US Federal Reserve bails out Bear Stearns

Stephen Foley
Saturday 15 March 2008 01:00

The Federal Reserve, the US central bank, is leading a desperate struggle to prop up one of Wall Street's largest and most historic investment banks, as the credit crisis threatened to spiral into a full-blown banking crisis.

In a day of developments that rocked the world's financial markets, the Fed said it and rival Wall Street bank JPMorgan Chase had begun funnelling emergency loans to Bear Stearns, whose exposure to the battered credit markets had led to a crisis of confidence in its ability to keep trading.

Clients and trading partners have been pulling their business from Bear Stearns in accelerating numbers since rumours about its solvency began circulating earlier this week, it became clear. And in a rushed conference call with investors yesterday afternoon, the company's management warned that its emergency lending facility with the Fed had so far failed to staunch the bleeding.

"We have been subject to a significant amount of rumour and innuendo in the past week," said Alan Schwartz, its chief exec-utive. "We attempted to provide some facts, but in the market environment the rumours intensified and a lot of people wanted to act to protect themselves first from the possibility that the rumours were true, and wait till later for the facts."

Bear Stearns has appeared the most fragile of Wall Street's major investment banks since the collapse of two internal hedge funds last July provided the first clues about the scale of the credit crisis that was beginning to unfold. But shares across the banking sector plunged on yesterday's developments as analysts feared that the Fed's willingness to intervene suggested that Bear's future was pivotal to the banking system, and that its failure could cause losses to cascade through its trading partners. Bear Stearns shares went into freefall, closing down 47 per cent.

A problem that began with rising defaults on low-quality mortgages has spread like a virus through the credit markets, and financial institutions have become increasingly reluctant to risk trading with each other while the value of the complex derivatives on their books remains so opaque.

Mr Schwartz said Bear Stearns had appointed Lazard to explore options for its future, in effect putting itself up for sale, and it was looking increasingly likely last night that a history stretching back 85 years could end with the company being broken up or swallowed piecemeal by JP Morgan. The crisis had already cost Mr Schwartz's predecessor, Jimmy Cayne, his job as chief executive.

The company said it was bringing forward its financial results to Monday so it could provide early details of its financial situation, and to answer analysts' questions about the scale of its exposure to risky mortgage derivatives, one of the largest on Wall Street.

Mr Schwartz described the emergency loan facility from the Fed and JPMorgan as "a bridge to a more permanent solution", but conceded that the withdrawal of financing by Bear Stearns' trading partners was continuing yesterday lunchtime and was "not materially different to what we have been dealing with during the week", despite the Fed's move.

Bob McDowall, the senior analyst at the financial sector research firm Tower Group, said: "This situation demonstrates what a loss of confidence in an investment bank can do to its ability to operate. These firms need capital and financing capabilities to run their business, and without the confidence of their trading partners, they come to a screeching halt."

Bear Stearns is unable to go directly to the Fed, the US economy's "lender of last resort", because it is an investment bank, not a commerical bank. Instead, funds from the central bank's "discount window" – which carry a punitive interest rate half a percentage point above the Fed's main rate – will be secured on Bear's collateral but channelled through JPMorgan. In a statement an hour before the New York Stock Exchange opened yesterday morning, JPMorgan said that "in conjunction with the Federal Reserve Bank of New York, it has agreed to provide secured funding to Bear Stearns, as necessary, for an initial period of up to 28 days [and] is working closely with Bear Stearns".

The Fed said it would provide liquidity to the financial markets "as necessary", leaving open the question of how much it might ultimately lend to try to prop up Bear Stearns, the fifth largest investment bank in the US.

Analysts said that Bear Stearns' position in the credit markets was too big for the Fed to allow it to fail. Pierre Ellis at Decision Economics, in New York, said: "Clearly the Fed is addressing what they feel is a systemic risk very aggressively."

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