Crises of Confidence in the Markets
Federal Reserve's Rescue of Bear Stearns Exposes Cracks in Financial
System
By David Cho and Neil Irwin
Wa****ngton Post Staff Writers
Tuesday, March 18, 2008; A01
Investors dumped stocks of the nation's major investment firms
yesterday after a rescue plan for one of the biggest, Bear Stearns,
exposed unexpectedly large cracks in the foundation of the financial
system.
Even after the Federal Reserve on Sunday night offered an
unprecedented credit line to investment banks, their shares plummeted.
Lehman Brothers was down 19 percent. Europe's largest bank, UBS, which
has recorded huge losses from mortgage investments like those at its
U.S. counterparts, suffered its sharpest drop in European trading in
nearly 10 years.
U.S. currency traders launched a furious sell-off of the dollar
immediately after the Fed acted Sunday, some staying up all night on
concerns, they said, that major U.S. bank failures could be on the
horizon. Major stock market indicators swung wildly, with the Standard
and Poor's 500-stock index falling as much as 2.4 percent but ending
0.9 percent lower. The Dow Jones industrial average rebounded from
early losses, fini****ng up about 0.2 percent on the strength of J.P.
Morgan Chase, which has agreed to purchase Bear Stearns for a fire-
sale price.
President Bush said his administration is "on top of the situation" in
dealing with the slumping economy, praising the Fed for its steps.
"One thing is for certain -- we're in challenging times. But another
thing is for certain -- that we've taken strong and decisive action,"
he told re****ters after meeting with Treasury Secretary Henry M.
Paulson Jr. and other economic advisers.
But critics accused Bush of bailing out big Wall Street firms while
ignoring ordinary homeowners.
The wild ride came after the Fed offered Bear Stearns a financial
lifeline but demanded control over the bank's fate in return for
keeping it out of bankruptcy. The arrangement, which involved J.P.
Morgan agreeing to buy Bear Stearns for only $2 a share, signaled that
investment banks may be even more vulnerable than had been previously
known. Bear Stearns shares closed at $30 on Friday.
"Bear Stearns's demise should probably be viewed as the first of
many," Richard Bernstein, chief investment strategist for Merrill
Lynch wrote in a research re****t. "Sentiment is just beginning to
catch on as to how broad and deep the credit market bubble has been."
Just a week ago, top Treasury officials said they opposed any plan
that put taxpayer dollars at risk by buying up troubled mortgage
securities or bailing out investment firms. But when these officials
examined Bear Stearns's books, they discovered the bank was
essentially out of cash and urgently decided to back the Fed taking on
these securities to save the banks.
"Last week, the position of the Bush administration was to let markets
correct themselves and to allow no bailouts and no subsidies," said
William W. Beach, senior fellow of economics at the Heritage
Foundation. "Somewhere over the last four days, that policy changed.
They discovered the rules of the road just didn't apply."
Paulson bristled at the notion that the Fed had bailed out big banks,
telling re****ters: "If you would ask the Bear Stearns shareholder in
terms of what has happened to their value, then I don't think any of
them would think that this has been a good outcome for them."
The Bear Stearns debacle has revealed a central reality of Wall
Street: Investment firms live and die on confidence.
Bear Stearns made most of its money by providing loans and services to
hedge funds so they could make massive investments. Bear Stearns's
clients include some of Wall Street's top investors, such as George
Soros, the billionaire hedge fund manager.
Like many investment banks, the firm relied on short-term loans from
money market mutual funds and other lenders to pay off its obligations
to its customers. But as it incurred huge losses on its holdings of
mortgage-related securities, the lenders lost faith in Bear Stearns.
Cash ran dry.
Bear Stearns would have had to file for bankruptcy Friday morning but
for an unusual emergency loan from the Fed. Leaders of the central
bank told Bear Stearns that by taking government money, the bank would
be ceding control of its own fate. They didn't want Bear Stearns to
accept government money, make risky investments and leave the
government holding the bag if these investments failed.
Throughout that day, things went from bad to worse. Bear Stearns
customers started abandoning the company: Investors who had brokerage
accounts canceled them, hedge funds that relied on Bear Stearns to
execute transactions looked elsewhere, and the Fortune 500 companies
that relied on it for advice on mergers and acquisitions ran from its
tainted name.
A bankruptcy at Bear Stearns would have led to big losses by the money
market mutual funds and other investors who lent it money. It also
would have triggered a sell-off of its mortgage securities, depressing
prices across the market. Because nearly all investment funds and
financial firms hold similar securities, that would have caused losses
across the banking system.
So Fed leaders pressed Bear Stearns executives to sell the firm to a
buyer who could take over the company's liabilities immediately, while
avoiding new strains in the market. Bear Stearns executives huddled
with their advisers, investment banking firm Lazard Freres, in
conference rooms at their Madison Avenue headquarters through the
weekend, considering offers from various bidders.
By Sunday, it became clear there was only one bidder that could pull
off the deal quickly enough to prevent a disruption to world markets.
With no other serious options, Bear Stearns accepted a low-ball offer
from J.P. Morgan.
Because J.P. Morgan was unwilling to take the risk of about $30
billion worth of assets on Bear Stearns's books, in particular bonds
linked to troubled mortgages, the Fed agreed to guarantee those
securities. The central bank was eager for the deal to close before
the Asian markets opened yesterday.
Any profit from the sale of these assets would go to the federal
government. But if there is a loss, tax payers would be on the hook.
Fed leaders estimate the gain or loss would be no more than a few
billion dollars in either direction, depending on how financial
markets fare in the coming months.
Some analysts have argued that Bear Stearns investors took a bath on
the deal, given that J.P. Morgan is purchasing a business that was
worth $8 billion on Thursday for only $236 million. But J.P. Morgan is
also taking on Bear Stearns's massive debts and the risk of
shareholder lawsuits and government investigations, which could cost
billions of dollars.
The acquisition of Bear Stearns is not a done deal because it still
needs the approval of shareholders. Some are already expressing their
unhappiness. An institutional shareholder called Eastside Holding
filed a lawsuit yesterday in Manhattan federal court, claiming the
bank misled investors about its finances.
Leaders of the Fed and the Treasury said they were pleased by how the
U.S. financial markets responded yesterday. Part of the reason may
have been the decision by the Fed on Sunday to make billions of
dollars available in short-term loans to investment banks, an option
ordinarily available just to commercial banks.
"There's been a lot of focus on Bear Stearns," Paulson said. "But the
Fed took, I believe, dramatic and very im****tant, powerful action to
make liquidity available to . . . the investment banks."
The Fed is closely watching whether its weekend actions successfully
restore investor confidence in other major investment firms. A crucial
test of market reaction comes today when Lehman Brothers and Goldman
Sachs, two of Bear Stearns's rivals, re****t their quarterly earnings.
"Lehman may have to follow Bear into the confessional before Good
Friday,'' Michael McCarty, an options strategist at Meridian Equity
Partners in New York, said during an interview with Bloomberg
Television on Friday.
Other financial analysts said they worried the federal government was
setting a precedent of pledging tax payer money to bail out private
investment houses.
"How do you convince people in the market that this is a one-time
deal, you're never going to do it again, you're swearing off demon rum
and you're going to stay on the wagon in future?" asked Daniel J.
Mitchell, a senior fellow at the Cato Institute. "Capitalism without
losses is like religion without hell."
----
Staff writers Jeffrey H. Birnbaum, Dan Eggen and Lori Montgomery and
researcher Richard Drezen contributed to this re****t.
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