Liquidity and the Collapse of Bear Stearns

We have followed the financial crisis in part because of the relationship to executive compensation and current efforts at reform.  We have also followed it because of the structural shift that has occurred in the securities markets, particularly the elimination of independent investment banks as financial intermediaries, an inevitable byproduct of the repeal of Glass-Steagall.  See The "Great Fall": The Consequences of Repealing the Glass-Steagall Act. 

The third reason for following the crisis has been the role of regulatory agencies in the process, particularly the SEC.  The Commission supervised the investment banks under the voluntary Consolidated Supervised Entity program, a system of supervision operated by the Division of Trading and Markets (then Market Regulation). 

Which brings us to a Bear Stearns.  Bear Stearns gets less attention these days.  The current financial crisis truly became inflamed with the collapse of Lehman Brothers in September 2008, a transaction that put markets on notice that everyone, even the largest financial institutions, were at risk.  Inter bank rates skyrocked and lending dried up.  

But Lehman had been only the most immediate crisis.  Months before, in March, Bear Stearns had disappeared into the acquiring arms of JP Morgan Chase, brought down at least in part by the deterioration in the market for mortgaged backed securities.  Because the consequences were not as immediately dire, the transaction has tended to be overlooked, subsumbed by Lehman, AIG and Citigroup.   But in many respects, it was the real beginning of the collapse. 

The collapse of Bear Stearns was the first of the major transactions that required considerable involvement from both the Fed and Treasury.  As part of the transaction, the Fed agreed to purchase $30 billion in hard-to-trade securities, reducing the risk absorbed by JP Morgan.  In effect, it was the first government bailout of the crisis.  When Paulson confronted the crisis at Lehman six months later, his response may have been bailout fatique, unwilling to save yet another ailing financial institution.   

Bear Stearns was under the supervision of the Securities and Exchange Commission.  A recent GAO Report explained the collapse, and the views of the staff, this way:

• In particular, Bear Stearns, formerly a CSE [Consolidated Supervised Entity], reported that it was in compliance with applicable rules with respect to capital and liquidity pools shortly before its failure, but SEC and Bear Stearns did not anticipate that certain sources of liquidity could rapidly disappear. According to SEC officials, Bear Stearns’ failure was due to a run on liquidity, not capital. Shortly after Bear Stearns’ failure, the then SEC Chairman noted that Bear Stearns failed in part when many lenders, concerned that the firm would suffer greater losses in the future, stopped providing funding to the firm, even on a fully-secured basis with high quality assets provided as collateral. SEC officials told us that neither they nor the broader regulatory community anticipated this development and that SEC had not directed CSEs to plan for the unavailability of secured funding in their contingent funding plans. SEC officials stated that no financial institution could survive without secured funding. Rumors about clients moving cash and security balances elsewhere and, more importantly, counterparties not transacting with Bear Stearns also placed strains on the firm’s ability to obtain secured financing. Prior to these liquidity pressures, Bear Stearns reported that it held a pool of liquid assets well in excess of the SEC’s required liquidity buffer, but this buffer quickly eroded as a growing number of lenders refused to rollover short-term funding. Bear Stearns faced the prospect of bankruptcy as it could not continue to meet its funding obligations. Although SEC officials have attributed Bear Stearns’ failure to a liquidity crisis rather than capital inadequacy, these officials and market observers also stated that concerns about the strength of Bear Stearns’ capital position—particularly given uncertainty about the potential for additional losses on its mortgage-backed securities—may have contributed to a crisis of confidence among its lenders, counterparties, and customers.

The explanation is not really an explanation.  It is true that collapses of the magnitude of Lehaman are often directly preciptated by a liquidity crises.  Lenders see the looming failure and stop lending.  Enron failed when lenders stopped lending.  It is not news to attribute failure to such a consequence. 

But the liquidity crisis merely begs the question.  What happened that caused the crisis and how did the inspection staff miss the warning signs?