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Bear Stearns’ Friday Stumble, Sunday Sale Reignites Concerns About More Failures in U.S. Financial Sector

By , Money Morning •

By Jennifer Yousfi
Managing Editor

Just days after Standard and Poor’s said the U.S. financial sector was through the worst of the subprime crisis, Friday’s near collapse of The Bear Stearns Cos. Inc. (BSC) has re-ignited credit fears and could cause investors to question the future of the four other major U.S. investment banks.

“Even though Bear was probably on the fringe, pushing the envelope anyway, traders are saying that because it happened, it could happen to somebody else,” Brandon Thomas, chief investment officer for Portfolio Management Consultants, the investment arm of Envestnet Asset Management, told CNNMoney.com.

Just one day after leading credit-rating agency Standard & Poor's (MHP) said that “the end of write-downs is now in sight for large financial institutions,” a collapse in investor sentiment on Friday sent Bear Stearns shares spinning downward by $27 each – or 47.4% – to close at $30, leaving the investment bank on the bring of collapse. That forced Bear to seek emergency funding from JPMorgan Chase & Co. (JPM) and the New York Federal Reserve – an arrangement that’s only intended to buy Bear time to work out a more-complete bailout plan, one that might even include an outright sale.

The sale possibility became a reality yesterday (Sunday) when the U.S. Federal Reserve approved a financing arrangement in which JPMorgan will acquire Bear Stearns in a deal that’s valued at $236.2 million.

The Fed also agreed to fund up to $30 billion of Bear Stearns’ less-liquid assets. U.S. Treasury Secretary Henry Paulson said he believes the moves made yesterday will have a major – and lasting – effect on the U.S. capital markets.

“Last Friday, I said that market participants are addressing challenges and I am pleased with recent developments. I appreciate the additional actions taken this evening by the Federal Reserve to enhance the stability, liquidity and orderliness of our markets,” Paulson said yesterday.

Yesterday’s Fed machinations are the latest in a recent string of unusual steps the central bank has taken to counterattack a credit market that’s threatening to spiral out of control – something that could then completely derail the U.S. economy.

But it remains to be seen whether this will mollify investors who have become increasingly concerned about the health of the U.S. investment banking sector.

The Domino Effect

Bear Stearns is the smallest of the five big investment banks, the least diversified, and the biggest issuer of mortgage-backed securities. It was also the first to divulge problems when last spring it revealed that two of its hedge funds imploded.

The four other investment banks are Merrill Lynch & Co. Inc. (MER), Morgan Stanley (MS), Lehman Brothers Holdings Inc. (LEH) and Goldman Sachs Group Inc. (GS). Of the four, most analysts believe the Lehman is the most vulnerable.

Shares in Goldman are only down about 12% over the last six months. That’s about the same as the Standard & Poor’s 500 Index. But shares in peer companies Morgan Stanley and Merrill Lynch are off nearly 40%.

That makes Goldman's earnings this week a critical bellwether, perhaps more for other investment banks than for itself. It still has the strongest balance sheet on Wall Street – strong enough to weather all but the worst economic downturns.

Bear Stearns faces some significant challenges. In addition to the loss of investor confidence, it may also have lost a crucial safety net. Citic Securities Co., China's largest brokerage by market value, said that it “can't guarantee'' that it will reach a final agreement on a proposed investment in Bear Stearns, Bloomberg News reported yesterday (Sunday).

Citic Securities Co. Ltd. hasn't signed any ``formal agreement'' or made any payment, it said in an e-mailed statement late last night. Citic would pay $1 billion for 6% of Bear Stearns, while the New York-based firm would invest the same amount in Citic, Bear Stearns said.

Clearly, there’s a big incentive in shoring up Bear Stearns finances. If Bear goes down, one or more of the other investment banks could follow. The impact on the U.S. economy from such a debt-fueled domino effect could be significant.

For instance, because Bear Stearns does business with a large number of other financial institutions, a failure to meet its financial obligations could cause “a ripple effect,” said Ali Samad-Khan, head of operational risk management consulting for the Enterprise Risk Management practice at Towers Perrin.

“They probably fall into the too-big-to-fail category,” Samad-Khan added. “The fact is, [the Fed] recognized that this is an important enough issue for them to get involved in.”

And that’s why the Fed has stepped in to make sure that doesn’t happen. If Bear Stearns fails, and it could, it would potentially spark a run on other investment banks.

“I don't think they can afford to let Bear go,” Charles Geisst, the author of “100 Years on Wall Street,” referring to the New York Fed bailout, told Bloomberg News. “At this particular moment in time, it would be a devastating blow to the markets.”

Bear Stearns has a large network of “counterparties” that include other banks, hedge funds and investors. And if Bear can't meet obligations to these counterparties, those counterparties will find themselves in serious financial trouble of their own.

Larger firms, such as Citigroup Inc. (C) could see big losses, but at the same time have the balance sheet assets and diversified streams of revenue to survive a big hit. But smaller, less diversified counterparties such as hedge funds are at risk of bankruptcy if Bear Stearns can’t meet its obligations.

And if the hedge funds start failing, it could mean another round of costly write-downs for banks that have already taken billions of struggling hedge fund assets onto their own books.

A long list of banks that includes HSBC Holdings PLC (HBC), Dresdner Bank AG Citigroup, Bank of Montreal (BMO) and WestLB AG have pledged support for foundering structured investment vehicles with a total of over $140 billion in assets.

For Bear Stearns, Perception is Everything

"Bear Stearns has been the subject of a multitude of market rumors regarding our liquidity,” said Alan Schwartz, Bear Stearns president and chief executive officer in a statement released Friday.

Despite repeated assurances from the bank’s CEO that Bear Stearns was adequately capitalized to meet liquidity needs, the persistent rumors resulted in clients withdrawing assets in cash.

“We have tried to confront and dispel these rumors and parse fact from fiction. Nevertheless, amidst this market chatter, our liquidity position in the last 24 hours had significantly deteriorated,” Schwartz added.

In finance, reputation is all-important. And while Bear Stearns now has the funding it needs to keep afloat, it might not be able to gain back the confidence of the market.

“Will you do that foreign exchange trade with Bear? Will you do that bond trade with Bear? And the answer is no because you don't know whether Bear's going to be there,” Brad Hintz, an analyst at Sanford C. Bernstein & Co., told Bloomberg News.

If no one is willing to deal, that’s death for an investment-trading firm.

When it became apparent that Bear Stearns would need help, the Federal Reserve tapped JPMorgan to help. It’s a role the bank is familiar with, as this is not the first time JPMorgan has stepped in to help an ailing financial institution.

“It may be a feather in JPMorgan's cap that they're considered able to do this,” Geisst, the Wall Street historian, told Bloomberg News. “The Fed could have chosen any number of banks to do this, and they chose JPMorgan.”

Using JPMorgan as a conduit, the New York Federal Reserve is loaning an undisclosed amount of capital to Bear Stearns for a minimum of 28 days. Bear Stearns management hopes it will be enough to hold the wolves at bay.

“We took this important step to restore confidence in us in the marketplace, strengthen our liquidity and allow us to continue normal operations," Schwartz said.

Bear Stearns at the Beginning of the Subprime Mess

It only seems fitting that the investment bank in question was the first to bring the credit crisis to the nation’s attention when two of its funds got into trouble early last summer.

By August, the two funds were essentially worthless and were forced to file for bankruptcy protection, but the company assured clients that the 84-year old firm had weathered challenging markets before and would do so again.

But the beleaguered investment bank’s troubles were far from over.

While Bear Stearns is only the fifth-largest Wall Street investment firm based on assets, it has a disproportionate level of mortgage-backed securities. Larger banking rivals such as Citigroup and Goldman Sachs are much more diversified. Reports estimate that as much as one-sixth of Bear Stearns’ income came from the repackaging and sale of mortgage assets. And as the subprime crisis has unfolded, the market for such assets has all but disappeared.

After Bear Stearns was forced to take a $1.9 billion write-down in December, James E. "Jimmy" Cayne was forced to step down as CEO. The president at the time, Alan D. Schwartz, was anointed as his successor while Cayne remained on as chairman.

At the time, some financial industry analysts questioned whether Schwartz, a 30-year Bear Stearns veteran, was the right man for the job.

"I am honored to have the opportunity to lead one of Wall Street’s great franchises," Schwartz said when his appointment was announced. "Bear Stearns has a bright future. Our franchise is rock solid thanks to Jimmy’s leadership; investors, customers and employees should not expect any abrupt changes in the period ahead."

But that wasn’t what shareholders wanted to hear. Change is exactly what investors were looking for after 2007’s dismal performance. Bear Stearns’ stock suffered more than any of the big Wall Street’s other firms, dropping 53% in 2007. The fourth-quarter loss of $854 million was the first in the esteemed firm’s long history.

Meanwhile, other rivals in the troubled sector – including Citigroup and Merrill Lynch - replaced their top managers with industry veterans and company outsiders that brought new ideas to the table. Some experts questioned whether Bear Stearns’ choice of a longtime insider as its new CEO - coupled with Cayne’s commitment to stay heavily involved as chairman - really represented the substantive change required to bring about badly needed improvements in the investment bank’s operations and corporate culture.

Now the long-standing firm might be on the auction block. With such a crisis of confidence, it’s doubtful that Bear Stearns will be able to go it alone. The bank has partnered with Lazard Ltd. (LAZ) to find a white knight that’s willing to step in and help engineer its financial turnaround. Perhaps Bear Stearns will have to look no further than its current ally, JPMorgan, which reportedly has been shopping for a prime brokerage.

Editor’s Note: Money Morning Executive Editor William Patalon III contributed to this report.

Timeline of Bear Stearns' Troubles

'Subprime' Became Household Word When Bear Stearns Funds Faltered

2007    
  June 14 Bear reports a 10 percent decline in quarterly earnings as the mortgage market shows signs of cracking. Chief Financial Officer Sam Molinaro says, "We are impacted in a weaker mortgage market until that industry turns around."
  June 18 Reports say Merrill Lynch seized collateral from a Bear Stearns hedge fund invested heavily in subprime loans - those made to people with poor credit.
  June 22 Bear commits $3.2 billion in secured loans to bail out its High-Grade Structured Credit Fund, says company's troubles are "relatively contained."
  July 17 Bear tells clients that the assets in one of the troubled funds are essentially worthless, while those in the other are worth 9 percent of their value at the end of April.
  Aug. 1 The two funds file for bankruptcy protection and the company freezes assets in a third fund.
  Aug. 5 Co-President and Co-Chief Operating Officer Warren Specter resigns. Alan Schwartz becomes sole president. CFO Molinaro takes over co-COO role.
  Aug. 6 Bear sends letters to clients reassuring them the company is financially sound. "Rest assured, Bear Stearns has seen challenging markets before and has the experience and expertise to serve you and us well," the firm says.
  Sept. 20 Bear reports 68 percent drop in quarterly income. The company's accounts slipped by $42 billion between the end of May and the end of August.
  Nov. 14 CFO Molinaro says Bear will write down $1.62 billion and book a fourth-quarter loss.
  Nov. 28 Bear lays off another 4 percent of its staff, two weeks after cutting 2 percent of its work force.
  Dec. 20 Bear takes $1.9 billion write-down. CEO Cayne says he'll skip his 2007 bonus.
2008    
  Jan. 7 CEO Cayne retires under pressure, but stays on as chairman. Schwartz takes over.
  Mid-Jan. Financial stocks swoon as economists predict the U.S. economy will slip into recession. President Bush unveils a $150 billion stimulus plan.
  Mid-Feb. Subprime woes spread to a broad range of assets, including certain kinds of municipal debt.
  Mar. 10 Market rumors say Bear may not have enough cash to do business. "There is absolutely no truth to the rumors of liquidity problems that circulated today in the market," Bear says.
  Mar. 12 Schwartz goes on CNBC to reassure investors his company has enough liquidity and he is "comfortable" it turned a profit in the fiscal first quarter.
  Mar. 14 The federal government and JPMorgan Chase & Co. bail out Bear. The company says it sought the emergency funding after realizing it would not be able to keep up with a spike in demand from lenders.
Source: The Associated Press, Money Morning Research

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