Bear Stearns Collapse / JPMorgan Rescue (Mar 2008)

Introduction

Bear Stearns Companies, Inc. was one of the oldest and most storied investment banks on Wall Street, founded in 1923 and by 2007 the fifth-largest US investment bank by assets. Its collapse in March 2008 was the first major institutional failure of the global financial crisis and the event that demonstrated the fragility of the US financial system's interconnections. The rescue arrangement — JPMorgan Chase acquiring Bear Stearns at a fraction of its peak value, backed by an unprecedented Federal Reserve emergency facility — raised immediate questions about the process, the pricing, and the role of the government.

The Hedge Fund Collapse: June 2007

The proximate origins of Bear Stearns' collapse lie in two internal hedge funds: the High-Grade Structured Credit Strategies Fund and the High-Grade Structured Credit Strategies Enhanced Leverage Fund, both managed by Ralph Cioffi and Matthew Tannin. The funds held heavily concentrated positions in collateralised debt obligations (CDOs) backed by subprime mortgages. As subprime mortgage default rates rose through early 2007, the CDO positions deteriorated. By June 2007 both funds had collapsed. Bear Stearns offered the High-Grade fund a secured financing facility of up to $3.2 billion, which fell to about $1.6 billion after further asset sales, and said it was providing no financing to the Enhanced Leverage fund, whose creditors and counterparties were left to unwind it in the market. Prosecutors later put investor losses at more than $1 billion.

The hedge fund collapse alone did not bring down Bear Stearns, but it damaged the firm's reputation and signalled its exposure to the subprime market to counterparties, prime brokerage clients, and funding providers.

The March 2008 Liquidity Crisis

By early March 2008 rumours about Bear Stearns' liquidity were circulating in markets. Prime brokerage clients began withdrawing funds and collateral. Counterparties refused to roll over short-term financing. The firm's liquidity pool — which stood at $18.1 billion on 10 March 2008, according to figures SEC Chairman Christopher Cox sent to the Basel Committee on 20 March 2008 — had fallen to $2 billion by 13 March 2008. Bear Stearns could not fund itself overnight and faced imminent default.

Over the weekend of 15-16 March 2008, the Federal Reserve Board authorized the Federal Reserve Bank of New York, under Section 13(3) of the Federal Reserve Act — emergency lending powers the Financial Crisis Inquiry Commission said had not been invoked since the Great Depression — to fund up to $30 billion of Bear Stearns' less liquid assets. When the amended terms were announced on 24 March, the portfolio (about $30 billion at Bear's 14 March valuation) was to be held in a special purpose vehicle named Maiden Lane LLC, funded by a New York Fed loan of about $29 billion (about $28.8 billion as finally drawn) and a roughly $1 billion subordinated loan from JPMorgan, which would absorb the first losses; the transaction closed on 26 June 2008. This structure allowed JPMorgan to acquire Bear Stearns without taking on the full credit risk of the illiquid portfolio.

JPMorgan's initial offer, valued at approximately $2 per share in its announcement, compared with a Bear Stearns close of about $30 on Friday 14 March, and a growing number of shareholders opposed it, according to press reports. On 24 March 2008 the two firms announced amended terms with an implied value of about $10 per share (0.21753 JPMorgan shares per Bear share, priced at JPMorgan's 20 March close), and JPMorgan agreed to bear the first $1 billion of losses on the Maiden Lane portfolio. JPMorgan CEO Jamie Dimon later told the Senate Banking Committee that the market doubted the $2 price would be enough to win shareholder approval and that JPMorgan raised its offer "to help achieve finality."

The Cioffi and Tannin Criminal Trial

Ralph Cioffi and Matthew Tannin, the hedge fund managers, were indicted by federal prosecutors in Brooklyn in June 2008 on charges of conspiracy, securities fraud, and wire fraud; Cioffi was also charged with insider trading. The government's theory was that the two had privately acknowledged the funds were in distress while publicly reassuring investors. Private emails between the two were central to the prosecution's case: in an April 2007 message quoted in the indictment, Tannin wrote that the "subprime market looks pretty damn ugly" and, conditionally, "If we believe [our internal modeling] is ANYWHERE CLOSE to accurate I think we should close the funds now" (capitals in the original). Both men were later acquitted.

On 10 November 2009, after a month-long trial and less than six hours of deliberation, a jury in federal court in Brooklyn (the Eastern District of New York) acquitted Cioffi and Tannin on all counts, including the insider-trading count against Cioffi. "The government never provided enough evidence to convict them," the jury forewoman said, according to Reuters, which described the case as the first against players in the subprime mortgage meltdown. The acquittal was a significant setback for the government's broader effort to prosecute financial crisis misconduct.

The SEC had also filed a civil complaint against both men on 19 June 2008, alleging that they misled investors about the funds. The civil case ended with settlements approved by the federal court in the Eastern District of New York in June 2012, which the two men entered without admitting or denying the allegations. The judgments permanently enjoined them from violating a securities-law prohibition on untrue statements in the offer or sale of securities and ordered payments totaling $1.05 million; the SEC separately barred Cioffi from associating with investment advisers, broker-dealers and similar firms for three years and Tannin for two.

The "Naked Short Selling" Conspiracy Theory

A persistent conspiracy framing attributes Bear Stearns' collapse not to its hedge fund losses and resulting liquidity crisis but to coordinated "naked short selling" — the practice of selling shares short without first borrowing them, allegedly used by sophisticated actors to drive down Bear Stearns' share price and trigger a self-fulfilling confidence collapse. Bear's own CEO voiced a version of this suspicion, while saying he had no specific facts. Alan Schwartz told the Senate Banking Committee on 3 April 2008 that "unfounded rumors" had become "a self-fulfilling prophecy" and caused "a run on the bank." Asked about the unusual options trading and whether it looked like more than rumors, he said, "I do not have any specific facts and I hope some facts will emerge over time," but added: "as an observer of the markets, that looked like more than just fear. It looked like there were people that wanted to induce a panic." He said "There is a lot of the trading that would point to that" and that "If facts can come to light, I think that would be very appropriate to go after." JPMorgan CEO Jamie Dimon told the same hearing "I do not know what the real facts are here, but I think there is enough smoke around the issue that it is a proper thing for the regulators to look at what actually happened," and that "if people knowingly created or passed on false rumors, they should be punished under the law." SEC Chairman Christopher Cox wrote on 20 March 2008 that Bear had a capital ratio "well in excess of the 10% level" used in the Federal Reserve's well-capitalized standard throughout the week of 10 March and that "The market rumors about Bear Stearns liquidity problems became self-fulfilling." Schwartz's remarks were a suspicion offered to senators rather than a finding, and Dimon likewise said he did not know the facts; as set out below, neither the SEC nor the Financial Crisis Inquiry Commission has reported finding such a campaign.

The SEC examined a surge in short selling and put-option trading in the days before Bear's collapse, and later subpoenaed hedge funds over rumors about Bear Stearns and Lehman Brothers. It has not brought short-selling charges over Bear Stearns' failure: the Financial Crisis Inquiry Commission's January 2011 report states that "The SEC to date has not brought short selling charges related to the failure of these investment banks," and quotes SEC Chairman Mary Schapiro telling the Commission that the SEC had no information "that manipulative short selling was the cause of the collapse of Bear and Lehman." The liquidity figures the SEC published — a pool of $18.1 billion on 10 March falling to $2 billion on 13 March — reflect funding withdrawals by customers and repo counterparties, as both Schwartz and Cox described.

Verdict

The claim judged here is that Bear Stearns was deliberately brought down by a coordinated campaign of naked short selling and false rumors, rather than failing under its own leverage and funding weaknesses. That claim is unsubstantiated. The surrounding events are not in dispute: the collapse itself, the Maiden Lane facility, the acquisition mechanics, and the regulatory response are a matter of public record. Short selling and put-option trading did surge beforehand, the SEC treated rumor-driven manipulation as worth investigating, both the SEC chairman and Bear's CEO described a confidence run on a firm that met regulatory capital tests, and Bear's CEO told the Senate it looked as though people wanted to induce a panic, though he said he had no specific facts. But no public investigation reviewed here has produced evidence of a coordinated campaign, SEC Chairman Mary Schapiro told the Financial Crisis Inquiry Commission the SEC had no information that manipulative short selling caused the collapse, and the documented funding-withdrawal mechanism operated on a firm with high leverage and a concentrated mortgage exposure that SEC staff had flagged and not acted on. The coordinated-manipulation component therefore lacks the evidence needed to displace that mechanism, though the record cannot rule out that individual traders spread false rumors for profit.

What Would Change Our Verdict

• Court findings or regulatory actions establishing that specific coordinated naked short selling was the primary cause of the liquidity collapse
• Documentary evidence of pre-arranged collusion between JPMorgan and federal officials to engineer Bear Stearns' failure below intrinsic value

The Anatomy of the Run: What the Options Market Saw

The liquidity collapse recounted above did not happen in a vacuum, and options-market data compiled by regulators and reporters at the time shows just how sharply trading in Bear Stearns' stock changed in the days before its fall. On 10 March 2008 — six days before JPMorgan's initial buyout announcement — the number of short sales using put options jumped from 167,439 to 465,820, according to Schaeffer's Investment Research data cited in a 21 March 2008 Washington Post report (as carried by the Spokesman-Review). On 13 March, 25,246 put trades betting the stock would fall to $20 a share were initiated, even though the stock had been trading above $50 for most of that day. On Friday, 14 March, 25 percent of Bear Stearns shares were being sold short — about five times the average for most stocks, according to Data Explorers' president, quoted in the same report. The report also said Bear Stearns executives were looking into whether rumors spread by former disgruntled employees or hedge funds triggered the run, citing a company official it did not name. Contemporaneous reporting on this data was careful to note the obvious limit of what it proves: the rise in short selling "does not necessarily mean that market manipulation was taking place." It is equally consistent with sophisticated traders correctly anticipating a firm that was, independently, running out of cash.

The Fed's First Move — and Why It Wasn't Enough

The rescue was not a single weekend decision; it happened in two steps, and the first one failed. On the morning of Friday, 14 March 2008, JPMorgan Chase and Bear Stearns announced an emergency financing arrangement — a $12.9 billion New York Fed loan to Bear Stearns through JPMorgan, secured by assets valued at $13.8 billion, according to the Fed's own history of the episode — and the Federal Reserve's Board of Governors put out its own release confirming it had "voted unanimously to approve the arrangement announced by JPMorgan Chase and Bear Stearns this morning," adding that it was "monitoring market developments closely and will continue to provide liquidity as necessary to promote the orderly functioning of the financial system." That Friday-morning backstop was meant to buy Bear Stearns time. It did not work: withdrawals and counterparty defections continued through the day and over the weekend, and by Sunday night, 16 March, the only option left was the outright JPMorgan acquisition at $2 a share, underwritten by the much larger Maiden Lane facility described above. The 48-hour gap between the first, failed rescue attempt and the second, successful one is itself evidence for how fast confidence was draining from the firm — a run that outran the first line of official support within two trading sessions.

What the SEC's Investigation Actually Found

The SEC's interest in the Bear Stearns rumors did not end when the firm was absorbed into JPMorgan. In autumn 2008, USA Today reported, an SEC investigation into whether traders spread misinformation in a bid to drive down shares of financial firms had produced subpoenas to numerous hedge funds. One subpoena the paper reviewed sought trading data and communications about market rumors and identified Bear Stearns and Lehman Brothers as firms the SEC believed may have been subject to short-selling manipulation; the SEC had also widened the inquiry to trading in AIG and Goldman Sachs shares, according to a person with direct knowledge of the case. The scope of the subpoenas shows that regulators took the rumor-manipulation hypothesis seriously enough to chase it through hedge-fund trading records. What the investigation did not produce, as far as the public record shows, is any enforcement action establishing that a coordinated rumor campaign, rather than Bear's own balance sheet, caused the collapse. When the Financial Crisis Inquiry Commission reported in January 2011, it noted that the SEC "to date has not brought short selling charges related to the failure of these investment banks." That absence is itself informative: it is the difference between regulators finding trading patterns worth investigating and regulators finding proof of wrongdoing.

The SEC Turns the Mirror on Itself

One of the more pointed documents to come out of the episode did not examine short sellers at all — it examined the SEC. On 25 September 2008, the SEC's own Office of Inspector General released a report on the agency's Consolidated Supervised Entity (CSE) program, the voluntary regime under which the SEC had overseen Bear Stearns' holding company. The report concluded bluntly that "it is undisputable that the CSE program failed to carry out its mission in its oversight of Bear Stearns," citing risk management with "numerous shortcomings, including lack of expertise by risk managers" and a program design that lacked any leverage-ratio limit even as Bear operated at a gross leverage ratio of approximately 33 to 1. Most relevant to the rumor question, the Inspector General found that a delayed review by the SEC's own Division of Corporation Finance of Bear Stearns' most recent 10-K filing "deprived investors of material information" about the firm's subprime exposure — information that, had it been current, might have helped "dispel the rumors that led to Bear Stearns' collapse." That finding bears on the manipulation theory in a limited way: a federal watchdog tied the information gap that let rumors flourish partly to the SEC's own slow disclosure review. The report did not assess whether the rumors were deliberate, though; it states that its audit scope "did not include a determination of the cause of Bear Stearns' collapse."

The Case Against the Manipulation Theory

Academic and journalistic assessments made later in 2008, once the crisis had widened to Lehman Brothers and beyond, generally pushed back on the idea that short sellers alone could bring down a fundamentally sound bank. One retrospective, Bill Saporito in Time on 18 September 2008, after both Bear and Lehman had failed, put it starkly: "Bear and Lehman died because they were undercapitalized." (The SEC chairman, by contrast, said Bear met regulatory capital standards throughout the week of 10 March.) The same article quoted MIT finance professor Paul Asquith on whether a short seller can take a firm down: "The answer is no. Not by themselves. If there is nothing fundamentally wrong, all you need is a couple of smart people on the other side to show that they're wrong." That is a general argument that a short campaign needs a real weakness to exploit; it does not by itself settle what caused Bear's run.

Aftermath: A Wake-Up Call for the Rest of Wall Street

Bear's collapse changed how regulators treated the remaining investment banks, which is itself a marker of how seriously officials viewed the underlying risk rather than treating it as a one-off rumor panic. According to reporting on internal regulatory documents, the New York Fed under Timothy Geithner and the SEC dispatched monitoring teams to Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley after Bear's failure, and by May 2008 had run liquidity stress tests modeled directly on what had just happened to Bear. Those tests reportedly found that Lehman Brothers would be "$84 billion short of cash" in a full "Bear Stearns scenario," and "$15 billion short" even under a less severe "Bear Stearns Light" scenario — a result regulators apparently did not force Lehman to act on before its own collapse four months later. That regulators used the Bear Stearns run as the template for assessing systemic risk across the rest of Wall Street underscores that officials treated the episode as a real liquidity-contagion event worth stress-testing for, not as an isolated case of manufactured panic to be dismissed.

Taken together, the record shows rumor dynamics that were real, documented, and taken seriously enough that the SEC subpoenaed hedge funds over them, and a liquidity crisis moving faster than the first line of Federal Reserve support could contain. None of that evidence closes the gap the SEC had not closed as of the FCIC's January 2011 report: a demonstrated case that coordinated manipulation, rather than a highly leveraged, mortgage-heavy balance sheet exposed by a loss of confidence, was what actually killed Bear Stearns.