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Fed, not Morgan Chase, bears risk of Bear Stearns bailout

Section: Daily Dispatches

Fed Races to Rescue Bear Stearns
In Bid to Steady Financial System

Storied Firm Sees
Stock Plunge 47%;
J.P. Morgan Steps In

By Kate Kelly, Greg Ip, and Robin Sidel
The Wall Street Journal
Saturday, March 15, 2008

Credit turmoil spread to the heart of the U.S. financial system as Bear Stearns Cos., an 85-year-old institution that has survived the Depression and two world wars, sought and received emergency funding backed by the federal government.

In an extraordinary move, the Federal Reserve and J.P. Morgan Chase & Co. stepped in to keep Bear afloat following a severe cash crunch.

The maneuver signaled that the Fed was trying to move aggressively to prevent Bear's crisis from spreading to the broader economy. But it seemed to do little to soothe fears. Bear's shares fell 47% to a nine-year low of $30 in New York Stock Exchange composite trading at 4 p.m. The Bear crisis, coming on the heels of this week's implosion of a publicly held affiliate of Carlyle Group, further rattled Wall Street. The Dow Jones Industrial Average fell nearly 195 points.

The lifeline gives Bear access to cash for an initial period of 28 days. J.P. Morgan will borrow the money from the Fed and relend it to Bear. Exact terms weren't disclosed, but the amount is limited only by how much collateral Bear can provide, Fed officials said.

The Fed, not J.P. Morgan, is bearing the risk of the loan. It is the first time since the Great Depression that the Fed has lent in this fashion to any entity other than a bank.

Some Wall Street executives said they thought Bear was likely to be sold, in whole or piecemeal, in a matter of days, to prevent it from going under. Bear, the fifth-largest investment bank, said it has retained investment bank Lazard to weigh alternatives. Those alternatives "can run the gamut," Bear Chief Executive Alan Schwartz said in a conference call.

Possible buyers, according to a person close to Bear, include J.P. Morgan and hedge fund Citadel Investment Group, which recently bought a big stake in online brokerage firm E*Trade Financial Corp. Private-equity firms also are expected to take a look at Bear, possibly including J.C. Flowers & Co.

Yesterday's developments were the latest in a series of blows to the financial system that began in August. Then, banks became so wary of lending to each other that money markets seized up and the world's central banks had to intervene. The trigger was a surge in delinquencies on U.S. subprime mortgages and the end to a spectacular rise in home prices.

But the turmoil has spread since to almost every corner of the credit markets. "The realization that mortgages might not be paid off led lenders to realize that other loans might not be paid off," said Douglas Elmendorft, a former Fed economist.

The pervasiveness of the financial problems and the risks to the economy became increasingly apparent at the beginning of the year. That led the Fed to cut short-term rates by 1.25 percentage points in 10 days, and the Bush White House and Democratic Congress -- usually unable to agree on anything -- to approve a large fiscal stimulus.

After initial relief, credit markets have taken a turn for the worse in recent weeks, breeding an every-man-for-himself attitude among Wall Street firms. With each firm intricately intertwined with others in a maze of loans, credit lines, derivatives, and swaps, the Fed and Treasury agreed that letting Bear Stearns collapse quickly was a risk not worth taking, because the consequences were simply unknowable.

Morale among Bear's 14,000 employees, already flagging from days of speculation that the firm was in trouble, sank Friday morning. As they learned of the emergency funding, some called their spouses, warning that they could soon be out of a job, one employee said. Employees have been barred from trading the shares because of longstanding "lockups" weeks prior to the company's earnings announcements.

Shortly after 10:30 a.m., a recorded video message from CEO Mr. Schwartz was broadcast to employees. Hundreds gathered in the mortgage-securities trading area on the seventh floor of the firm's Madison Avenue headquarters in New York. Mr. Schwartz, CEO for only two months, said he was disappointed but employees should try not to lose heart.

Alan "Ace" Greenberg, the 80-year-old chairman of Bear's executive committee -- and the man credited with building the firm into a power during the 1980s and early 1990s -- tried to keep up appearances. A few minutes after noon, he left his trading-floor office and went upstairs to the 12th floor for his usual lunch in Bear's dining room. Asked early in the afternoon how his spirits were, he said, "I feel fine." He declined to answer further questions.

Bear's situation echoed in some ways that at British mortgage lender Northern Rock PLC, which in September became the target of the U.K.'s first bank run in more than a century, after the Bank of England stepped in with an emergency line of credit.

"At Northern Rock, it was depositors running. At Bear Stearns, it was counterparties" -- the parties a financial firm trades with -- said Tim Bond, a Barclays Capital strategist. In Northern Rock's case, the firm's problems only grew after it got a central-bank bailout, because of the effect on customers' confidence in the firm. Ultimately, the U.K. nationalized the lender.

Bear, although not one of the giants of Wall Street, long had a reputation as one of the most astute risk managers. It has a large mortgage business, but its mix of other businesses is less diverse than those of investment-banking rivals. That profile hurt Bear when the subprime-mortgage problems developed last spring. Two of Bear's mortgage-related hedge funds collapsed in July, costing investors more than $1 billion and worsening the credit crunch then developing.

Longtime CEO James Cayne, who was seen by some investors as too hands-off when the mortgage mess unfolded, stepped down in January, though he remained chairman. His successor, Mr. Schwartz, has been trying to rally Bear. But another downturn in the credit markets in the past couple of weeks fed nagging fears that Bear wasn't financially strong enough.

Word began to spread among fixed-income traders nine days ago that European banks had stopped trading with Bear. Some U.S. fixed-income and stock traders began doing the same on Monday, pulling their cash from Bear for fear it could get locked up if there was a bankruptcy.

That development put firms that still wanted to do business with Bear in a tough position: If Bear did fail, they would have to explain to their clients why they ignored the rumors. On Tuesday, a major asset-management company stopped trading with Bear.

On Thursday, an article in The Wall Street Journal13 reported that firms were growing cautious about their dealings with Bear. The exit by counterparties intensified. Bear executives spent most of this week fielding nervous calls and trying to put to rest rumors of banks being unwilling to trade with Bear and about Bear facing requests for more collateral on loans.

On Monday, Bear issued a statement in which Mr. Schwartz wrote that the firm's "balance sheet, liquidity, and capital remain strong." On Wednesday, he ducked out of a Bear media conference in Palm Beach, Fla., for a CNBC interview in another effort to deflect speculation about Bear's situation.

But by Thursday afternoon, it was becoming clear within Bear that the firm couldn't withstand an accelerating retreat by worried customers -- in effect, a run on the bank. Securities firms that had been willing to accept collateral from Bear Stearns were insisting on cash instead. And the hedge funds that use Bear to borrow money and clear trades were withdrawing cash from their accounts. Around 4:30 p.m. Mr. Schwartz was convinced that Bear was facing a desperate situation.

He huddled with Chief Financial Officer Samuel Molinaro, Chief Risk Officer Michael Alix and Bear lawyers, debating what to do next, said people familiar with the discussions. The group convened a conference call with the board to discuss options. Mr. Cayne dialed in from Detroit, where he was playing in a bridge tournament, say people familiar with the matter.

Some time after 6 p.m., Mr. Schwartz called James Dimon, CEO of J.P. Morgan, the second-largest U.S. bank in stock-market value. J.P. Morgan's risk officers were familiar with Bear's collateral because J.P. Morgan was the clearing agent for its trades; thus, J.P. Morgan seemed to be in good position to lend Bear money, say people familiar with Mr. Schwartz's thinking.

Mr. Dimon sprang into action. He got on the phone with Steve Black, co-head of J.P. Morgan's investment bank, on vacation in the Caribbean. The group had a number of conversations with Fed representatives, concluding that something needed to be done for Bear, in part because a failure of the firm could have wide consequences.

By 7:30 p.m. Thursday, when it became clear Bear had not managed to secure necessary financing or a strategic deal, Fed officials began to realize they might have to step in.

The Fed each day lends money to its 20 "primary dealers," including Bear, through its money-market "repo" operations, which provide funding for one to 28 days to influence the level of interest rates. But those operations don't permit the Fed to advance much money to Bear by itself, and the loans must be secured by the highest-quality collateral, which is now in short supply.

The Fed can lend directly through its "discount window," but ordinarily only to commercial banks. A 1932 provision of the Federal Reserve Act allows the Fed to lend to non-banks if at least five of its seven governors approve. That provision was last regularly used during the Great Depression. It is meant to underscore that the central bank should lend to nonbanks only in extreme circumstances.

"I would be very cautious about opening that window up" to investment banks, Fed Vice Chairman Donald Kohn told Congress on March 4. Commercial banks get the access because they are subject to extensive federal supervision.

On a conference call at 7:30 p.m. Thursday, officials from the Securities and Exchange Commission and Bear disclosed to the Fed that Bear had lost far more of its liquidity that day than it had realized. A team of examiners from the Fed spent the night at Bear.

At about 5 a.m. Friday, regulators including New York Fed Chief Timothy Geithner, Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson, and the Treasury undersecretary for domestic finance, Robert Steel, convened by conference call. At the end of the call at 7 a.m. the Fed had decided it would offer the loan. Mr. Paulson called and briefed President Bush, who was due to speak on the economy in New York. The Fed, with two governors' seats vacant and one governor overseas and unreachable, invoked a special legal clause to approve the loan with just four governors.

For Fed officials it was a difficult choice. They did not want to single Bear out for help and they realized their actions aggravated "moral hazard" -- the tendency of bailouts to encourage future risky behavior. But the alternative was potentially far worse. Bear risked defaulting on extensive "repo" loans, in which it pledges securities as collateral for overnight loans from money-market funds. If that happened, other securities dealers would see access to repo loans become more restrictive. The pledged securities behind those loans could be dumped in a fire sale, deepening the plunge in securities prices.

By 7 a.m. Friday the New York Federal Reserve Bank had agreed that it would provide financing to Bear Stearns via J.P. Morgan Chase. J.P. Morgan Chase was used as a conduit because, as a commercial bank, it already has access to the Fed's discount window, is under the Fed's supervisory authority, is Bear's clearing bank, and knows Bear well from a previous discussion of a possible strategic tie-up.

Thus, technically the Fed still hasn't lent directly to investment banks. But the central bank has explicitly assumed the risk of the loan. If Bear fails and the collateral it posts is insufficient to cover the loan, the Fed will sustain a loss. Officials say there is no preset maximum amount of the loan, other than how much collateral Bear is able to provide to meet the Fed's requirements.

At 9 a.m. Friday, Mr. Geithner; Mr. Paulson; Erik Sirri, head of market regulation at the SEC; and Messrs. Schwartz and Dimon held a conference call with representatives from Bank of New York Mellon and the Wall Street securities firms. Mr. Paulson said all had a stake in making the effort work.

The role of J.P. Morgan as Bear's savior is somewhat paradoxical, considering the recent tense relationship between the two firms. J.P. Morgan was one of several lenders that played a role in Bear's troubles last summer when J.P. Morgan demanded more collateral from one of Bear's struggling hedge funds. There was a heated conversation between Mr. Black, co-head of J.P. Morgan's investment bank, and Mr. Spector, then Bear's co-president, over Bear's reluctance to bail out the hedge fund. J.P. Morgan ultimately served Bear with a default notice on a loan to Bear.

Prosecutors in the U.S. attorney's office for the Eastern District of New York, based in Brooklyn, are investigating whether the funds' managers misled investors in a way that constitutes fraud.

In addition to being a Bear creditor, J.P. Morgan is a regular trading partner with Bear and therefore could be on the hook for big losses if Bear fails.

Last fall, J.P. Morgan played a leading role in a Treasury-backed effort to thaw frozen credit markets by creating a "superfund" for certain off-balance-sheet investment vehicles that were struggling. Ultimately, the owners of those investment vehicles resolved the problems on their own.

The role of rescuer has long been part of J.P. Morgan's history. In what's known as the Panic of 1907, a semi-retired J. Pierpont Morgan helped stave off a national financial crisis when he helped to shore up a number of banks that had seen a run on their deposits. And when the New York Stock Exchange was close to running out of cash, the financier raised $25 million -- supposedly in 10 minutes -- that kept the exchange in business.

Some 80 years later the bank played a similar role when it helped organize a government-backed bailout of Chicago's Continental Illinois, a bank sagging under a mountain of bad loans.

J.P. Morgan has been on the prowl for acquisitions. Although it is thought to be most interested in a large regional bank, Bear's assets could be too good, and too cheap, to turn down.

J.P. Morgan might also be interested in buying just Bear's prime brokerage business, a key Wall Street business -- used by hedge funds to borrow money and clear trades -- that J.P. Morgan doesn't now have. The Bear unit has a good reputation but has suffered from a loss of cash balances in recent months.

Rating agencies cut their credit ratings on Bear. Moody's rating is now three levels above junk; S&P's and Fitch's ratings are two above junk.

The immediate capital infusion isn't likely to restore enough confidence in Bear to stop the exodus. Robert Sloan, a managing partner of New York-based S3 Partners LLC, a financing specialist for hedge funds, said that two of them on Friday pulled whatever money of theirs still remained in Bear's prime-brokerage operation. "Once Bear started to come out with 'Hey, this is why we're OK, this is why we're still liquid, and you should keep your assets here,' they were basically telling you to move your business," Mr. Sloan said.

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