Bear Stearns was a distinguished firm on Wall Street for more than 87 years, which collapse in disgrace during the 2008 financial crisis. The same financial crisis that had as a root cause mortgage backed securities. It is no coincide that Bear Stearns fall and the mortgage backed securities (and collateralized debt obligations) on its financial statements were indelibly linked. One of the main difficulties that was seen in financial markets surrounding mortgage backed securities was the difficulty in properly valuation the products. This was no different at Bear Stearns and it helps to highlight the offsetting nature of relevance and reliability. It was very relevant to have the mortgage products on Bear Stearns financial statements but their reliability due to the valuation issues (as well as others) was virtually nonexistent. These problems were compounded when fair value accounting was thrown into the mix. The other issues related to reliable valuation of MBS products relate to actively utilising information asymmetry to the firms advantage, be it through adverse selection or moral hazard to help obfuscate information on the market.

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This allows us to further look at the contrast between the efficient market hypothesis and behavioural finance and the way Bear Stearns used very complex products and how their complexity helped to hide their risk. Finally, we see the complete failure of Bear Stearns fiduciary duty to its shareholders through its lack of proper disclosure of the risks on its financial statements. Much of this disclosure comes from poor corporate governance and the unaccountable executives who received excessive compensation.? Bear Stearns and their Activities Prior to its Collapse

The Bear Stearns Company was a leading investment, securities trading and brokerage firm. Throughout its history dating back to the 1980s the company had a reputation of tremendous discipline. They performed detailed analysis on mortgage backed securities (MBS) and could predict how quickly the bonds could repay. Between 1994 and 1998 they were overseeing 10 billion in bond trades a day. In the mid-1990s Bear Stearns acquired the lending firm, EMC Mortgage and together with their strict lending practices theywere able to remain afloat when other sub- prime mortgage lenders went under.

Page 2 Bear Stearns Essay

These practices slowly degraded during the years 2004 to 2007. As the number of sub-prime mortgages increased, the demand increased. The race to bid for a larger number of loans outweighed the concern for quality. Theonly control in place by Bear Stearns was the review of the loan files by a third party firm and they only reviewed 20% or fewer of the mortgages they were buying. It was the gold rush and these safeguards were a hindrance to profits. The initial signs of trouble began with the derivative fund called ‘High Grade Structured Credit Strategic Fund’ which provided a return of 46. 8% from October 2003 to early 2007. It was leveraged 30 to 1, its investors put 1. 53 billion in assets but the total assets (bets) totaled 10 to 40 billion. One reason disclosure was not required was that the funds contained private assets and the fund was located in the Cayman Islands. All the speculation revolved on the premise that home prices would increase. In June 2007 a drop in income was reported by Bear Stearns for the sup-prime mortgages. The series of bad news that continued caused the stock prices to fall, consumer confidence took a nose dive and in March 2007 the company was sold to JP Morgan.

Thus ends its 87-year run as a securities firm. , Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDO) Mortgage market regulation, and financial services regulation more generally, has always been highly contested in the United States. Financial crisis can, but not always, spur politicians to act against special interest groups. With the rise of sub-prime mortgages the government enacted in 1994 the Truth in Lending Act (TILA). The first part required the government to regulate certain high cost mortgages but this had limitations.

The second part required the Federal Reserve Board to prohibit unfair or deceptive practices. The act was not self-executing, and the Federal Reserve could choose its appropriate response. 3 Historically, mortgage practices in the United States have changed with the economic and financial environment. They first began with the consumers going to their local bank for a loan. These were long term fully amortized fixed rate mortgages. The lenders bore the risk of default loans and as a result conservative lending and regulation practices were observed.

In the 1980s, interest rates rose, lending and real estate sales declined. In response the government removed interest rate caps on home mortgages and it removed the restriction of fixed rate mortgages. This gave birth to a range of mortgage products. A secondary market began with Fannie Mae and Freddie Mac, federal housing finance agencies. Their mortgages were regulated and had government approved underwriting standards. In the 1970s they bought mortgages, packaged them and sold them as bonds to investors. The interest rate risks were allocated to different tranches.

They were called mortgage-backed securities (MBS). The government securitized these mortgages and guaranteed the timely payment of principle. With no risk of loss of principle, investors were not concerned with good information on default risk. 4, In the 1990s private companies (called private label securitization (PLS)) arose in an unregulated environment and displaced the government securitized mortgages. Complex mortgage instruments flourished and the growth came mainly from sub-prime mortgages. The structure was called collateralized debt obligations (CDO).

Each tranche contained pools of bonds with their own risk, interest, and maturity. Each tranche had a different level priority in repayment. Eighty percent of securities backed by sub-prime mortgages had their top tranche rated AAA. A CDO is an instrument which enables investors to trade slices of the credit risk in a credit portfolio. To further add to the complexity, CDO could be pooled, tranched into a new set of CDO and re-securitized. The investment banks then transferred these securities to special purpose vehicles (SPV), wrote drafted prospectuses, and made filings with the SEC.

The SPV took the form of a trust and sold the CDO to investors. 4, There were valuation methods and procedures used to estimate the value and risk associated with the CDO securities but in the end they were the structure of MBS that led to the financial crisis of 2008. Accounting Theory, Mortgage Backed Securities, and the Collapse of Bear Stearns At the base of the collapse of Bear Stearns is the notion of accounting theory in relation to mortgage backed securities. We have gone over the history of Bear Stearns, as well as that of MBS’, we will now analyze the many ways that the latter helped to bring down the former.

We will do this by looking at the offsetting nature of relevance and reliability and the difficulty in obtaining either with mortgage backed securities. This will also lead us to discuss the measurement approach, and more specifically fair value accounting. We will also analyze the components of information asymmetry, those being adverse selection and moral hazard, and the ways in which investors operated in an opaque investing environment. The final subjects that we will analyse can be covered under two broader subjects.

The first of these broad subjects being the limitations and gaming of market efficiency where we will contrast the concepts of the efficient market hypothesis versus behavioural finance and the use of complexity to hide risk from the market. The second and final broad subject, being the fiduciary duty of a corporation towards its investors and the markets through its disclosure to investors, its corporate governance, and the compensation it provides to its executives. The Offsetting Nature of Relevance and Reliability

Under SFAS 115, MBSs are classified into one of three categories: trading securities, held-to-maturity securities, or available-for-sale securities. 7 The concept of decision usefulness approach in accounting requires reporting relevant and reliable information for investment decisions. To improve relevance, the value of high risk investments is best reflected using fair value. The CDO securities (at Bear Stearns) were not traded on the active market, rather a transaction between dealer and investor occurred and the sales volume and pricing were not posted.

There was no resale market. Valuation needed to rely on modeling rather than market values. 4 Currently, the theoretical valuation of CDOs is particularly complex as it requires accurate and up-to-date estimation of the co-movement of defaults among the entities in the credit portfolio backing the CDO. 6 The CDO sold by Bear Stearns were poorly collateralized and these sub-prime loans had suboptimal credit-risk characteristics. 7 The CDO comprised of pools of bonds that were managed outside the firm and all the activities were not observable or disclosed.

Due to these changing conditions and the complexities of CDOs, the rating agencies reviewed the restrictions of the collateral to assign a rating to each of the tranches and with this rating a sale price was determined. 4 As a result there assigned values were not verifiable and this resulted in financial statements with low reliability. To increase investor confidence the following features were implemented: 4 -The lender provided representations and warranties on the products they sold with recourse clauses -The rating agencies provided the top tranche with AAA ratings -A credit enhancement was provided for high ratings.

They were overcollateralization and excess spread. This meant that the total balance of the principle of the loans exceeded the outstanding principle balance on the securities and the interest payments from borrowers exceeded the interest owed to bondholders. -Credit Default Swaps were created to hedge the default risk of CDOs. In spite of the added protection, the CDOs remained shrouded from the public. The procedures in place were flawed. Bear Stearns did not anticipate a decline in housing prices. The lender’s warranties did not provide adequate protection.

The credit default swaps were also used for speculative trading and AIG (among others), providers of SWAP derivatives, could not cover the amount of defaults. One significant flaw with this process was that the agencies were not liable for errors in judgment and they became collaborators with the underwriters. 4 The market could not know what the cash flows for specific portfolios of mortgage backed securities were but it became clear that there were greater losses on mortgage-backed securities than their triple-A ratings implied.

Efficient securities market theory is defined relative to a stock of publicly known information. The market was unaware of the information risk. There are two sources of information asymmetry. One of the sources was that Bear Stearns had poor underwriting standards for the CDOs and this resulted in a moral hazard for the public. The other source was that Bear Stearns was not always aware of the borrower’s credentials such as, the applicant’s loan- to- value and debt-to- income ratios. The information asymmetry in this case caused an adverse selection of the mortgages Bear Stearns was buying.

This information asymmetry resulted in the efficient market price for Bear Stearns deviating greatly from the fundamental firm value. The main diagonal of the information system had low probabilities and the earnings were of poor quality. This will be touched upon, in greater depth, further in the paper. When there is a large write-down of assets part of the loss in value is not only due to the reduced cash flow but also the market’s judgement of the risk. 8 During the crisis the demand for CDOs evaporated. In time and with more information the market adjusts the market price to reflect the new efficient market price.

Fair Value Accounting This leads us to fair value accounting and its role in the collapse of Bear Stearns. In November 2007, FASB implemented FAS 157, also known as the Fair Value Measurements. Initially, this FAS 157 was implemented in order to create a generally accepted accounting definition of fair value, methods for measuring fair value, and expand disclosures about fair value measurements in financial statements. The purpose of this statement was to increase consistency, comparability and transparency among statements that incorporated fair value measurements.

However, this induced the beginning of the collapse of Bear Stearns, as it caused a write down of its assets, which depleted its capital. This write down was necessary because the CDOs that were on Bear Stearns’ financial statements as assets, deviated from their fundamental market price. As the housing market began to soften, the market price did not accurately represent the underlying asset’s true value; therefore, these assets on Bear Stearns balance sheet had to be accounted for at the lower of historical cost or fair value.

These assets were tested for impairment and, written down to the present value of future cash flows, and since the California housing market was softening; investors and creditors were becoming fearful about being unable to collect all amounts due. This lead to the assets values being much less than the value under normal liquidity conditions which resulted in lowering shareholders’ equity. Writing down the assets would not have caused Bear Stearns to collapse had the market had not lost confidence in the firm.

The loss of confidence stems from a lack of liquidity that a firm may have, otherwise known as the Diamond–Dybvig model, which shows how banks’ mix of illiquid assets, the CDOs, and liquid liabilities may give rise to self-fulfilling panics among depositors. At Bear Stearns prime, it was listed seventh-largest securities firm in terms of total capital by Institutional Investor magazine. A year prior to its collapse, the company had total capital of approximately $66. 7 billion and total assets of $350. 4 billion. At its downfall, Bear Stearns had notional contract amounts of approximately $13.40 trillion in derivative financial instruments, of which $1. 85 trillion were listed futures and option contracts. Also, it was carrying more than $28 billion of unobservable assets, meaning that the value cannot be depended upon, versus a net equity position of only $11. 1 billion. Therefore, this $11. 1 billion supported $395 billion in assets , which means a leverage ratio of 35. 6 to 1. This balance sheet was too highly leveraged and consisted of many illiquid and potentially worthless assets, which led to investor and lender confidence, and that triggered the collapse. Information Asymmetry

The accounting problem at Bear Stearns, like most companies affected by the crisis, started off with information asymmetry. Despite the concept of information asymmetry being a simple one, it is undoubtedly one of the biggest problems that affect accounting today. Information asymmetry is caused by the seller knowing more about the assets being traded than the buyer. It is divided in two categories, moral hazard, when there is lack of incentive to guard against risk where one is protected from its consequence and adverse selection, when undesired results occur when buyers and sellers have access to different information.

Adverse Selection Thus, if we start from the root of the problem, banks and mortgage companies created adverse selection by allowing risky mortgage seekers to take out subprime mortgages, as it attracted the more likely to default, and in return, these risky mortgage seekers created moral hazard by taking out loans which they had no capability to repay. Subsequently, by selling these mortgages to investors, these banks and mortgage companies essentially knew the quality of the product, but were taking advantage of the limited information available to the investors.

Theoretically, the Akerlof theory would entail that at the trading floor level, sellers with high quality products will not be able to get the desired value from buyers and have no choice but to withdraw or be willing to receive a lower price. This means that most of the trading products left on the trading floor would be of lower quality. Consequently, trading would result in mainly lower levels of quality, excluding both, the high quality product buyers and sellers. This is perfect example of the definition of asymmetrical information, and what happened with Bear Stearns.

Hence, this created a vast information gap, where Bear Stearns traders couldn’t decipher between securities that were backed by high quality or sub-prime home loans. Reason being, by the time they reach Bear Stearns, located on the opposite coast of the country, they were bundle in CDOs and that type of information was not available at the trading floor level. Moral Hazard Does the Federal Reserve Bank providing $30 billion dollars for Bear Stearns “less liquid assets” constitute a moral hazard?

Many claim that this intervention has encouraged investment banks to continue their risky business and still maintain the expectation that the Federal Reserve will throw a lifeboat when their ship is about to sink; the help, of course, will come from taxpayers’. On a different wavelength, this could also take the form of self-interest. Otherwise, why make the decision to let Lehman Brothers go bankrupt and decide to save Bear Stearns right before a new funding facility, Primary Dealer Credit Facility, was being set up?

Rumours are that Henry Paulson sent the “rescue team” just in time, when he saw that Goldman Sachs was heading towards bankruptcy (his previous employer where he enjoyed a long and successful career). It is said that Bear Stearns’ was too big to fail and that its failure would have brought substantial collateral damage the global financial markets. Thus, Henry Paulson chose to rescue Bear Stearns in an attempt to save the U. S. financial markets. (There were similar arguments used during the meltdown of Enron, WorldCom & Drexel.) Factoring out the global economy and the U. S. financial markets, it is the stockholders who took the hit for Enron and co, but with the Federal Reserve funding Bear Stearns & other primary, it was the U. S taxpayers’ who ended up suffering the most. 33, , Market Efficiency versus Behavioral Finance Market efficiency, otherwise known as efficient market hypothesis (EMH) formulated by Eugene Fama in 1970, suggests that prices fully reflect all available information on a particular stock at any given time.

According to the EMH, no investor has an advantage in predicting a return on a stock price because no one has access to information not already available to everyone else. What EMH failed to acknowledge, is that this theory would only work on the assumption that an investor is investing his money, and is a not related to a firm. In modern times, many of the investors do not invest their own money. They invest it in their banks, which in turn use their traders to invest it for them. This is the premise of behavioural finance, the study of behavioral-based securities market inefficiencies.

The EMH does not cover the issues that affect the rationale behind the reflection the prices. The EMH factors that investors are all gifted with similar intelligence and that the message the financial statements are trying to convey are all comprehended fairly and equally by all investor. The reality is that individuals may have limited attention where they may not have the time to process all available information, and might concentrate on only certain elements of the information, such as the bottom line. On the other hand, individuals may be conservative, and not react fast enough to the information.

The behavioural theory also suggests that most investors are often overconfident, and overestimate the precision of the information they collected themselves. The theory goes on to say that individuals assign too much weight to evidence that is consistent with the individual’s impressions of the population. The theory also implies that other individuals carry self-attribution bias, whereby individuals feel that good decision outcomes are due to their abilities, and bad outcomes are due to unfortunate realizations f states of nature, hence, not their fault.

This theory states that if enough investors behave this way, that momentum can develop. Unfortunately; in market efficiency, all the information needed has not always been there. This is where behavioral finance helps out. Behavioral finance is not an alternative for market efficiency. It helps out where market efficiency has its limitations. Behavioral finances analyzes while using rational and logical theories. While market efficiency assumes that all the factors are present while making decisions; behavioral finance takes into account how real people make decisions.35, , If we parallel this behavior to Bear Stearns, there definitely was an aggressive corporate culture that allowed the company to grow for many years, but also allowed aggressive behaviour on behalf of the traders that allowed themselves to put their private gains ahead of the public interest. With interest rates at historical lows, investors were happy to borrow and invest while expecting to make profits. In the case of CDOs however, the credit rating agencies were giving the CDOs the best rating possible, and traders only had that information to rely on.

The financial engineers that built these CDOS are the ones to blame for the collapse, and they are not directly affected by the EMH, where their jobs do not interact immediately to the market information released. The Use of Complexity to Hide Risk There was a belief that CDOs were so complex that only mathematicians (known as Quants at Wall Street firms) could calculate and interpret their risk. However, at the heart of this complex financial tool lied simplicity; an amalgamation of many informal documents acknowledging debt.

It is often thought that the widespread use of complex derivatives, and the use of models like Value at Risk (measurement of the risk of loss on a specific portfolio of financial assets) was used to hide risk in the long tails of outcome distributions. Hence, no one can blame just mathematics for this, despite financial firms doing their best at it. Mathematicians provide a tool, and it is up to the users of the tools to adjust it for its use and to understand it. For defenders of economics and finance, the popular story is that complex derivatives like collateralized debt obligation, and credit default swaps allow participants to “complete the market” and reduce the effects of asymmetric information, and that however, the risk from this transaction is so complex, that a human cannot calculate it. However, critics of finance insist that the complex issue with CDOs were their mispricing, and not their calculation of risk. Nonetheless, the calculation of risk does affect the calculation of price.

The complexity associated to these products comes from the fact that people do not generally understand their meaning and provenance. Due to the fact that many financial products are merged together, and sold as a unit, the calculation of all the risk might have a complex mathematical formula; however, one who understands the essence of this financial product will be able to understand an approximate outlook on the risk associated with this type of product. Disclosure to Shareholders Bear Stearns did fail to properly disclose risk inherent to its financial statements.

In fact, in the consolidated class action complaint for violations of the federal securities laws, it is clearly stated that even their auditing firm, Deloitte, also had a professional obligation to assess whether other disclosures in documents containing the financial statements were materially inconsistent with the financial statements. It also states that the Bear Stearns had previously been warned by the SEC in 2005 that it had failed to take into account critical inputs reflecting risk in the housing market.

One of the causes of the 2008 financial crisis was the build-up of excessive balance sheet leverage in the banking system, despite meeting their capital requirements. It was only when the banks were forced by market conditions to reduce their leverage that the financial system increased the downward pressure on asset prices. This exacerbated the decline in bank capital. Although Bear Stearns did not have enough capital to cover his leverage, the amount was properly disclosed under the standards at that time. However, new changes have been implemented in order to assure that this does not happen again.

The Third Basel Accord will be applied in March 2018, and will introduce a leverage ratio that was designed to put a cap on the build-up of leverage in the banking system as well as introducing additional safeguards against model risk and measurement errors. Corporate Governance Corporate governance entails the approval of the company’s strategic plans, supervision of work processes, as well as recognizing weaknesses in the company and always looking to improve its position of leadership, while increasing shareholder’s value. This is exactly what management attempt to obtain but with a pinch of self-interest.

According to the Consolidated Supervised Entity (CSE), Bear Stearns was compliant with the capital and liquidity requirements, even with a leverage ratio of 33:1. Such high leverage increases liquidity risk, and according to the CSE, Bear Stearns was required to maintain only $5 billion dollars of liquidity in portfolio as compared to $10 billion dollars for other companies with liquidity requirements. The decision to maintain liquidity at $5 billion lower has raised a few eyebrows and quite a few questions. 36, Inside Bear Stearns, there was an issue of poor corporate governance.

With the Board of Directors meeting only 6 times a year, it was clear that many critical decisions were left to lower management. In addition, two members of their audit committee were serving on several other audit committees. They had been chosen for their “intellectual wealth” but it appears they had far too many other commitments than actually invest that intellect into Bear Stearns. With the SEC targeting mainly corporations for wrongdoings, this has led directors to believe that they can escape the long hand of the law. 37, , Executive Compensation

We will refer to the five named executive officers (Table 1) that held key positions throughout the 2000-08 periods in the company. Their revenues had to be disclosed under the U. S. securities law. Since January 2000 till January 2007 the stock price sky-rocketed (Figure 1), but within less than 2 years Bear Stearns market price fell from $172 to $2/share, in a deal where it was taken over by JP Morgan in March 2008. Was this a result of aggressive investment on behalf of the company’s executives or plain lack of vision and anticipation?

We shall discuss this in greater details below. With about 30% of Bear Stearns shares held by its own employees, many would claim that the CEO and executives were amongst those who took the largest share of the loss. This was, all in all, a paper loss. But let us examine the cash inflows to those officers specified above. Executives were earnings huge incentives and equity shares in a short-term period. This can be seen by the constant increases in incentives paid to the executives based on the firm’s performance between 2004 and 2006, with 2006 being the peak (Table 1).38 It was surprising that the firm did not include a retro-action clause should the investment decisions turn bad in the long-term, which is what happened. The executives were allowed to sell more shares that they actually held within a one –year period and this practice also as listed below, gave an impressive cash inflow to the executives and once again highlighting the cause for the executives to think short-term rather than long-term strategy. Through bonuses to sales of equity that did not hold for long, Bear Stearns execs earned approximately $1,850 million.

As far as the paper loss that they incurred, we can assume that the executives did not foresee the market to crash as early as 2008. In comparing all the years’ gains by the executives versus the end of term paper loss, it was the U. S. citizens that stood at a net loss of $30 billion dollars of their tax money in aid of JP Morgan and another $200 billion for primary investors. Bear Stearns will remain in the memories of many during the years to come, but the lessons from this catastrophe must be learnt and all performance evaluations should reflect a long-term delivery of incentives and deferred exercise power. 38, , Conclusion

We’ve examined in depth the issues surrounding mortgage backed securities and the collapse of Bear Stearns, as well as their very own history. We have examined the offsetting nature of relevance and reliability and the difficulty in obtaining either with mortgage backed securities. This led us to discuss the measurement approach, and more specifically fair value accounting at Bear Stearns in relation to MBS’. We also analyzed the components of information asymmetry, those being adverse selection and moral hazard, and the ways in which investors lacked a considerable amount of knowledge and how this affected them.

Our final topics fell under the umbrella of two broader subjects. The first of these broad subjects being the limitations and gaming of market efficiency where we contrasted the concepts of the efficient market hypothesis versus behavioural finance and the use of complexity to hide risk from the market with the use of CDO’s and MBS’. The second and final broad subject, being the fiduciary duty of a corporation towards its investors and the markets and how Bear Stearns failed its investors through its amount of disclosure to investors, its corporate governance, and the compensation it provided to its executives. ?

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