Tsinghua University Graduate School of Economics and Management

1
Tsinghua University Graduate School of Economics
and Management

• Lecture 2008/8
• Case Study Bear Stearns
• and
• U.S Financial Regulatory Reform
• Andrew Sheng
• Adjunct Professor
• April 2008

2
Profiles

• A leading global investment banking, securities
  trading and brokerage firm
• Founded in 1923 , BSC(NYSE), employs
  approximately 14,000 people worldwide.
  Headquartered in New York City,
• Three core segments
• Capital Markets
• Wealth Management
• Global Clearing Services

3
Company Culture

• Guiding principles
• Respect
• Integrity
• Meritocracy
• Innovation
• Philanthropy
• Access open doors and approachability.
• Visibility accomplishments visible to senior
  managers, as well as the firm.
• Flexibility the freedom to think and explore
• Entrepreneurialism outstanding opportunities
  available for creative and resourceful people

4
Corporate Governance
5
Board of Committees

• Board of Directors
• Audit Committee
• Compensation Committee
• Corporate Governance and Nominating Committee
• Finance and Risk Committee
• Qualified Legal Compliance Committee

6
Major Directors of Board
7
Executive Officers
8
Incentives Scheme and Compensation Analysis

• Principles of compensation program
• Performance-Based
• Ownership
• Competitive
• Its named executive officers owned about 7.8 of
  the outstanding Common Stock at February 20, 2008
• Components and Operation of Compensation Program
• Base Salary
• Performance-Based Annual Bonus
• other benefits(Health,Welfare,401(k),etc)

9
Summary Compensation Table
Nov,30 2007
10
Securities Ownership of Directors and Executive
Officers
11
Major Holders of BS
April 17,2008
12
Securities Ownership of Certain Beneficial Owners
13
Financial Analysis
14
Stock Price of BSC
15
Business and Performance

• Principal business activities
• Investment banking,
• Commission(securities and derivatives sales and
  trading),
• Clearance,
• Brokerage
• Asset management and energy trading
• Performance of fiscal 2007
• A decrease in the volume of new securities
  issuances, MA results in lower revenues in
  investment banking
• A reduced volume of securities and futures
  transactions and reduced market liquidity results
  in lower revenues from principal transactions and
  commissions
• CDOs and SIVs resulted in significant price
  declines across all mortgage-related products in
  fiscal 2007.

16
Revenues by Business Segment
17
Bear Stearns Revenues
Percentage
18
Revenue Divided by Business Nature
Commissions
Principal transactions
Investment banking
19
Non-Interest Expenses
20
Direct Competitor Comparison
Bear S
Goldman S
Lehman B
Merrill L
Industry
April 17, 2008
21
Material Assets of Bear Stearns
22
Material Liabilities of Bear Stearns
23
Cash Flows
(in millions)
24
Gross leverage and Net adjusted leverage
(in millions, except ratios)
25
The Company's Total Capital
November 30
26
Valuation and Risk Discussion
27
Valuation of Financial Instruments

• Three categories methods
• (1) Valued Based on Inputs Based on Quoted Market
  Prices for Identical Assets or Liabilities in
  Active Markets
• (2) Inputs are Observable Market Based or
  Unobservable Inputs Corroborated By Market Data
• (3) Inputs to Determine the Fair Value Is
  Estimated Based on Internally Developed Models or
  Methodologies Less Readily Observable from
  Objective Sources

28
Mortgage-Related Products

• Approximately 2.3 billion write downs in
  Mortgage-related net inventory in the second half
  of fiscal 2007
• Valuation adjustments of approximately .26
  billion in Leveraged finance revenues
• At November 30, 2007, the Company had
  approximately 46 billion of mortgages, mortgage
  backed and asset backed securities including 12
  billion of floating rate commercial loans and 3
  billion of fixed rate commercial loans.

29
Securitization Activities
Agency Mortgage-Backed
Other Mortgage-and Asset-Backed
(in billions)
total
Total Securitizations
Fiscal 2007
23.0
73.8
96.8
Fiscal 2006
21.8
99.3
121.1
Fiscal 2005
26.2
89.8
116
Fiscal 2004
30.2
75.2
105.4
59.0
56.7
115.7
Fiscal 2003
23.6
78.6
Fiscal 2002
55.0
30
The Company's CDOs and Subprime-Related Exposures
(net of hedges)
31
Risk Management

• Main risks
• Credit risk
• Non-performance by counterparties, customers,
  borrowers or debt security issuers,etc
• Market risk
• Including interest, currency, exchange rates,
  equity, futures and commodity prices, changes in
  the implied volatility of and price deterioration
  or changes
• Operational risk
• Deficiencies in legal documentation and
  technology, noncompliance with legal, regulatory
  responsibilities,
• Funding risk
• Legal risk
• Accounting risk
• Reputational risk

32
VaR for Each Component of Market Risk
November 30
(In millions)
2003
2004
2005
2006
2007
Market Risk
Interest Rate
29.9
72.4
22.1
15.3
14.9
Currency
0.8
1.4
0.3
1.4
0.9
Equity
3.0
6.5
3.6
2.8
3.7
Commodity/Energy
0.0
12.5
0.0
0.0
0.0
Diversification Benefit
(4.9)
(23.5)
(4.6)
(4.7)
(4.2)
Aggregate Value-at-Risk
28.8
21.4
14.8
15.3
69.3
All VaRs calculation are based on one day
interval and 95 confidence level
33
Fair Value Changes in Credit, Interest Rate,
Prepayment Speeds
34
Over-the-Counter Derivatives Credit Exposure
Nov 30,2007 ( in millions)
As of November 30, 2007, the Company had
notional/contract amounts of 13.40 trillion of
derivative financial instruments, of which 1.85
trillion were listed futures and option contracts.
35
Conclusion

• Lessons from Bear Stearns Case
• Over-leverage
• Excessively concentrated exposure on CDOs and
  Subprime product,
• Complicated but increditable Valuation Models
• Maturity Mismatch
• Weak Risk Management
• Information Asymmetry

36
Blueprint For A Modernized Financial Regulatory
Structure

• The Department of U.S.Treasury
• March 2008

37
Content

• Regulatory Challenges and Experiences
• US Legacy Model Institutional and State/Federal
• Short-Term Recommendations
• Intermediate Recommendations
• Long-Term Optimal Regulatory Structrue
• Conclusion

38
Regulatory Challenges and Experiences

• Regulatory Challenges
• Forces for Change
• Changing Bank Model
• Foreign Experiences
• Australian Wallis Report Recommendations
• UK Regulatory Structure

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Forces for Change
Changing Customer Needs

• Efficiency
• Competition
• More discerning customers
• Further globalisation
• Further conglomeration
• Market widening
• Intermediaries markets
• Innovation

Technology
Regulatory Change
40
Changing Bank Model

• From Deposit-to-lend To Originate-to-Distribute
  Model
• High element of Proprietary Trading
• Conflicts of Interest
• Derivatives make Leverage levels unclear at
  institution and system level

41
Australian Wallis Report Recommendations

• New Regulatory Architecture
• Four Pillars (peaks)
• APRA (prudential)
• ASIC (conduct and disclosure)
• ACCC (competition)
• RBA (systemic stability)

42
UK Structure

• Tripartite MOU between
• Treasury (Political decision)
• Bank of England (Financial Stability and Payment
  Systems)
• FSA (Super-regulator)

43
US Legacy Model Institutional and
State/Federal

• Current Structure
• Banking - State, Thrifts (OTS), OCC, FDIC, Fed
• Securities and Futures - SEC ,CFTC
• Insurance - NAIS, all State Chartered
• Pension Funds - all State supervised
• Fed - Systemic Stability, but limited to banks
  only
• Weakness of current structure
• Regulatory gaps and redundancies co-exist.

44
Short-Term Recommendations

• Presidents Working Group(PWG) on Financial
  Markets
• Mortgage Origination
• Liquidity Provisioning by the Federal Reserve

45
Presidents Working Group

• PWG focus would be broadened to financial sector,
  not just markets
• Focus on-
• Mitigating systemic risks
• Enhancing financial market integrity
• Promoting consumer/investor protection
• Supporting capital market efficiency and
  competitiveness
• Expanded to include OCC, FDIC OTS
• Report direct to President and coordinator for
  financial regulatory policy

46
Mortgage Origination

• New Mortgage Origination Commission to regulate
  broker and origination
• Fed still in charge of Truth in Lending Law
• Enforcement authority for Mortgage Origination
  and lending clarified and enhanced

47
Liquidity Provisioning

• Temporary liquidity provision process should be
  caliberated and transparent appropriate
  conditions are attached to lending and
  information flows to Fed are adequate
• PWG will consider broader regulatory issues
  relating to liquidity provided to non-depository
  institutions

48
Intermediate Recommendations

• Thrift Charter,OTSOCC
• State-Chartered Banks
• Payment and Settlement Systems
• Insurance Oversight
• Securities and Futures Merger

49
Thrift Charter

• Original focus on providing funding for
  residential mortgage
• The role of federal thrifts to diminish,no
  necessary to go on
• For Thrift Charter,OTS to merge with OCC within 2
  years

50
State-Chartered Banks

• To authorize Fed to regulate all the
  State-Chartered Banks with federal deposit
  insurance
• Or to authorize FDIC to regulate all the
  State-Chartered Banks with federal deposit
  insurance
• overall reform of the Fed for any shift of
  regulatory authority

51
Payment and Settlement Systems Oversight

• Current regulation to be idiosyncratic and
  optional
• To create a federal charter and incorporate
  federal preemption
• Fed to have discretion and full regulatory
  authority

52
Insurance Oversight

• To establish an optional federal charter(OFC)
  for insurers
• To establish the Office of National
  Insurance(ONI) within treasury to regulate
  insurers holding OFC
• To create an Office of Insurance Oversight
  (OIO) to focus immediately on key issues.

53
Futures and Securities

• Prior to the merger,SEC should
• To adopt core principles modeled after the ones
  adopt by CFMA
• To issue a rule to update,streamline the SRO
  rulemaking process
• To grant exemption for the products actively
  traded in the U.S. and abroad
• To permit registration of global investment
  company

54
Futures and Securities

• When undertaking the merger,
• Merger between CFTC and SEC
• To adopt overaching regulatory principles(investor
  protection,market integrity,system risk
  reduction)
• To harmonize several differences between futures
  and securities regulation
• Harmonization regulation and oversight of
  broker-dealers and investment advisers

55
Long-Term OptimalRegulatory Structure

• Four Conceptual Options
• Objectives-Based Regulatory Approach
• Three New Institutions Federal Charter
• The New Regulatory Structure
• Market Stability Regulator Fed
• Prudential Financial Regulator PFRA
• Business Conduct Regulator CBRA
• Federal Insurance Guarantee Corporation(FIGC)
• Corporate Financial Regulator(CFR)

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Four Conceptual Options

• Maintain status quo
• Move to functional-based system
• Move to Single Regulator
• Move to Objectives-based approach as adopted by
  Australia and Netherlands recommended way
  forward

57
Objectives-Based Regulatory Approach

• Market stability regulation to address overall
  conditions of financial stability that could
  impact the real economy (oversight all 3
  types_FIDIFIIFFSPs)
• Prudential financial regulation to address issues
  of limited market discipline caused by govt
  guarantees (FIDI FIIs)
• Business conduct regulation (linked to consumer
  protection regulation) to address standards for
  business practices. For all.

58
Three New Institutions

• FIDI (Federal insured Depository Institutions)
• FII for insurers offering retail products where
  some govt guarantee is present
• FFSP (federal financial services provider_ for
  all other types of financial services providers)

59
The New Regulatory Structure

• Fed to have authority to participate in PFRA and
  CBRA examinations
• PFRA (OCC OTS)
• CBRA (CFTC SEC) SRO
• FIGC (FDIC Insurance Guarantee) - act as
  receiver for failed FIIs or FIDIs.
• Corporate Finance Regulator

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Market Stability Regulator - Fed

• More detailed information of financial
  institutions and holding companies
• Authority to make regulatory policies and
  undertake corrective actions
• To create market stability discount window to
  non-FIDIs with high threshold
• To oversee the payment and settlement system

61
Prudential Financial Regulator PFRA

• To establish a FIDI charter including all
  deposit-lend institutions with preemption
• To establish a FII charter for insurers and a
  federal guarantee structure(FIGC)
• Not to regulate GSEs in the long term,but to
  oversee them in the near term for transition

62
Business Conduct Regulator CBRA

• To establish a FFSP charter for all non FIDIFIIs
• To specify the types of business conduct issues
  responsible by CBRA
• To preserve effective SROs as regulatory
  component given its broad responsibility
• To establish a proper role of state regulation

63
FIGC and CFR

• FIGCDeposit Insurance(FDIC) FIGF
• FIGFFederal Insurance Guarantee Fund
• FIGC to operate much as the FDIC today and act as
  receiver of failed FIDIs or FIIs
• CFRCorporate Finance Regulator
• CFR to be responsible for corporate oversight in
  public securities market(such as information
  disclosure)

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Conclusion

• The short-term recommendations focus on the
  immediate reforms of current mortgage and credit
  market
• The intermediate recommendations focus on
  modernize the regulatory structure within the
  current system
• The long-term recommendations are towards optimal
  regulatory framework,an objectives-based regime.

65
Thank You
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