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Zoe Greenwood, vice president at Foundation Investment Advisors, was glancing through the offering memorandum for a new commercial mortgage-backed securities (CMBS) deal on April 1, 2010, a time when the opportunities for commercial mortgage investors had been bleak to the point of comical. This new CMBS deal represented the first opportunity to buy CMBS backed by loans to multiple borrowers since credit markets had shut the securitization pipeline in June 2008.

The offering gave Greenwood a new investment opportunity to suggest to her firm's latest client. She had planned to recommend an expansion in her client's traditional commercial mortgage business, but these new bonds looked intriguing. Could the new CMBS offer her client a superior risk-return tradeoff compared with making individual mortgage loans?

After students have analyzed the case they will be able to:

• –Learn how to construct promised cash flows from both commercial mortgages and commercial mortgage-backed securities

• –Understand the benefits and costs of direct lending versus indirect lending (purchase of mortgage-backed bonds)

• –Underwrite commercial mortgage loans issued by others to identify potentially hidden risks

• –Evaluate at what price a mortgage-bond investment makes financial sense

–Learn how to construct promised cash flows from both commercial mortgages and commercial mortgage-backed securities

–Understand the benefits and costs of direct lending versus indirect lending (purchase of mortgage-backed bonds)

–Underwrite commercial mortgage loans issued by others to identify potentially hidden risks

–Evaluate at what price a mortgage-bond investment makes financial sense

In October 2008, in the midst of a financial crisis, Anthony Keating, investment manager at the Boston private bank Billingsley, Blaylock, and Montgomery, was searching for an investment strategy to recommend to his high-net-worth clients. Traditional investments in the equity markets were being decimated, and Keating’s clients would be looking to him for ideas. Inspired by the success of Paulson and Co., Keating began to explore the possibility of entering a trade that would profit as homeowners defaulted on their mortgages. The more Keating learned about the trade, the more he realized that he needed to know about mortgage-backed securities and credit default swaps. The case provides instructors with a chance to introduce these financial instruments, while at the same time providing lessons applicable to students interested in value investing or real estate finance.

After reading and analyzing the case, students will be able to:

• Explain how home mortgages are securitized into financial instruments that are traded in public markets

• Describe how credit default swaps can be used to speculate on the value of an underlying financial instrument

• Identify potential mispricing across related financial instruments

• Understand the potential risks and rewards of various financial investment strategies that look to capitalize on defaults on subprime mortgages

Explain how home mortgages are securitized into financial instruments that are traded in public markets

Describe how credit default swaps can be used to speculate on the value of an underlying financial instrument

Identify potential mispricing across related financial instruments

Understand the potential risks and rewards of various financial investment strategies that look to capitalize on defaults on subprime mortgages

In 2011, Sherry Hunt was a vice president and chief underwriter at CitiMortgage headquarters in the United States. For years she had been witnessing fraud, as the company bought billions of dollars in mortgage loans from external lenders that did not meet Citi credit policy and sold them to government-sponsored enterprises (GSEs). This resulted in Citi selling to GSEs such as Fannie Mae and Freddie Mac pools of loans that were considerably defective and thus likely to default. Citi had also approved hundreds of millions of dollars' worth of defective mortgage files for U.S. Federal Housing Administration insurance. After reporting the mortgage defects in regular reports, notifying and working closely with her direct supervisor (who was subsequently asked to leave Citi after alerting the chairman of the board to these issues) to stop the purchase of defective loans, leaving anonymous tips on the FBI's and the Department of Housing and Urban Development's websites, and receiving threats from two of her superiors who demanded that she change the results of her quality control unit's reports, the shy and conflict-avoidant Hunt had to decide who she should tell about the fraud, and how.

The case gives students the opportunity to recommend how Hunt should proceed based on their analysis of the stakeholders involved. To aid instructors, the case includes Kellogg-produced videos of Hunt—the only on-camera interviews she has ever given—explaining what happened after she reported the fraud to Citi HR and, later, the U.S. Department of Justice. Within the case, students are also briefly exposed to legislation and bodies pertinent to whistle-blowing in the United States, including the Dodd-Frank Act, the Sarbanes-Oxley Act, and the SEC Office of the Whistleblower.

This case won the 2014 competition for Outstanding Case on Anti-Corruption, supported by the Principles for Responsible Management Education (PRME), an initiative of the UN Global Compact.

• Analyze stakeholders' motivations to prepare counter-arguments to the resistance one might encounter when reporting unethical behavior

• Write a script for who to tell, how, and why

• Discuss how incentive structures, management, and culture play roles in promoting or hindering ethical behavior in organizations

• Identify behaviors that help a whistle-blower be effective

• Gain experience resolving ethical dilemmas in which two values may conflict, such as professional duty and personal ethics

Analyze stakeholders' motivations to prepare counter-arguments to the resistance one might encounter when reporting unethical behavior

Write a script for who to tell, how, and why

Discuss how incentive structures, management, and culture play roles in promoting or hindering ethical behavior in organizations

Identify behaviors that help a whistle-blower be effective

Gain experience resolving ethical dilemmas in which two values may conflict, such as professional duty and personal ethics

Gary Parr, deputy chairman of Lazard Freres & Co. and Kellogg class of 1980, could not believe his ears. “You can't mean that,” he said, reacting to the lowered bid given by Doug Braunstein, JP Morgan head of investment banking, for Parr's client, legendary investment bank Bear Stearns. Less than eighteen months after trading at an all-time high of $172.61 a share, Bear now had little choice but to accept Morgan's humiliating $2-per-share, Federal Reserve-sanctioned bailout offer. “I'll have to get back to you.” Hanging up the phone, Parr leaned back and gave an exhausted sigh. Rumors had swirled around Bear ever since two of its hedge funds imploded as a result of the subprime housing crisis, but time and again, the scrappy Bear appeared to have weathered the storm. Parr's efforts to find a capital infusion for the bank had resulted in lengthy discussions and marathon due diligence sessions, but one after another, potential investors had backed away, scared off in part by Bear's sizable mortgage holdings at a time when every bank on Wall Street was reducing its positions and taking massive write-downs in the asset class. In the past week, those rumors had reached a fever pitch, with financial analysts openly questioning Bear's ability to continue operations and its clients running for the exits. Now Sunday afternoon, it had already been a long weekend, and it would almost certainly be a long night, as the Fed-backed bailout of Bear would require onerous negotiations before Monday's market open. By morning, the eighty-five-year-old investment bank, which had survived the Great Depression, the savings and loan crisis, and the dot-com implosion, would cease to exist as an independent firm. Pausing briefly before calling CEO Alan Schwartz and the rest of Bear's board, Parr allowed himself a moment of reflection. How had it all happened?

An analysis of the fall of Bear Stearns facilitates an understanding of the difficulties affecting the entire investment banking industry: high leverage, overreliance on short-term financing, excessive risk taking on proprietary trading and asset management desks, and myopic senior management all contributed to the massive losses and loss of confidence. The impact on the global economy was of epic proportions.

In recent years Lehman Brothers, one of the five largest investment banks in the United States, had grown increasingly reliant on its fixed income trading and underwriting division, which served as the primary engine for its strong profit growth. The bank had also significantly increased its leverage over the same timeframe, going from a debt-to-equity ratio of 23.7x in 2003 to 35.2x in 2007. As leverage increased, the ongoing erosion of the mortgage-backed industry began to impact Lehman significantly and its stock price plummeted. Unfortunately, public outcry over taxpayer assumption of $29 billion in potential Bear losses made repeating such a move politically untenable. The surreal scene of potential buyers traipsing into an investment bank's headquarters over the weekend to consider various merger or spin-out scenarios repeated itself once again. This time, the Fed refused to back the failing bank's liabilities, attempting instead to play last-minute suitors Bank of America, HSBC, Nomura Securities, and Barclay's off each other, jawboning them by arguing that failing to step up to save Lehman would cause devastating counterparty runs on their own capital positions. The Fed's desperate attempts to arrange its second rescue of a major U.S. investment bank in six months failed when it refused to backstop losses from Lehman's toxic mortgage holdings. Complicating matters was Lehman's reliance on short-term repo loans to finance its balance sheet. Unfortunately, such loans required constant renewal by counterparties, who had grown increasingly nervous that Lehman would lose the ability to make good on its trades. With this sentiment swirling around Wall Street, Lehman was forced to announce the largest Chapter 11 filing in U.S. history, listing assets of $639 billion and liabilities of $768 billion. The second domino had fallen. It would not be the last.

This case covers the period from the sale of Bear Stearns to JP Morgan to the conversion into bank holding companies by Goldman Sachs and Morgan Stanley, including the Lehman Brothers bankruptcy and the sale of Merrill Lynch to Bank of America. The case explains the new global paradigm for the investment banking industry, including increased regulation, fewer competitors, lower leverage, reduced proprietary trading, and-potentially-reduced profits.

In August 2007 the Mainsail II SIV-Lite was frozen by its trustee as a result of the ongoing credit crisis. The state of Maine held $20 million of Mainsail commercial paper in its Cash Pool portfolio, a short-term portfolio that puts temporary, excess state revenues to work. When word of the potential loss became public, the Treasurer came under attack. The case introduces the functions of a state Treasury department, with particular emphasis on the investment objectives and guidelines for the cash pool as well as its composition. The case reviews the events leading up to and including August 2007, the month when the credit markets first began to seize and when the financial crisis effectively began. It examines securitization, structured finance, and the Mainsail SIV-Lite structure in some detail.

Hedge fund Magnetar Capital had returned 25 percent in 2007 with a strategy that posed significantly lower risk to investors than the S&P 500. Magnetar had made more than $1 billion in profit by noticing that the equity tranche of CDOs and CDO-derivative instruments were relatively mispriced. It took advantage of this anomaly by purchasing CDO equity and buying credit default swap (CDS) protection on tranches that were considered less risky. Now it was the job of Alec Litowitz, chairman and chief investment officer, to provide guidance to his team as they planned next year's strategy, evaluate and prioritize their ideas, and generate new ideas of his own. An ocean away, Ron Beller was contemplating some very different issues. Beller's firm, Peloton Partners LLP, had been one of the top-performing hedge funds in 2007, returning in excess of 80 percent. In late January 2008 Beller accepted two prestigious awards at a black-tie EuroHedge ceremony. A month later, his firm was bankrupt. Beller shorted the U.S. housing market before the subprime crisis hit, and was paid handsomely for his bet. After the crisis began, however, he believed that prices for highly rated mortgage securities were being unfairly punished, so he decided to go long AAA-rated securities backed by Alt-A mortgage loans (between prime and subprime), levered 9x. The trade moved against Peloton in a big way on February 14, 2008, causing $17 billion in losses and closure of the firm.

This case analyzes the strategies of the two hedge funds, focusing on how money can be made and lost during a financial crisis. The role of investment banks as lenders to hedge funds such as Peloton is explored, as well as characteristics of the CDO market and an array of both mortgage-related and credit protection-related instruments that were actively used (for better or worse) by hedge funds during the credit crisis of 2007 and 2008.

Business contracts are formed through negotiations, where the parties agree on some terms, disagree on others and keep yet others undecided. Over a period of time, they see themselves as having moved from being negotiating parties to contracting parties, settling on most of the terms. The law, however, states that a contract is formed when a person makes an offer and the other accepts it. The principle arose from the rudimentary trade practices in the past. The principles coming from the prior centuries and the modern business practices may not be in consonance. The Gibson v. Manchester City Council Case, a judgement of the House of Lords of the United Kingdom, reviewed attempts to modernize the law.

In January 2008, Citi and Merrill Lynch are trying to steer their ships back to calm waters. The new CEOs, Vikram Pandit (Citi) and John Thain (Merrill), have been at the helm of their companies for less than three months. This case focuses on their steps to counteract the massive losses resulting from their firms' investments in subprime-mortgage structures. What actions have these leaders taken thus far and what actions should they consider going forward? See also “Warren E. Buffett, 2008” (UVA-F-1550).

In the early months of the 2007-08 financial crises, a loan manager faces a real estate financing decision. Should he approve a bullet structure three-year loan to a longstanding client, a legendary Texan developer? The developer, who near retirement downsized his business, is seeking financing for his only project: residential or commercial development on an attractive piece of land in suburban Houston. The loan manager considers the decision in light of the mortgage market turmoil, seeing commercial projects as safer, but also factoring that the residential market could bring higher returns if the market stabilizes soon. The manager collects the data and asks an analyst to assess the risks; that ultimately requires assessing the economics of both projects from both the bank's and the developer's perspectives. The bank could still change the interest rate on the loan to receive adequate compensation for the risk it carries, but the loan manager knows that doing so will change their long-term client willingness to take on the loan.