single firm’s problems could pose systemic risks if the firm was large enough and had enough counterparties. The rescue also established a precedent: the Fed would use its emergency powers to prevent large firm failures.

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