Order Code RL34420
Bear Stearns: Crisis and “Rescue” for a Major
Provider of Mortgage-Related Products
Updated March 26, 2008
Gary Shorter
Specialist in Business and Government Relations
Government and Finance Division

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Bear Stearns: Crisis and “Rescue” for a Major Provider
of Mortgage-Related Products
Summary
In March 2008, Bear Stearns, the nation’s fifth largest investment banking firm,
was battered by what its officials described as a sudden liquidity squeeze related to
its large exposure to devalued mortgage-backed securities. On March 14, the Federal
Reserve System announced that it would provide Bear Stearns with an unprecedented
short-term loan. This was rendered essentially moot when, on March 16, a major
commercial bank, JP Morgan Chase, agreed to buy Bear Stearns in an exchange of
stock shares for about 1.5% of its share price of a year earlier, a price that translated
to $2/share. To help facilitate the deal, the Federal Reserve agreed to provide special
financing in connection with the transaction for up to $30 billion of Bear Stearns’s
less liquid assets.
During the weekend of March 22, in the wake of criticism from Bear
shareholder and employees (employees own about one-third of the firm’s outstanding
stock) over the $2/share price, Bear Stearns and JP Morgan renegotiated the terms
of the deal: JP Morgan will purchase 95 million newly issued shares of Bear’s
common stock at $10/share in a stock exchange. In response to the changed deal
conditions, the Fed altered the terms of its financial involvement: it got JP Morgan
to agree to absorb the first $1 billion in losses if the collateral provided by Bear for
a loan proves to be worth less than Bear Stearn’s original claims. Instead of its
original agreement to absorb up $30 billion, the Fed will now be responsible for up
to $29 billion.
The Fed’s unprecedented role has generated a widespread debate on the
implications of such an intervention. Some argue that the help made sense in the
interest of avoiding potential systemic financial risk. Others argue that it tells the
market that it is willing to help a large and failing financial enterprise, setting a bad
precedent in terms of corporate responsibility.
This report will be amended as events dictate.

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Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Some Background on Bear Stearns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Mortgage-Backed Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Bear Stearns and the Initial Fed “Rescue” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
JP Morgan Initially Agrees to Acquire Bear Stearns with Fed Assistance . . . . . . 5
The Amended Buyout Offer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
The Altered Terms for the Fed and the Debate over Moral Hazard and
Systemic Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

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Bear Stearns: Crisis and “Rescue”
for a Major Provider of
Mortgage-Related Products
Introduction
On March 14, 2008, Bear Stearns (Bear), the nation’s fifth largest investment
banking firm, was verging on bankruptcy from what its officials described as a
sudden liquidity squeeze related to its large exposure to devalued mortgage-backed
securities. On that day, it also received word that it was getting an unprecedented
loan from the Federal Reserve System (Fed). The funding would take the form of a
28-day Fed loan to be channeled through the large commercial bank, J.P. Morgan
Chase (JP Morgan). The decision was unprecedented: never before had the Fed
committed to “bailing out” a financial entity that was not a commercial bank. The
action was criticized by some Members of Congress, but gained support from
Chairman Christopher Dodd of the Senate Banking Housing, and Urban Affairs
Committee, which has Fed oversight.1
Bear’s liquidity crisis and the resulting Fed intervention, largely viewed as an
effort to stabilize the firm and to avert a wider financial panic, sent alarms throughout
the stock markets over Bear’s fragility and more broadly over the potential
precariousness of other major financial institutions. The day of the announcement,
Bear’s stock lost almost half of its value, and the stocks of other major Wall Street
firms also tumbled. These concerns then spilled over into the broader universe of
stocks: the Dow Jones Industrial Average, a broad index of the overall stock market,
lost nearly 200 points, slightly more than 1.5% of its value.
The Fed’s actions were characterized as a short-term fix; at the same time, Bear
executives were also seeking a buyer to purchase the highly-leveraged firm, which
was also one of the nation’s largest underwriters of now-troubled mortgage-backed
securities. On March 16, two days after the announcement of the Fed intervention,
JP Morgan agreed to buy it.
This report provides an overview of Bear Stearns, examines the Fed’s “rescue
plan,” and JP Morgan’s subsequent agreement to acquire the firm.
1 In recent memory, the Fed only approached this kind of specific non-bank intervention in
1998 when it helped organize a rescue of Long-Term Capital Management (LTCM), a large
U.S.-based hedge fund. Concerned about the possible dire consequences for world financial
markets if the failing LTCM collapsed, Fed officials were instrumental in convincing a
group of U.S. and European financial institutions to inject several billion dollars into the
hedge fund. They did so, and in exchange collectively received a majority share.

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CRS-2
Some Background on Bear Stearns
With about 14,000 employees worldwide, 85-year-old Bear is a diversified
financial services holding company whose core business lines include institutional
equities, fixed income, investment banking, global clearing services, asset
management, and private client services.
As is also the case for its Wall Street and commercial banking peers, as housing
prices took off and the mortgage industry surged earlier in this decade, Bear became
actively involved in aspects of this market. It was a vertically integrated involvement
that ranged from the purchase and operation of residential mortgage originators to
packaging and underwriting vast pools of mortgages into “structured” securities
products broadly known as mortgage-backed securities (MBS). Such products would
in turn be sold to institutional investors, such as hedge and pension funds, while
some were retained by the bank itself.
With the collapse of the housing market, Bear began facing very dramatic
financial travails in June 2007: the firm announced that two of its hedge funds that
were significantly invested in subprime mortgages were in trouble. In an attempt to
keep them afloat, Bear poured $1.6 billion into the funds. Nonetheless, soon
afterwards, the funds lost all of their value and were allowed to wind down. By
various accounts, the funds’ meltdown signaled the start of a collapse in the vital
element of trust that must exist between a firm like Bear and its many customers. In
October 2007, Bear agreed to a needed $1 billion capital investment from China’s
government-controlled Citic Securities. Later, in the fourth fiscal quarter of 2007,
having written down more than $2 billion in devalued mortgage securities,2 the
company reported its first-ever quarterly loss, an unexpectedly high deficit of $859
million.
At the heart of Bear’s problems have been MBS, which Bear and other Wall
Street firms such as Merrill Lynch were actively engaged in packaging, underwriting,
trading, and investing in for themselves. What follows is a brief primer on MBS.
Mortgage-Backed Securities
In an overview of the general credit market doldrums that are a product of
problems that originated in the housing and mortgage markets, CRS Report
RL34182, Financial Crisis? The Liquidity Crunch of August 2007, described MBS:
Securitization allowed mortgage lenders to bypass traditional banks.
Securitization pools mortgages or other debts and sells them to investors in the
form of bonds rather than leaving loans on lenders’ balance sheets. The MBS
market developed in part because long-term fixed rate mortgages held in banks’
portfolios place banks at significant risk if interest rates rise (in which case, the
banks’ interest costs could exceed their mortgage interest earnings). MBS were
2 David Smith and Dominic Rushe, “Bear Stearns: The Banking Twister Heading Your
Way,” The (UK) Sunday Times, March 16, 2008.

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CRS-3
popular with investors and banks because it allowed both to better diversify their
portfolios. But because the MBS market was growing rapidly in size and
sophistication, accurate pricing of its risk was difficult and could have been
distorted by the housing boom.
There are several forms of MBS. The simplest are called pass-throughs —
interest and principal payments from homeowners are collected by the lender (or
a service firm) and passed through to the owner of the MBS. More complex
securities are created by pooling MBS as well as mortgages, and by giving
investors a menu of risk and return options. A mortgage pool may be split into
parts (called tranches) to allow cautious investors to purchase safer portions and
aggressive investors to purchase the riskier, high-return tranches (e.g., tranches
that bear initial losses). Finally, mortgage cash flows may be combined with
derivative instruments that link payment levels to the performance of financial
variables, such as interest rates or credit conditions. These securities —
combinations of traditional bonds and derivatives — are called structured
products.
The growth of securitization meant that more loans could be originated by
non-banks, many of which are not subject to examination by federal bank
examiners and not subject to the underwriting guidances issued by federal
financial regulators....3
Bear Stearns and the Initial Fed “Rescue”
A little more than a week before the Fed’s announced rescue on March 14,
2008, fixed income traders reportedly began hearing rumors that European financial
institutions had ceased doing fixed income trades with Bear. Fearing that their funds
might be frozen if Bear wound up in bankruptcy, a number of U.S.-based
fixed-income and stock traders that had been actively involved with Bear, had
reportedly decided by March 10 to halt such involvement.4
That development placed firms that still wanted to do business with Bear in a
quandary: in the event that Bear did succumb, they were likely to be in the difficult
position of explaining to their clients why they had ignored the rumors; on March 11,
a major asset-management company ceased doing trades with Bear.5 The same day,
however, the Bear’s Chief Executive Officer, Alan Schwartz, wrote that the firm’s
“balance sheet, liquidity and capital remain strong.”6
That same week, many other firms began exercising extreme caution in their
dealings with Bear, as the firm saw the exodus of a growing number of its trading
3 CRS Report RL34182, Financial Crisis? The Liquidity Crunch of August 2007, by Darryl
E. Getter, Mark Jickling, Marc Labonte, and Edward Vincent Murphy.
4 Kate Kelly, Greg Ip, and Robin Sidel, “Fed Races to Rescue Bear Stearns in Bid to Steady
Financial System Storied Firm,” Wall Street Journal, March 15, 2008, p. A1.
5 Ibid.
6 Ibid.

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CRS-4
counterparties. Some hedge fund clients, demanding that Bear provide cash as
collateral on trades they had done with the firm, withdrew funds from their accounts
with the firm. Hedge funds that had used Bear to borrow money and clear trades
were withdrawing cash from their accounts. Some large investment banks stopped
accepting trades that would expose them to Bear, and some money market funds
reduced their holdings of short-term Bear-issued debt. Concerned that the firm’s
ability to pay claims was looking less assured, a number of institutional investors
with credit default swaps (insurance policies that protect against corporate bond
defaults) purchased from Bear, were attempting to undo those trades. (Bear had
developed a sizeable market in swaps.)
This ongoing activity contributed to a precipitous and alarming drop in Bear’s
cushion of liquidity reserves. By the afternoon of March 13, the firm’s CEO was
convinced of the severity of the problem. After deliberating with other senior
company staff and company lawyers, a call was made to James Dimon, CEO of JP
Morgan, the nation’s second largest bank in stock market capitalization. As the
clearing agent for Bear’s trades, JP Morgan was familiar with Bear’s collateral
position and thus seemed like a good prospect for lending to the firm.7
Later, JP Morgan’s CEO and other JP Morgan senior officials held
conversations with representatives from the Fed. The conclusion was that something
needed to be done because a failure at Bear could have widespread financial
repercussions.
By the evening of March 13, Bear had been unable to secure emergency
financing or negotiate a strategic acquisition deal. Officials from the firm and the
Securities and Exchange Commission, the principal Bear regulator, then informed
officials from the Fed that Bear had lost far more of its liquidity than it had
previously been aware of. The Fed then sent a team of examiners to look at Bear’s
books overnight. Early on the morning on March 14, a cadre of financial regulators,
including New York Fed Chief Timothy Geithner, Fed Chairman Ben Bernanke, and
U.S. Treasury Department Secretary Henry Paulson conducted a conference call. At
7:00 a.m., at the call’s conclusion, the Fed decided it would offer a short-term
“discount window” loan.8
Through the discount window, the Fed can make direct short-term loans to
commercial banks. A 1932 provision of the Federal Reserve Act allows it to lend to
non-banks if at least five of its seven governors approve, a provision that has not
been used since the Great Depression. With two governors’ seats vacant and one
governor out of the country and inaccessible, the Fed invoked a special legal clause,
allowing it to approve the 28-day loan to Bear with only four governors. The
arrangement would involve providing collateral-based financing to Bear through JP
Morgan, which would be used as a conduit, since as a commercial bank, it already
has access to the discount window and is also under the Fed’s supervision. Exact
terms were not disclosed, but the loan amount would only be limited to the amount
7 Ibid.
8 This is credit extended by a Federal Reserve Bank to an eligible depository institution that
must be secured by collateral.

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CRS-5
of collateral Bear could provide. JP Morgan would have incurred no risk from the
transaction but the Fed would.9
JP Morgan Initially Agrees to Acquire Bear Stearns
with Fed Assistance
The Fed’s rescue effort would soon, however, be eclipsed and essentially made
moot by a bigger development: on Sunday, March 16, two days after the lifeline’s
announcement, JP Morgan, one of the only major banks not to be significantly
battered by the mortgage meltdtown, agreed to acquire Bear for $236 million. In the
preceding days, Bear executives were both preparing for a possible Chapter 11
bankruptcy filing and pursuing a purchaser for either all or parts of the firm. The idea
was that securing an immediate acquirer before trade resumed on Monday, March 17
would allow the firm to avoid likely mass withdrawals by its clients in early opening
markets like Japan. After intense negotiations between Bear and JP Morgan with the
active encouragement of the Fed and Treasury officials, JP Morgan signed on as
Bear’s purchaser.
JP Morgan’s stock-for-stock buyout was valued at $2 a share for Bear stock, the
closing share price on March 15, which represented a 94% discount to Bear’s closing
share price of $30 on March 14, and slightly over 1% of the $170 share price that
Bear stock had fetched a year earlier. The boards at both Bear Stearns and JP Morgan
quickly approved the deal, as did the Fed, and the Office of the Comptroller of the
Currency.
The deal needed the approval of shareholders at both Bear and JP Morgan. At
Bear, a schism between its bondholders and its shareholders had reportedly arisen
after the announced sale. Interested in keeping the firm out of bankruptcy, and
protecting their investment in it, bondholders were generally said to be supportive of
the sale. But many shareholders, including some employees with an equity interest
in the firm, were said to be opposed to the $2 a share offer. In heavy trading on
Tuesday, March 18, the firm’s share price closed at $5.91.10
A release from JP Morgan said that, “effective immediately, JP Morgan Chase
is guaranteeing the trading obligations of Bear Stearns and its subsidiaries and is
providing management oversight for its operations.... The transaction is expected to
have an expedited close by the end of the calendar second quarter 2008....”11
9 Kate Kelly, Greg Ip, and Robin Sidel, “Fed Races to Rescue Bear Stearns in Bid to Steady
Financial System Storied Firm.”
10 Landon Thomas, “It’s Bondholders vs. Shareholders in a Race to Buy Bear Stearns
Stock,” New York Times, March 19, 2008.
11 “JP Morgan Chase To Acquire Bear Stearns,” J. P. Morgan News Release, March 16,
2008.

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CRS-6
According to spokespersons at the Fed, the initial loan commitment to Bear (via
JP Morgan) was made on Friday, March 14 and was then repaid on Monday, March
17.
An integral part of the initial merger deal was that the Fed would agree to
provide what is described as a non-recourse loan to JP Morgan for up to $30 billion
of Bear’s less-liquid assets.12 The Fed would then be in a position to liquidate the
assets. If they rose in value before they are sold, the Fed will make money. If they
fell in value, the Fed would lose. The Fed’s role in this was reportedly deemed
necessary to overcome JP Morgan’s reluctance to taking on much of Bear’s risky
portfolio of complex mortgages and other questionable investments.13
The Amended Buyout Offer

Reportedly responding to Bear shareholders and employees (who own about
one-third of Bear stock) angry over the $2 a price share offer and to avert the
attendant threat of shareholder litigation, Bear and JP Morgan renegotiated the terms
of the merger during the weekend of March 22. The ensuing stock-for-stock merger
agreement would value Bear stock at $10 a share. JP Morgan will also buy 95 million
new shares of Bear Stearns for the offering price. Under the new terms of the stock-
for-stock deal, JP Morgan will pay 0.21753 of a share for each share of Bear, up from
the original exchange ratio of 0.05473.14 Under the new terms, Bear would be valued
at about $1.2 billion up from the earlier $236 million.15
Also under the terms of the agreement, before April 8, Bear will sell 39.5% of
95 million shares of newly issued stock to JP Morgan, allowing the transaction to
avoid a law in the state of Delaware, where both firms are headquartered. Delaware
state law states that a shareholder vote is not necessary for the particular transaction
if a company is selling up to 40% of its holdings. JP Morgan and Bear officials are
probably hoping that combined with the 5% of Bear shares held by members of its
board, the 39.5% vote will give them the majority votes required for eventual
shareholder approval.
Generally, the New York Stock Exchange, where JP Morgan and Bear shares
are listed and traded, requires shareholder approval if an issue of new shares are
12 Ibid.
13 Andrew Clark, “Bear Stearns Saved by Rock-Bottom JP Morgan Bid.”
14 There are reports that during a March 17, 2008, phone call with JP Morgan’s CEO, the
Chairman of Bear’s board, James Cayne, criticized the $2-a-share price, even after voting
for it. Additional reports have said that after the initial terms of the deal were made, Bear’s
CEO, Alan Schwartz, was privately telling people that he felt that the company had been
“mugged.” Robin Sidel and Kate Kelly, “J.P. Morgan Quintuples Bid to Seal Bear Deal,”
Dow Jones, March 25, 2008, p. A-1.
15 There are a number of observers, however, who question whether shareholders will be
uniformly satisfied with the new price and will be willing to either withdraw or desist from
shareholder suits.

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CRS-7
convertible into more than 20% of a listed company stock. But the rule has an
exception if adherence to the procedure delays or seriously jeopardizes the financial
viability of the listed company. Bear and JP Morgan are reportedly invoking the
exception and according to some reports, the NYSE is not expected to oppose the
transaction and press for the imposition of the rule.16
JP Morgan Chief Executive Jamie Dimon said that “... we believe the amended
terms are fair to all sides and reflect the value and risks of the Bear Stearns franchise
and bring more certainty for our respective shareholders, clients, and the
marketplace.” Bear’s CEO, Alan Schwartz, observed “...our board of directors
believes the amended terms provide both significantly greater value to our
shareholders, many of whom are Bear Stearns employees, and enhanced coverage
and certainty for our customers, counterparties, and lenders.”17

The Altered Terms for the Fed and the Debate over
Moral Hazard and Systemic Risk
According to some reports, the Fed was not initially supportive of the $10/share
deal, raising questions about the pricing during the negotiations. Some observers
think that some officials at the regulator preferred a lower price because “of the
message it sent to the rest of the market...”18
In the end, however, the Fed appears to have supported the new terms but
arranged for a more favorable role for itself. It agreed to make a $29 billion non-
recourse loan to JP Morgan at the discount rate (currently 2.25%, but fluctuating over
time) for a term of 10 years, renewable by the Fed. In return, the Fed will receive
collateral in the form of assets worth $30 billion (with a haircut) at marked to market
prices. Twenty billion of the assets are reportedly mortgaged-backed securities.
Unlike the original arrangement, JP Morgan will be responsible for the first $1 billion
in losses if the collateral provided by Bear for the loan proves to be worth less than
Bear’s original claims.
The unprecedented Fed intervention has unleashed a widespread debate over the
action’s merits. The two predominant and opposing views are:
! Intervention made sense because of the threat of increased
market instability if Bear went down. It was argued by some,
16 Robin Sidel and Kate Kelly, “J.P. Morgan Quintuples Bid to Seal Bear Deal,” Dow
Jones, March 25, 2008, p. A-1.
17 Peter Coy, “A Sweeter Bear Bid May Sour the Fed, JP Morgan Raises its Offer in Hopes
of Winning over Shareholders. Is the Federal Reserve too Cozy with Wall Street?”
BusinessWeek.com. March 25, 2008.
18 Andrew Ross Sorkin, “The Hand Behind The Deal,” New York Times, March 25, 2008.

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CRS-8
including Treasury Secretary Henry Paulson,19 that the Fed’s
intervention was wholly justified in pursuit of the larger goal of
ensuring financial stability by averting potentially far reaching
spillovers into the larger financial world if Bear were to collapse —
often called systemic risk. One concern was that such a failure
would unleash additional lack of confidence into markets already
fraught with substantial pessimism and uncertainty. Another
concern involved the $46 billion in mortgages, mortgage-backed and
asset-backed securities (as reported on November 30, 2007) held by
the firm. If Bear failed, it would likely have to liquidate such assets,
a large fraction of which held somewhat questionable valuations
based on what it said were estimates derived from “internally
developed models or methodologies utilizing significant inputs that
are generally less readily observable.”20 A large stream of such
assets released into risk-averse markets with leery and anxious
buyers would be likely to force many institutions with similar assets
into substantial asset write downs. The outcome of all of this could
be a financial meltdown.
! The intervention helps shield the firm and the markets from the
consequences of running a badly performing firm. Moral hazard
occurs when entities do not bear the full cost of their actions, thus
becoming more likely to repeat them. And a major concern here is
that with Fed intervention, neither Bear nor the markets in general,
would benefit from the painful but important lesson that failed firms
should simply be left to their own fate. For example, if, after the
Bear intervention, another Wall Street firm like Lehman also found
itself “on the ropes” — would there be an expectation that it also
would be rescued? These kind of arguments are often used to
challenge the widely held belief in “Too Big to Fail” — the idea that
the largest and most powerful financial institutions are too large a
part of the financial system to let fail. In the case of Bear Stearns, a
more apt variation on this them is that “it was too widely connected
(to clients and counterparties) to fail.”
Some observers such as Senate Banking Committee Chairman Christopher
Dodd, have said that the Fed’s action was defensible given the threat of systemic
risk.21
19 Andrew Clark, “Bear Stearns Saved by Rock-Bottom JP Morgan Bid,” Guardian.co.uk,
March 16, 2008.
20 Gretchen Morgenson, “Rescue Me: A Fed Bailout Crosses a Line,” New York Times,
March 16, 2008, p. Bu-1.
21 William Neikirk, “Fed Action Awaited on Size of Rate Cut Markets Hope Likely Rate Cut
will Stem Tide,” Baltimore Sun, March 18, 2008.

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However, others, like John Taylor, CEO of the National Community
Reinvestment Coalition, are critical. Mr. Taylor have said that the action was an
unjustifiable bailout because, “ … we may be left holding the bill as taxpayers.”22
Expressing a kind of “middle ground” view on the Fed’s intervention, Vincent
Reinhart, a former Fed official who is now with the American Enterprise Institute,
observed that “it is a serious extension of putting the Federal Reserve’s balance sheet
in harm’s way. That’s got to tell you the economy is in a pretty precarious state.”23
22 David J. Lynch, “Is it a $30B Bailout by the Fed or Just a Smart Move?” USA Today,
March 18, 2008.
23 “Fed Cuts Discount Rate, Backs Bear Stearns Deal, Providence Business News, March
15, 2008.

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