Investment Banking

Investment Banking in 2008 Group Report 1. Failure Analysis: Identify the major factors that contributed to Bear Stearns’s failure? Who stood to benefit from its implosion? How did Bear Stearns’s collapse differ from the ‘Long Term Capital Management’ failure a decade earlier? What could Bear Stearns have done differently to avoid this fate? In the early 2000’s? And during the summer of 2007? And during the week of March 10, 2008? (1) Identify the major factors that contributed to Bear Stearns’s failure? Bear’s somewhat cutthroat and renegade culture of maverick may have contributed a lot to their failure.
This culture somehow made it killed by the credit crisis, while other investment banks survived. But the direct factors resulted in Bear’s implosion were the failure of Ralph Cioffi’s High-Grade Structured Credit Strategies Fund and Enhanced Leverage High-Grade Structured Credit Strategies Fund, which invested in sophisticated credit derivatives backed by mortgage securities. And these failures cost Bear more than 1. 6 billion dollars to prop up two hedge funds. And the failures of two hedge funds led to a continuous questioning about Bear’s financial stability.
At the same time, Bear concentrated its business on CDOs, which means it had high exposure to this item. Thus when credit crisis happened, it is significantly impacted. And in early 2008, Moody’s downgraded 163 tranches of mortgage backed bonds issued by Bear. Almost everyone realized that Bear will face liquidity problem. But meanwhile, Bear highly relied on repo to finance itself. When lender lost confidence in Bear, it failed in finding another effective way to find cash. In sum, the reasons above contributed to the failure of Bear in 2008 crisis. (2) Who stood to benefit from its implosion?

JP Morgan is the beneficiary from Bear’s bankruptcy. It gained a company which had $172. 61 worth less than 8 months ago with an incredible low price of $10 a share. (3) How did Bear Stearns’s collapse differ from the ‘Long Term Capital Management’ failure a decade earlier? The origin in LTCM’s failure was the high-leveraged structure. It obtained excessive debt for the investment of the bonds. Simultaneously, the market capacity was not sufficient to support LTCM’s large bloated size. As time had gone, market competition and capacity diminished its profitability.
But with such a high leverage, LTCM had no other choice but to gain enough profit to move on. Therefore, they got a foot into some unfamiliar area. Meanwhile, as to the trading strategy, LTCM held a large quantity of asset with low liquidity. However, situation was different from what they had predicted. Big loss happened eventually, but LTCM could not sell asset for enough cash. It inevitably had to go bankruptcy. High leverage structure of Bear’s hedge fund also had great impact on its collapse. But the awful strategy of Bear’s management should blame most for its bankruptcy.
If it was in a less turbulent environment, things might be different. Continual bad news about Bear from executives’ unmannered behavior to its first quarterly loss since foundation ruined the confidence of investors. And another difference in the failure of both was that Bear mainly died of market failure. When the whole market was fear of the loss of subprime asset, the large subprime assets holding companies such as Bear Stearns, could not avoid a fate of great loss and liquidity problem. (4) What could Bear Stearns have done differently to avoid this fate?
In the early 2000’s? As an investment bank, Bear was just in pursuit of the return while underestimated the potential aftermath of being too risky. Most of its profit was composed of fixed income securities. Meanwhile, Bear should not let each hedge fund manager just specialize in a particular security to make volatility. It is obvious that Bear’s risk management had significant flaw. Furthermore, since the over-confident Bear was desperate for the incredible return, it was not attentive to such supernormal growth of the housing price.
They should not just concentrate on CDOs without also devoting their asset in other business, as diversification is so important for a firm. But it may not happen, since Bear was not less greed than the surrounding. And during the summer of 2007? If Bear realized the market could not be defeated, they should have controlled Cioffi’s risky action of raising new hedge fund with a higher leverage. Conversely, they should liquidate the fund. If the liquidation was performed, they should not have lost such great amount in this worthless fund.
And meanwhile it began to try to search for cash to finance itself. Except those worthless ‘toxic assets’, Bear still had some assets, which could provide it some cash flow. If Bear sold these assets earlier with determination, they might not sink in liquidity problem so deeply. And during the week of March 10, 2008? After Bear was downgraded by Moody, market had lost confidence in it. Almost everyone realized bear’s liquidity problem. When pointed out to have liquidity problems, Bear’s executives should realize the severity of the crisis rather than believing the worst was once again behind them.
Even though they could not recover from the difficulty, prime actions could be taken, including exposing the reality to the market, reassuring the investors, making urgent strategies, applying for emergent aids from the Fed, and applying for temporary held in stock trading. 2. Liquidity Crisis and Business Model of Investment Banks: What is the role of Liquidity for banking and investing banking firms? Is perception of Liquidity more important for a banking/investment banking firm than manufacturing firms (such as Ford or Boeing)? Why?
What could Bear Stearns have done to address its Liquidity concerns, which initiated the run on the bank? Looking back, what lessons can we infer from Bear Stearns’s failure regarding the business model of investment banks? Looking forward is the concept of ‘pure-play’ investment banks sustainable? (1) What’s the role of liquidity for banking and investing banking firms? Liquidity can reveal the untrue existence of cash (and cash equivalents), short-term investments, accounts receivable and accounts payable, etc. To which extent it lives up to the real condition.
It measures whether the bank’s business is legal, reasonable and whether the financial status is promptly and properly reflected on the financial reports. Liquidity risk is also important. It values the repayment of debt and reminds the board of the corporation’s risk at any time. Managing liquidity is a daily process requiring bankers to monitor and project cash flows to ensure that adequate liquidity is maintained. The investment portfolio serves as the primary source of liquidity and represents a smaller portion of assets. Investment securities can be liquidated to satisfy deposit withdrawals and increased loan demand. 2) Is perception of Liquidity more important for a banking/investment banking firm than manufacturing firms (such as Ford or Boeing)? Why? Yes. The main sources of funding for commercial banks are deposit, interbank borrowings, commercial banks deposits, the international money market borrowings and the issuance of financial bonds, among which the short-term deposit accounts for the vast majority of the proportion. However, these funds are primarily used for commercial loans, discounting business, securities investment, etc. These higher profitability and long-term loans account for the absolute proportion in the composition of assets.
This mismatch between assets and liabilities makes the liquidity of assets very important in banks’ operation. Since when sudden changes occurred in the market, a large number of customers will be forced to perform withdrawal, therefore the bank will be very difficult to realize its assets and to meet its liquidity needs. In some sense, it is similar for the investment banks. The difference is just that they do not raise money from retail depositors; most of the money is funded in the interbank market and is used to hold illiquid mortgage backed securities.
Once banks were not able to provide funding for business, a banking contagion will occur and spread. A traditional manufacturing business is generally funded by equity or long-term debt and has steady cash flows from business operations. Even in the case of a collapse of such businesses, it would not have the same contagion effect as banks. (3) What could Bear Stearns have done to address its Liquidity concerns, which initiated the run on the bank? 1. The basis of the modern financial system is not physical assets, but people’s confidence in this system.
Actually when the rumor of BSC running out of cash was widely spread, BSC was forced to make a public announcement to ensure the public that their financial situation was solid and their liquidity was sufficient. Unfortunately, BSC did not take valid action or provide strong evidence such as strengthen its financial sheets or reducing leverage to convince investors. The board should pay more attention to the operation of the corporate rather than participate in a bridge tournament. 2. BSC could reduce leverage by selling their risky assets to generate cash during a period of financial stress.
They should maintain enough reserves in the form of short-term instruments of the highest credit quality to meet the obligation. So an amount of funds should be invested only in instruments that have guaranteed liquidity, like treasury instruments. 3. Bear Stearns, three-quarters of whose revenue was still dependent on the market (see the source below), should adopt diversification strategy to find a real alternative to business and improve its finance. The plans could be accelerate the development in other countries and diversified business, including equities, investment banking and asset management businesses.
Source: http://finance. sina. com. cn/money/future/20080403/09024705325. shtml (4) What lessons can we infer from Bear Stearns’s failure regarding the business model of investment banks? Diversification of the investment is the foremost thing to consider for any matured investor. Investing heavily into one company, one industry, or having only one investment strategy is unadoptable. You are banking for speculation that one company or industry will always do well. But in fact, it is hardly possible to be in perfect condition at any time.
You must make your investment portfolio diversified. Maybe an element of international stocks can be added into the portfolio. When the U. S. market is unprofitable, it still has the chance to get profits from Asia and Europe so as to keep the portfolio solid. Sometimes high leverage can kill a firm. In March 2008, Bear owned tangible equity capital of about $11 billions versus total assets of $395 billions—a leverage ratio of 36. For several years, this reckless financing bring the company a profit margin of about one third and a return on equity of twenty percent.
However, when the market endured a sharp downturn, Bear lose a lot of capital and willing creditors. During the ensuing months, the same story was to be played out at scores of other banks and non-banks. (5) Looking forward is the concept of ‘pure-play” investment banks sustainable? The performance of a pure-play investment bank can be highly influenced by the type of investing style which targets at it. For instance, if a pure-play bank’s business is favored by growth investing, the company will do well during a bull market, where growth stocks tend to outperform the market.
Conversely, a pure-play bank associated with growth investing will do poorly during bear market, when a value investing strategy is historically more profitable. What’s more, the pure-play investment banks have relied heavily on short-term capital, especially repo transactions in which counterparties take collateral as security against the cash they lend. As public companies, pure-play banks faced pressure to deliver return on equity comparable to that of universal banks, even as those banks put competitive pressure on traditional advisory businesses such as M;A, underwriting, and sales and trading.
In response, pure-play banks resorted to the two advantages they had over non-depository institutions: unlimited, unregulated leverage capacity, and increasing reliance on proprietary trading to deliver earnings. 3. Systemic Banking Crisis and Regulation: What is a “systemic banking crisis”? What is ‘banking contagion”? What was the rationale for the creation of ‘fire-wall’ of separation between investment banking and commercial banking in USA that was institutionalized by the Banking Act of 1933? Why did the regulators weaken and phase out that ‘fire-wall of separation’ in 1990s?
Identify the major Deregulatory Acts and its role in the meltdown of the investment banking industry? In your opinion, based on lessons from past global banking crisis, what steps should regulators institute now to address similar future problems? (1) What is a “systemic banking crisis”? Systemic banking crisis refers to the crisis detrimental to the whole financial system. It is the fatal chaos that several disastrous crises occur simultaneously, such as monetary crisis, banking system crisis, foreign-debt crisis, etc.
The crisis expands from one financial market to another. For example, from the stock market to the real estate market or foreign-trade market, etc. (2) What is ‘banking contagion”? Banking contagion refers to a scenario where the banks, which initially affected by some crisis spread to the other banks even the other countries whose economy is previously healthy. In this scenario, the expansion could be very quick and disastrous. The international spread might cause the whole banking system to be paralyzed and need another several more years for recovery. 3) What was the rationale for the creation of ‘fire-wall’ of separation between investment banking and commercial banking in USA that was institutionalized by the Banking Act of 1933? There are 3 major factors. 1. Risk of losses (safety and soundness). Banks that engaged in underwriting and holding corporate securities and municipal revenue bonds presented significant risk of loss to depositors and the federal government that had to come to their rescue; they were also more subject to failure with a resulting loss of public confidence in the banking system and greater risk of financial system collapse. . Conflicts of interest and other abuses. Banks that offer investment banking services and mutual funds were subject to conflicts of interest and other abuses, thereby resulting in the harm to their customers, including borrowers, depositors, and correspondent banks. 3. Improper banking activities. Even if there were no actual abuses, securities-related activities are contrary to the way banking ought to be conducted.
The Act prohibited the combination of a depository institution, such as that, commercial banks (those that accept deposits) were prohibited from engaging in most investment banking activities, including underwriting and selling securities, and from affiliating with investment banks and other companies “engaged principally” in the trading of securities. Likewise, investment banks were barred from accepting deposits. (4) Why did the regulators weaken and phase out that ‘fire-wall of separation’ in 1990s? Inspired by a desire to make U. S. nvestment banks competitive with foreign deposit-taking investment banks such as UBS, Deutsche Bank, and Credit Suisse First Boston, a Republican Congress and President Clinton passed the Gramm-Leach-Bliley Financial Services Modernization Act in 1999, permitting insurance companies, investment banks, and commercial banks to compete on equal footing across products and markets. (5) Identify the major Deregulatory Acts and its role in the meltdown of the investment banking industry? 1999–Glass-Steagall Act Fell The repeal of the Glass-Steagall Act in 1999 had larger ramifications than any other steps in deregulation.
Repealing this act made it possible for investment banks to be savings and loan banks and to receive to the same government protections as savings and loan banks. An investment bank could make investments with people’s savings, sometimes irresponsibly, and those investments now were guaranteed by the federal government. 1988–Securitization In 1988, securitization, or repackaging assets as a financial instrument to sell to investors, became legal. Banks were allowed to sell their mortgages to SPVs. Mortgages were no longer being made to hold but to sell, and lending requirements became substantially more lenient.
This created a combination of bad loans and banks without the funds to back them up. 2004–SEC In 2004, the SEC abolished the “net capital” rule, which restricted the amount of debt their brokerage units could take on-demonstrated this growing appetite for leverage. This led investment banks to leverage themselves at a financially irresponsible 30 to 1 percent, meaning that for every $1 they had on hand they had $30 in debt. When some of these investments collapsed, the banks did not have the ready capital to maintain their companies. Ultimately, increased leverage and proprietary trading ravaged the nvestment banking industry, leading to the collapse, merge, or restructure of all 5 major pure-play banks on Wall Street. This time, the SEC took the unprecedented step of temporarily banning short sales of financial institution stocks. The ban caused massive losses in hedge fund portfolios and dissuaded them from making additional investments, denying would-be issuers access to needed capital. Moreover, the SEC placed a ban on so-called ‘naked’ shorting, which reduced the total amount of short interest that could accumulate in a stock. 6) In your opinion, based on lessons from past global banking crisis, what steps should regulators institute now to address similar future problems? 1. The regulations should be placed on the fundamental part of economy. For example, when there seems to have bubbles in one field, the Fed should not ignore. It should adjust the policy towards the industry to change the unbalanced situation. 2. To fortify the risk awareness continuously in traders’ mind, especially those who control the wealth of millions of people. Their behaviors might have huge influence to the market and the profitability of the firms. 3.
The Fed should research for adjustment for investors from the market of different systems to ensure that obstacles will not exist in multinational trades. Meanwhile, policies of staying resistant to exterior crisis should be prepared in case of the explosion of crisis. 4. Federal Bailout and Public Policy: Why did the Federal Reserve bail-out Bear Stearns? Why was Lehman Brothers allowed to collapse while Bear Stearns was not? Is the Fed orchestrated sale of Merrill Lynch to Bank of America the optimal solution for addressing the crisis? Could Morgan Stanley and Goldman Sachs have survived with out becoming bank holding companies?
In your view, what public policy role should the Federal Reserve play in maintaining sustainability in global banking and stability securities markets? Why was there such a public out-cry against the bailout of Wall Street investment banks? Based on this recent performance how would you rate the Federal Reserve’s response to the financial crisis? (1) Why did the Federal Reserve bail-out Bear Stearns? If Bear went bankruptcy, it would affect other firms in Wall Street as well, since Bear was a market leader in prime brokerage and clearing who provided trading and back-end services to many other Wall Street financial institutions.
Most customer asset would get frozen in the event of bankruptcy, and many hedge funds had collateral in the firm. Because of Bear’s holding of 13 trillion credit default swaps, the collapse of Bear would influence many other companies, which means too big to fail at that time. However, the Fed didn’t forecast that this kind of matter will happen again. The Fed Reserve bailed out Bear Sterns just to avert crisis and dissuade further irresponsible risk-seeking. The bailout benefited Wall Street at the expense of Main Street and the low share price was to discourage banks from taking on similar risk. 2) Why was Lehman Brothers allowed to collapse while Bear Stearns was not? The decision to let Lehman Brothers fail was largely made by then-Treasury Secretary Henry Paulson and the British Financial Services Authority. The public outcry over the taxpayer assumption of $29 billion in potential Bear losses made repeating such a move politically untenable. Therefore, the Fed refused to back Lehman’s liabilities and backstop losses from Lehman’s toxic mortgage holdings. Moreover, Barclay’s quitted the acquisition, worrying that it could not be satisfied with the timely shareholder approval, which directly led to the collapse of Lehman.
The Fed also wanted to set it as an example, to let other company to know that not every time the government will come out to bail out the company, so they will have deliberate consideration repeatedly before making all kinds of risky investments. (3) Is the Fed orchestrated sale of Merrill Lynch to Bank of America the optimal solution for addressing the crisis? No. This transaction doubled the investment banking size of Bank of America. Furthermore, it exposed Bank of America to mortgage-backed securities, which had negative impact on the long-term credit rating of the bank.
This transaction could not prevent the occurrence of another such case like Merrill Lynch’s, and this behavior could not bring unforgettable lesson to other banks. (4) Could Morgan Stanley and Goldman Sachs have survived without becoming bank holding companies? No. According to the research, Goldman Sachs was a major beneficiary of the government’s bailout of the financial services industry, not only through AIG but also through its ability to fall under the regulatory umbrella as a bank holding company, which made it eligible for debt guarantees and other government backstops.
Every financial services company on the earth wanted to become a bank and line up for the handouts coming from Washington such as American Express, GE Capital, and GMAC. Even Willem Buiter, a former central banker, wanted to become a bank. Goldman was in a more precarious position than bank holding companies because of the vulnerabilities of being a broker-dealer. Nouriel Roubini warned repeatedly before Lehman’s collapse that the large full services broker-dealer model was broken. (5) In your view, what public policy role should the Federal Reserve play in maintaining sustainability in global banking and stability securities markets?
From the lesson of subprime housing crisis, we think the Federal Reserve should control the capital, but without influencing the supply and demand. Since this crisis was created by those bad loans, the government’s control would limit people to invest on housing market, and somehow be better for people who are really in need of a place to stay. Furthermore, we have several pieces of advice to the Fed, besides in housing matters: a) Regulate the gross domestic and international banking environment. b) Reinforce the supervision over the risk control of investment banks. ) Restrict the expansion of any potential crisis once any symbol occurs. d) Do best to avoid the asymmetric information in the market. e) Ensure a fair and open environment for trading. (6) Why was there such a public out-cry against the bailout of Wall Street investment banks? People’s being against to government’s bailout the Wall Street had 2 main reasons. First, people believed Wall Street got this mess by themselves and they should be the one to clean it up, rather than that the government used tax payer money to save the Wall Street.
They thought this was not fair, because this kind of action would increase the US government’s debt, and tax payer would have to pay more tax in the future to cover this debt. This debt may take a long time to be recovered. Second, when the government did get involved in the Wall Street crisis, the free market would not exist anymore, and next time if any firm had problem, they would ask the government to save them, which would totally be against the American economic policy, and belief. 7) Based on this recent performance how would you rate the Federal Reserve’s response to the financial crisis? Based on the recent performance, we think they had done what they had to do, but we think they should let the economic fail, based on the free market of American. They should let the invisible hand control the market, and the market should flow freely by itself. It will come back up, however long it takes. Now the government is using the tax payer’s money to cover Wall Street crisis, which actually is not fair.

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