The $2 Bail-out

The wreck and rescue of America's fifth-biggest Wall Street bank.
Economist StaffMarch 21, 2008

As pranks go, it oozed vitriol. On March 17th, while employees at Bear Stearns were coming to terms with the implosion of their once-venerable investment bank, one of them stuck a $2 note to the revolving doors of the firm’s midtown-Manhattan headquarters. That was the amount, per share, that Bear had fetched in a fire sale to JPMorgan Chase a day earlier, when the Federal Reserve was rushing to secure a deal before the markets opened on Monday. A year ago the shares had topped $170.

Now that the credit crisis has hit at the heart of Wall Street, policymakers are meeting the threat of catastrophe with some extraordinary manoeuvres. On March 18th the Fed slashed interest rates by 75 basis points, adding to big cuts over recent months. It is also ripping up its rulebook on financing troubled institutions. As the takeover of Bear was being finalised, it extended lending through its discount window, usually reserved for commercial banks, to all bond dealers; for the first time, investment banks have a lender of last resort (though too late for Bear, alas). All this underlines how what began as a seemingly containable problem in one part of the mortgage market now threatens the integrity of America’s financial system. One day, the Fed will make Wall Street pay for its support—possibly through far stronger oversight.

The frenzy highlights another big change. Thanks to rampant innovation, particularly in futures, options and swaps, regulators must worry not only about those banks that are too big to fail, but also about middle-sized outfits with tentacles that wind through the derivative markets. Measured by assets, Bear is not that big. But with positions in credit-default and interest-rate swaps worth a notional $10 trillion, the idea of its sudden collapse was chilling—and nobody wanted to put that foreboding to the test. Aptly, although the Fed’s rescue is no bail-out of Bear, it does set out to save the system.

Bear, the smallest of the big five Wall Street investment banks, was the most exposed to the toxic mortgage market. It had been in trouble since two of its hedge funds collapsed last summer. Regulators had been frustrated that the bank was working less hard than its peers to shore up its funding. Nevertheless, the speed of its demise was shocking. Clients withdrew $17 billion in two days last week, after rumours swirled that other banks were refusing to step into clients’ shoes as counterparties in derivatives trades. The Fed moved in with emergency funding, using JPMorgan Chase, Bear’s clearing bank, as a conduit. But it was clear that no one would want to do business with a bank reliant on 28-day loans from the central bank. With Bear facing bankruptcy if it could not find a quick buyer, JPMorgan opened its arms.

At $236m, the deal looks like a steal for Jamie Dimon, JPMorgan’s canny boss—and reward for keeping his bank relatively stable as others have stumbled.

Bear’s swanky headquarters alone is worth six times that. To smooth the deal, the Fed is taking the unprecedented (and, some say, disturbing) step of financing up to $30 billion of Bear’s weakest assets. This could cost the central bank several billion dollars if those assets fall in value.

Tellingly, JPMorgan’s shares rose sharply the day after the takeover, even as other financials tumbled. The $14 billion added to its stockmarket value was Bear’s true worth, said cynics. Brad Hintz, an analyst at Alliance Bernstein, puts the break-up value of Bear’s good bits at $7.7 billion. Around $3 billion comes from its prime-broking business, which finances hedge funds’ trading, and which Mr Dimon has wanted to get into for some time.

But the deal carries risks. JPMorgan has pledged to honour all of Bear’s commitments, despite having had only two days for due diligence. Bear’s gross mortgage exposure is still likely to be well over $10 billion after the Fed guarantees the least liquid stuff. And the bank faces piles of lawsuits over the hedge-fund collapses and, now, a takeover that wipes out almost all its perceived value. JPMorgan puts the costs associated with the deal at some $6 billion (though it clearly has an interest in overestimating them). Moreover, Mr Dimon has to weave the two banks together, in an industry with a terrible record on mergers.

JPMorgan’s motivation is not purely opportunistic. As the biggest dealer in credit derivatives, it was heavily exposed to Bear. Had the bank gone bust, it would have led to huge uncertainty, and large potential losses, on a variety of contracts.

Investment banks are particularly vulnerable to credit-market turmoil, because they rely on funding not from depositors but from wholesale markets, much of it short-term. Understandably, the other big Wall Street firms—Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley—portray Bear as an outlier when it comes to this “liquidity risk”. Its mix of businesses was less diverse and it relied more heavily on overnight funding in repurchase, or repo, markets, in which dealers sell securities to investors then buy them back the next day for slightly more, with the difference being the interest. This vast, $4.5 trillion market usually functions like clockwork, but has come under strain in recent weeks. As doubts grew, Bear was in effect shut out.

Could the same happen to a competitor? All of them felt funding pressure this week. Merrill, which has had to swallow enormous mortgage-related write-downs, is seen by some as vulnerable. But Lehman, the fourth-largest Wall Street bank—and, like Bear, big in mortgage-backed securities—is top of many worry lists. It is going to great lengths to avoid a similar fate, providing unprecedented detail on its levels of cash and reassuring nervous counterparties. Senior managers are sweet-talking supervisors at other firms where traders are reluctant to deal with Lehman. Dick Fuld, Lehman’s boss, cut short a trip to India to manage the crisis.

The hope is that the investment banks are safer now that they have emergency funding, thanks to the Fed, which will take a range of securities from them as collateral. And on one measure at least, Lehman’s liquidity looks stronger than that of its peers. On March 14th the bank secured a $2 billion, three-year facility with a group of banks. It also says that its holding company has $64 billion of “unencumbered” assets that can be used as collateral to generate cash.

There is much at stake. The new Fed window is untested and the very act of drawing on it could rattle markets. The fear is that if Lehman suffers a Bear-style run, funding will dry up across Wall Street. “If Lehman goes there are no sacred cows,” says a rival. Just in case, others are busily touting numbers that put them in a positive light. Morgan Stanley, for instance, says it has cut its use of repos sharply, to 15.6% of total funding, and that it now has 45% more accessible cash than it did last year. Goldman, too, has reduced its reliance on overnight funding. Across Wall Street, long-term funding has doubled since 2004, to around $800 billion.

Though all this may be reassuring, the nature of liquidity in today’s ready-cash funding model of investment banking is that it is strong until it suddenly is not. Only a few days before Bear’s desiccation, remember, some analysts embarrassingly pointed out that it had enough liquid assets and borrowing capacity to keep it going for almost two years. Hank Calenti of RBC Capital Markets thinks that, at the Fed’s urging, “shotgun weddings” for Lehman and Merrill could be in the planning stages, in case of emergency.

This explains the palpable relief when, on March 18th, both Lehman and Goldman posted first-quarter results that were less bad than feared. Net income dropped by 57% and 53%, respectively, thanks to write-downs of around $2 billion each, but there were no nasty surprises. Share prices stormed ahead on the news, with the financial shares in the S&P 500 gaining 8.5%.

The outlook remains bleak, however. By one estimate, banks will write off a further $50 billion of degraded inventory this quarter. If they are more tightly regulated, they could have less scope to make profits. Using tangible book value as a yardstick, Meredith Whitney of Oppenheimer concludes that financial shares are due a further fall of up to 50%. With house prices still falling, credit deterioration spreading and derivatives markets deeply unsettled, is anyone willing to bet that Bear Stearns is the last of the $2 sales?