Bond Market Response to the Collapse of Prominent Investment Banks

• DOI: http://doi.org/10.1111/fire.12019
• Published date: 01 November 2013
• Date: 01 November 2013
• Author: Nivine Richie,Jeff Madura,Si Li

The Financial Review 48 (2013) 645–670

Bond Market Response to the Collapse

of Prominent Investment Banks

Si Li

School of Business and Economics, Wilfrid Laurier University,

PBC School of Finance Tsinghua University

Jeff Madura

Florida Atlantic University

Nivine Richie∗

University of North Carolina Wilmington

Abstract

Wefind that the Bear Stearns rescue in March 2008 elicited a neutral or moderately favor-

able impact on bond prices. Conversely, we findthat the Lehman Brothers failure (combined

with news about Merrill Lynchand American International Group) in September 2008 elicited

a pronounced negative impact. Bond prices of financial firms suffered more than bonds of

nonfinancial firms following the Lehman failure. Our multivariate analysis shows that bonds

issued by financial institutions that were previously presumed to be protected (based on bond

rating and firm size) suffered more pronounced losses in response to the Lehman failure.

Keywords: bonds, event study, market efficiency, credit spreads

JEL Classifications: G12, G14

∗Corresponding author: 601 South College Road, Wilmington, NC 28403; Phone: (910) 962-3606; Fax:

(910) 962-7464; E-mail: richien@uncw.edu.

C2013 The Eastern Finance Association 645

646 S. Li et al./The Financial Review 48 (2013) 645–670

1. Introduction

Investment banks serve as key financial intermediaries to facilitate the flow of

funds. The financial problems of large investment banks could signal potential con-

tagion effects and, therefore, may have major consequences in the bond market. We

examine the effects on corporate debt markets in response to two notable credit events

regarding investment banks—the rescue of Bear Stearns and the subsequent failure

of Lehman Brothers. Although both events were triggered by similar underlying

financial problems for the firms, the signals were distinctly different.

1.1. Rescue of Bear Stearns

Bear Stearns was a major intermediary for securitizing mortgage-backed securi-

ties, and was particularly active in mortgage-backed securities representing subprime

mortgages. It relied heavily on repurchase agreements for short-term funding to fi-

nance its operations. In 2007 and early 2008, Bear Stearns experienced financial

problems because of its heavy exposure to the mortgage market and its excessive

financial leverage. Due to Bear Stearns’ questionable asset quality and creditworthi-

ness in early 2008, many of the financial institutions that provided short-term loans

refused to renew the loans. On March 13, 2008, Bear Stearns secretly notified the

Federal Reserve that it was experiencing liquidity problems and would haveto file for

bankruptcy the next day if it could not access funds. On Friday, March 14, 2008, the

Federal Reserve announced that it was providing financing to Bear Stearns through

a commercial bank, J.P. Morgan Chase.

1.2. Failure of Lehman Brothers

Lehman Brothers was a major intermediary for fixed-income securities, and also

made substantial investments in mortgage-backed securities representing subprime

mortgages. Lehman Brothers experienced serious financial problems in 2008 because

of its excessive holdings of subprime mortgages during the mortgage meltdown.Like

Bear Stearns, it was highly levered and also relied heavily on short-term funding to

finance its operations.

By September 2008, much of its funding was cut off as creditors became more

concerned about its survival. Lehman Brothers also appealed to the U.S. government

for financial support, but did not receiveany. On September 15, 2008, a day described

as one of the most dramatic days in the history of U.S. financial system, Lehman

Brothers filed for bankruptcy.

On that same day, Merrill Lynchagreed to be acquired by Bank of America, and

American International Group (AIG) was in the news because of concerns about its

trading of credit default swaps, structured notes, and guaranteed investment agree-

ments. Like Lehman Brothers and Merrill Lynch, AIG experienced a substantial loss

in value over the previousyear because of its excessive direct and indirect exposure to