Bear Stearns is Causing More Trouble - Subprime Woes Continue

Bear Stearns on Saturday, March 15, 2008 was down by more than 47 percent having rocketed from a weak $57 per share to an abysmal $30 per share evidencing a 27 point loss in equity value with a huge loss of $1.5 billion having been reported for 2007. What happened?

Bear Sterns is predominantly an investment bank as opposed to a commercial bank. Much of Bear Stearns' market expertise is in the mortgage market and much of the mortgage market has recently been comprised of subprime mortgages that are now critical to the housing market collapse ala rampant mortgage foreclosures, which is all integral to the current credit crisis.

It was two Bear Stearns hedge funds, which were heavily invested in subprime mortgages, that caused the mortgage market panic that began in 2007 and is still having repercussions among home owners today via foreclosures. Hedge funds are high risk instruments that are added to some investment portfolios to temper the risk of loss of other kinds of investment instruments. In this case, the risks didn't pay off as the subprime market came crashing down in a way reminiscent of the junk bond market collapse fostered by Drexel at the end of the 20th century.

So what happened? Mortgages were sold at subprime rates during a time of easy money with low interest rates. The prime interest rate is the rate that banks charge their most trustworthy clients such as well funded corporations; subprime rates are rates below the prime rate and were given to the bank's least trustworthy clients to encourage home purchases, which boosted up the real estate market. Banking institutions with a high percentage of subprime mortgages, or funds invested in subprime mortgages, lost money when these subprime mortgages began to go into default. Bear Stearns lost $854 million in the fourth quarter of 2007 alone, which is why Bear sought to attain funding through a stock trade-off with China's Citic Securities late in 2007. But Bear was in good company as Merrill, Morgan Stanley and Citigroup were among others that lost phenomenal amounts on subprime investments as well.

Now, after Bear Stearns' huge losses (the counterpoint of their $1.1 billion profits of 2006) they have been having trouble keeping their daily operations financed. This is what precipitated a phone call Thursday evening, March 13, from Bear's chief executive officer Alan D. Schwartz to JPMorgan Chase's CEO James Dimon during which Schwartz asked for an emergency bail-out in order to keep day-to-day transactions from defaulting. Without a bail-out from someone, Bear could have been the casualty of a full fledged bank run, in fact, the New York Times reported that there was "what amounted to a bank run" on Thursday.

JPMorgan exercised the option of calling in the Federal Reserve Board in the person of Timothy F. Geithner, president of the New York Federal Reserve. A deal was negotiated whereby JPMorgan, essentially a commercial bank, would borrow from the Fed's discount-window and loan it to Bear Stearns with the onus of the risk ultimately lying with the Federal Reserve and not JPMorgan. Since Standard & Poor's had dropped Bear's short-term rating from A-3 to A-1 (and the long-term rating from A to BBB), Bear would have had a difficult time borrowing money directly in the money markets.

Investments banks are not subject to the Federal Reserve Board requirements pertaining to reserves as are commercial banks because investment banks do not hold customer deposits. Since deregulation in 1999 through the repeal of the Glass-Steagall Act, distinctions between commercial and investment banks are a little harder to clarify. It is because of this fuzziness that JPMorgan and the Fed could negotiate a temporary plan to rescue Bear giving them 28 days to find a permanent solution to their liquidity problem.

The permanent solution turned out to be the sale of the 85 year old investment bank of Bear Stearns, founded in 1923, to one of the interested parties that had been hovering around Bear's threshold. On Monday March 17, the announcement came out that the prize went to the front running contender for the Bear buy-out, JPMorgan Chase itself. Rumors of this had been reported in Sunday morning editions of international newspapers. As stated by Investor Guide, only time will tell what this soultion will mean to the stock market and to the current credit crisis. No new panic selling was wittnessed on Monday following the initial plunge of another 200 points off the Dow at the market start. Along with JPMorgan's purchase of Bear at $2 a share, the Federal Reserve on Sunday, March 16 made the surprising move of cutting its discount rate (for money lent by the Fed to banks) and offering to loan money to a new list of companies. If Bear Stearn had defaulted on any obligations, the repercussions for the economy could have been enormous. JPMorgan and the Fed acted quickly to prevent what could have amounted to a run on the world's major financial companies but how will this effect the world stock markets over time?

References:
http://www.investorguide.com/browse2.cgi?id=18068
http://www.nytimes.com/2008/03/15/business/15bear.html?_r=1&th&emc=th&oref=slogin
http://topics.nytimes.com/top/news/business/companies/bear_stearns_companies/index.html?inline=nyt-org
http://news.xinhuanet.com/english/2008-03/16/content_7798336.ht
http://www.investorguide.com/story.htm?guid={43265631-1656-4697-8377-55F05D859B76}&siteid=ADD57DEB-C347-41BB-AE1B-319007791BCB&exstyle=t&