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The world economy experienced significant growth between 2001 and 2007. This growth was attributed to increased international trade, efficient business practices and user-friendly banking practices that enabled people to borrow money for investment (Lewis et al 17).
However, in the second half of the 2007 financial year, the economic boom fell into a crash, which led to the global financial crisis. Banking institutions were the worst hit. Some declared insolvency, while others requested for bailouts just to keep afloat. This paper shall analyze the causes of the problems Bear Stearns experienced during the credit crisis.
Bear Stearns Companies, Inc. was a well renowned and reputable firm in the global investment industry. Since its inception in 1923, the firm managed to survive through various recessions and even the Great Depression.
However, in 2007, the financial institution, which had over the years established itself as an investment bank, securities trader and a brokerage firm started experiencing financial difficulties. It was later acquired by JP Morgan Chase in 2008.
Causes of Bear Stearns problems during the financial crisis
- Excessive debt leverage/ imprudent lending
According to Wade, most banking institutions were offering loans equivalent to 100% of the collateral, ignoring the income verification procedures and giving low interest rates on high risk loans (27).
This led to a situation whereby the risk of bad debts increased significantly. When the credit crisis hit, people were unable to repay the loans and the assets previously offered as collateral were not worth their initial value. As such, financial institutions such as Bear Stearns incurred enormous losses due to dubious and reckless banking practices.
- Poor regulatory mechanisms
A primary cause of the financial crisis was the failure of the regulators to protect the financial system from credit related risks that were present since 2002. According to Davies and Green, the regulators, as well as the congress had an obligation to monitor and prevent excessive credit problems within the financial industry (33).
However, failure to accomplish their objective led to an abject situation in which banks borrowed above their capacity, withheld information from investors, and got involved in get-rich-quick schemes that involved a lot of risks to the banks and investors.
- Housing bubble
From 2002 to 2005 the housing prices within the United States skyrocketed. This was attributed to the fact that loans were easily accessible, and banks were willing to offer 100% mortgage financing (Lewis et al. 14). As such, the housing bubble presented Bear Stearns with an opportunity to make huge profits.
The investment bank borrowed more from other banks and invested in asset-backed mortgages. As a result, it had too much leverage at a time when the credit situation was getting worse by the minute. This led to a situation whereby Bear Stearns lost over 90% of its market value within a week.
Bear Stearns’ Subprime mortgage crisis
In June 2007, Bear Stearns declared that one of its hedge funds (the Bear Stearns High-Grade Structured Credit Fund) was in need of a bailout. As such, the investment bank decided to take loans from other banks amounting to 3.2 billion against the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund in order to facilitate the bailout.
However, Bear Stearns had only raised $35 million, and the bailout would have ruined the institution’s reputation. Consequently, the money was invested in Collateralized debts obligations (CDOs).
However, the CDOs were not able to raise the required amount, and there was concern that Bear Stearns would have to liquidate its CDOs. This meant that there would be a significant price cut in other portfolios dealing with similar assets. By mid July, the two hedge funds had lost over half of their initial value, and in August, they were closed.
Legal actions were taken against Bear Stearns for misleading investors in regard to the state of the funds. Bear Stearns had told investors that the funds were improving well knowing that this was not true.
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The truth was that the hedge funds were actually plummeting. Soon after this incident, Bear Stearns’ credit rating was downgraded from AA to A. with no other available option; Bear Stearns requested a bail out from the federal bank reserves. However, this request never went through leading to its acquisition by JP Morgan Chase.
Analysis of the problem
As can be evidenced from the discussion above, Bear Stearns collapsed due to liquidity problems. The financial institution had bet heavily on subprime loans and as the market for these loans declined in 2007, the firm could not survive. While most would argue that the collapse of Bear Stearns was due to lack of confidence, documented evidence prove that it was because of lack of adequate funds.
To a large extent, the problems faced by Bear Stearns were internal. However, external factors such as inflation, decline in demand for subprime loans and a fragmented regulatory regime played a significant role towards the collapse of Bear Stearns.
As a result of poor regulatory mechanisms, banks engaged in risky investment practices. Inflation and market forces (demand and supply) influenced the purchasing power of the people leading to losses. Banks could not recover their money and borrowing avenues were limited. These factors contributed to the credit crisis, which saw numerous banks declare bankruptcy.
Davies, Howard and David Green. Global Financial Regulation. Cambridge, UK: Polity, 2008. Print.
Lewis, Victor, et al. “Was the 2008 Financial Crisis Caused by a lack of Corporate Ethics?” Global Journal of Business Research 4.2 (2010): 79. Print.
Wade, Robert. “The First-World Debt Crisis of 2007-2010 in Global Perspective.” Challenge 51.4 (2008): 23–54. Print.