Wash. Post: Collapse just beginning


Richard Moore

"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 
report. "Sentiment is just beginning to catch on as to how broad and deep the 
credit market bubble has been."


[links in original]

Crises of Confidence in the Markets

Federal Reserve's Rescue of Bear Stearns Exposes Cracks in Financial System

By David Cho and Neil Irwin
Washington 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, finishing 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 reporters 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 

"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 
report. "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 
reporters: "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 

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 

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 important, 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, report 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 report.

© 2008 The Washington Post Company

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