The Decline and Fall of Investment Bank
Bear Stearns
Breaking Developments In London Market Law
03/20/08
The recent and highly publicized fall of Bear Stearns provides a dramatic cautionary tale in the
unfolding sub-prime crisis. The chronology of events surrounding Bear Stearns’ demise closely
tracks economic developments in the broader U.S. sub-prime lending industry, as explained in a
series of January 2008 presentations given for various London Market Insurers by Lane Powell
attorneys John Devlin and David Young.*
On 14 December 2006, Bear Stearns announced record earnings, and a month later its stock
closed at a high of $174 per share. By mid-June 2007, however, the 85-year-old investment bank
reported a decline in earnings, based largely on weak results from its mortgage securities
sections. It was also revealed that two hedge funds managed by Bear Stearns had sustained
heavy losses from sub-prime mortgage investments. A month later, Bear Stearns announced that
these hedge funds had “very little value.” In December 2007, Bear Stearns wrote off $1.9 billion
in bad debts, posting its first quarterly loss ever. On 12 March, 2008, Bear Stearn’s CEO assured
the public that the firm had ample liquid assets; but JPMorgan, backed by the Federal Reserve,
provided an undisclosed amount of emergency financing only two days later.
On 16 March, JPMorgan agreed to purchase Bear Stearns for a mere $2 per share, subject to a
vote of Bear Stearns stockholders approving the transaction. In the meantime, officials from
JPMorgan have assumed control of Bear Stearns' operations. Read the merger agreement here
(http://bearstearns.com/includes/pdfs/investor_relations/merger.pdf).
Proposed Federal Legislation to Reduce Foreclosures
On 13 March 2008, as Bear Stearns’ fortunes approached their nadir, Rep. Barney Frank and
Sen. Chris Dodd announced proposed legislation designed to combat the rising tide of mortgage
foreclosures. Their plan would allow the Federal Housing Administration (“FHA”) to insure and
guarantee refinanced mortgages in exchange for significant write-downs by mortgage holders
and lenders. The plan specifically targets widespread “negative equity” problems, in which
mortgage values exceed the currently declining values of homes securing the loans. It is
estimated that between one and two million loans could potentially be refinanced in this way.
The two proposals would authorize FHA to issue up to $400 billion in guarantees to help
maneuver at-risk borrowers into viable mortgages. Lenders that agree to write down a substantial
portion of principal to reflect current market values would be eligible to have the entire
(reduced) loan amount paid off by a government-backed lender. The borrower would then
continue to make payments to the new FHA-approved lender on the reduced loan amount. The
cash buyout and the FHA guarantees leave the original lender with no further credit risk from the
borrower.
The plan follows on the heels of policies encouraged one week earlier by Federal Reserve
Chairman Ben Bernanke, who urged banks to forgive substantial portions of loans held by
troubled borrowers. Chairman Bernanke has also advocated giving authority to FHA to regulate
underwriting standards and risk premiums.
Sen. Dodd observed that “[t]here is no bailout for those who made the loans. ... The lenders are
going to have to take their losses. This will be some help to homeowners, but not with tax
dollars,” reports The Washington Post. Nevertheless, the plan could prove expensive for the
government if housing prices continue to drop, resulting in mortgages backed by properties of
insufficient market value. One opponent of the plan, Treasury Secretary Hank Paulson, says new
FHA legislation is unnecessary and recommends that Congress pass existing proposals for FHA
reform, instead, reports the Financial Times.
What This Means for Subprime Exposure
The proposed federal legislation will present lenders with a trade-off: immediate write-off of a
substantial part of the loan value (and a corresponding decline in the corporate balance sheet and
stock prices), in exchange for long-term stability and income from the loans (thereby avoiding
the more serious write-offs and uncertainty associated with foreclosure). In the aftermath of the
Bear Stearns collapse, this trade-off may seem more attractive.
If the proposed legislation becomes law, lenders who take the proposed trade-off and other
market participants may still be exposed to claims, such as claims relating to an alleged
overstatement of stock value or other misrepresentations. Thus, it may not substantially reduce
the number of claims implicating D&O and E&O policies subscribed by London. However, the
stability provided by the proposed government-backed mortgages may stabilize stock prices,
minimize losses, and thereby mitigate the amount of damages sought in those claims. The
proposed legislation may also condense the time period in which these claims are brought, by
instigating write-offs and the lawsuits that inevitably follow such losses. The latter may assist the
London Market in providing greater certainty with regard to the timing of claims.
* If you would be interested in consulting with Mr. Devlin and Mr. Young regarding the U.S.
sub-prime crisis and its continuing implications for London Market Insurers, please contact
them via e-mail (devlind@lanepowell.com and youngd@lanepowell.com) or telephone, 011206-223-7000, to arrange a mutually convenient time.
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Members of Our London Client Team
Seattle:
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Gabe Baker - bakerg@lanepowell.com
Mark Beard - beardm@lanepowell.com
Stanton Beck - becks@lanepowell.com
John Devlin - devlinj@lanepowell.com
Larry Gangnes - gangnesl@lanepowell.com
Robert Israel - israelr@lanepowell.com
Steve Jensen - jensens@lanepowell.com
Mark Johnson - johnsonm@lanepowell.com
Katie Matison - matisonk@lanepowell.com
Barry Mesher - mesherb@lanepowell.com
Laura Morse - morsel@lanepowell.com
Kathleen Nelson - nelsonk@lanepowell.com
Jeffrey Odom - odomj@lanepowell.com
Benjamin Roesch - roeschb@lanepowell.com
Cathy Spicer - spicerc@lanepowell.com
Andrew Steen - steena@lanepowell.com
James Stoetzer - stoetzerj@lanepowell.com
Emilia Sweeney - sweeneye@lanepowell.com
Mary Schug Young - youngm@lanepowell.com
David Young - youngd@lanepowell.com
Anchorage:
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Brewster Jamieson - jamiesonb@lanepowell.com
Portland:
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Stephen McCarthy - mccarthys@lanepowell.com
Victoria Blachly - blachlyv@lanepowell.com
Tanya Durkee - durkeet@lanepowell.com
London Client Team
206.223.7000 Seattle
503.778.2100 Portland
LMNews@lanepowell.com
www.lanepowell.com
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