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Surprise Rate Cut And Bear Stearns Buyout Inspires Investor Skepticism, Not Calm

By Jennifer Yousfi
And William Patalon III
Money Morning Editors

In a surprise move yesterday (Sunday), the U.S. Federal Reserve announced that it had cut the Discount Rate by a quarter of a percentage point – a key element of a three-point financial package that includes the takeover of troubled investment bank Bear Stearns Cos. Inc. (BSC) by JPMorgan Chase & Co. (JPM).

The central bank believes the moves made yesterday will keep the U.S. credit markets from seizing up.

“This is a serious crisis,” David Goldman, a senior portfolio strategist at Asteri Capital in New York and a former head of debt research at Banc of America Securities LLC (BAC), told Bloomberg News. The sale of Bear Stearns "tells us that something is systemically very wrong and we're at a very dangerous moment," he said.

The announcement comes just two days before central bank policymakers are scheduled to meet and consider a possible reduction in the Federal Funds Rate, the short-term interest rate that serves as the benchmark for commercial loan rates. The policymaking Federal Open Market Committee (FOMC) meets tomorrow (Tuesday) and analysts say that a Fed Funds Rate cut of three-quarters of a percentage point is possible – if not downright likely.

In a conference call late last night, Fed Chairman Ben S. Bernanke said the central bank’s three-point plan “will provide financial institutions with greater assurance of access to funds.”

The Fed’s moves consist of:

  • A decision to pare the Discount Rate from 3.5% to 3.25%. The discount rate is the interest rate that the central bank charges on direct loans to Fed-member banks, using either government securities or some form of commercial paper as collateral. This process establishes a floor for interest rates, since banks set their lending rates just above the Discount Rate. By making this move, the central bank reduces the “spread” between the Discount Rate and the benchmark Fed Funds Rate to a quarter percentage point. The Federal Reserve Board also boosted the maximum maturity of Discount Rate loans from 30 days to 90 days.
  • The approval of a financing arrangement in which JPMorgan Chase & Co. (JPM) will acquire The Bear Stearns Cos. Inc. (BSC) in a deal that’s valued at $236.2 million. JPMorgan is getting Bear Stearns for the equivalent of $2 a share, Reuters reported. As part of that arrangement, 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.
  • And creation of a lending package that would help keep the debt markets moving freely. The financing packages would allow the “primary dealers” to provide financing to participants in the asset-backed debt markets. Primary dealers are the relatively small group of banks or investment dealers authorized to buy and sell government bonds in conjunction with the Federal Reserve Bank of New York as it conducts operations designed to regulate the U.S. money supply. This credit package will be in place starting today (Monday) and may be collateralized by a broad range of investment-grade debt. The interest rate on these loans will be the same as the Discount Rate.

Art of the Deal

From the initial reaction in the financial markets, it’s not altogether clear that the Fed’s latest moves are inspiring investor confidence [For a report on the moves that the U.S. central bank has made during the past week, check out a related article in today’s issue of Money Morning. To read the article, please click here].

The takeover of Bear Stearns is an all-stock deal that values the investment bank at $2 a share, or $236 million. Bear Stearns’ shares plunged 46% on Friday, closing at $30.85 – meaning the fifth-largest U.S. investment bank had a market value of $3.5 billion. The shares hit a record high of more than $171 back in January 2007, according to Reuters.

Bear Stearns all but collapsed on Thursday when its cash reserves were drained as part of a customer exodus. On Friday, Bear received emergency funding through JPMorgan Chase in a deal that was arranged by the U.S. central bank.

With the deal that was outlined late yesterday, the Fed has agreed to provide special funding and to also fund up to $30 billion of Bear Stearns’ less-liquid assets. That’s allowing JPMorgan to exchange 0.05473 shares of its stock for one share of Bear’s stock – and to also guarantee the trading obligations of Bear Stearns and its subsidiaries.

“The fact that the Bear Stearns’ board is letting these assets go at such a deep discount brings into question the value of assets on a lot of corporate balance sheets,” Timothy Ghriskey, the chief investment officer at Solaris Asset Management in New York, told Reuters. “The main concern is what other financial institutions are worth in the current environment, given the discount [at which] JPMorgan is acquiring Bear.”

Bear Stearns Chief Executive Officer Alan D. Schwartz said the deal represented the “best outcome for all of our constituencies based upon the current circumstances.”

JPMorgan CEO James “Jamie” Dimon said that Bear’s “clients and counterparties should feel secure that JPMorgan is guaranteeing Bear Stearns' counterparty risk.”

JPMorgan Chief Financial Officer Michael J. Cavanaugh said on a conference call last night that deal-related costs would total $6 billion – which includes the costs of litigation, debt-reductions, integration and severance costs from the reduction of some of Bear’s 14,000 employees. The deal should close in about 90 days.

However, once Bear Stearns is integrated into JPMorgan’s operations, the deal should be accretive to the tune of $1 billion. Cavanaugh said Bear Stearns’ debt exposure totaled $16 billion to commercially oriented mortgage-backed securities, $15 billion in prime mortgages and $2 billion in subprime debt.

Investors Skeptical?

The reaction has been swift and harsh.

All across Asia early today (Monday), stocks plunged, with financial shares from Australia to Japan leading the way. Hong Kong's Hang Seng Index slumped more than 3%. In Japan, stocks plunged to their lowest point in more than two years, and analysts say that the deal was the problem. Financial stocks were hardest hit, Bloomberg News reported. That’s an indication that investors fear a growing global contagion.

The Nikkei 225 Stock Average sank for a third day, losing 4.5% to reach 11,691.00 as of 12:37 p.m. [Tokyo time]. That’s the stock index’s lowest point since July 13, 2005. The broader Topix index dropped 50.91, or 4.3%, to reach 1,142.32. All 33 of the industry groups on the benchmark declined.

Japan Securities Finance Co. Ltd. (PINK: JSFNF), that nation's largest stock lender, dived 14%, the steepest drop in a decade. Nomura Holdings Inc. (NMR), Japan's biggest brokerage, fell 4.3%, the lowest since Jan. 22.

“The $2 price for Bear Stearns tells everything about how bad the operating situation is for brokerages," said Naoki Fujiwara, the chief fund manager in Tokyo at Shinkin Asset Management Co., said that “investors worry other securities companies are in a similar situation.”

The dollar plunged to a record low against the European euro and the Swiss franc. It hit a 12-year low against the Japanese yen, falling all the way to 95.76 yen early today from 99.09 yen in New York on Friday, putting the greenback at its lowest level since Aug. 14, 1995.

Gold rose to a record. In response to the dollar’s decline, gold for April delivery jumped 3.4% to a record $1,033.90 an ounce, as the dollar’s decline from the emergency rate cut boosted investor demand for a save haven from the greenback.

Sony Corp. (SNE), which gets a quarter of its electronics sales from the U.S. market, skidded 6.7%, hitting its lowest point since November 2005. Nomura Securities cut its rating on the company today by one level from its top grade, saying any additional gains in the yen will be impossible for Sony to absorb.

A 1 yen change against the dollar affects Sony's operating profit by 6 billion yen a year, the company said on Jan. 31. Sony expects the yen to average 105 in the three months to March 31.
“The dollar is facing a credibility crisis,” Koji Fukaya, a senior currency strategist at Deutsche Bank AG’s (DB ) Tokyo-based Deutsche Securities, said in an interview. “All the markets are entering a vicious cycle.”

Investors in U.S. stocks can expect a rough day today. Treasuries surged as investors fled to safer assets. U.S. stock index futures plunged, guaranteeing a horrid start to the trading day on Wall Street today.

“I just can't imagine it's going to be a good day in financial markets [today] just because of fear, and not because of any particular knowledge, but just because of fear of what could be in or what's not in all financial-service company balance sheets,” Solaris Asset Management’s Ghriskey said.

Standard & Poor’s 500 Index futures fell 21.20 points, while Dow Jones Industrial Average futures fell 119 points. Nasdaq 100 futures fell 27 points.

The Weak Week Ahead?

Don’t expect an improvement anytime, soon.

The central bank’s policymaking Federal Open Market Committee (FOMC) meets tomorrow (Tuesday) to consider reducing the benchmark Federal Funds Rate. The consensus estimate calls for a three-quarter-point rate reduction.

The Fed has slashed its rate by 2.25% in the past six months, taking the benchmark Federal Funds rate down to 3% from 5.25%. It’s a near certainty that Fed policymakers will reduce the rate again at tomorrow’s Federal Open Market Committee (FOMC) meeting. Futures on the Chicago Board of Trade show a 90% chance that the Fed will cut the federal funds rate by another 0.75% tomorrow.
And some economists believe that an even-more aggressive move will be necessary.

Citigroup Inc.'s (C) U.S. economists on Friday said that they anticipate Federal Reserve policymakers will lower the benchmark Fed Funds rate by a full percentage point, taking it down to 2% from its current 3%, and said “and more cannot be ruled out,” reported.

Economists led by Robert DiClemente said that “aggressive action is needed to stabilize the financial setting.” The economists said Friday’s near-collapse of Bear Stearns Cos. Inc. (BSC) “underscores the current fragility of the system.”

Indeed, that “fragility” has manifested itself in many economic reports – and probably will show up in the reports due out this week. The only indicator that hasn’t demonstrated weakness is inflation.

But the Fed’s move shows the stagnating economy and panic in the financial markets are still at the forefront of concern.

Let’s take a look at the week’s economic reports from last week:

  • Government is Bad Business: On Wednesday, the Department of the Treasury released its monthly budget statement for February 2008. The U.S. government is running a huge deficit as outlays are far outpacing receipts to the tune of about $263 billion year-to-date for fiscal year 2008. You could never run a company with a balance sheet bleeding that badly.
  • At Least Someone’s Working: On Thursday, the U.S. Department of Labor released its initial jobless claims report for the week ending Mar. 8, which was unchanged at 353,000 from the previous weeks figure. It brought the 4-week moving average down 1,250 to 358,500, a decrease from the previous week's revised average of 359,750. This is good news, however slight.
  • Ramping Up Prices: On Friday, the Bureau of Labor Statistics released its Consumer Price Index for February 2008. CPI increased slightly by 0.3% over the prior month and was a mind-boggling 4% higher than February 2007. Year-over-year, it was down from 4.3%, but it still means everything from bread and milk to cars and vacations are costing American consumers 4% more this year than last year. Core CPI, which excludes volatile food and fuel prices and is the Fed’s chosen measuring stick, was down a tenth to 2.3%. But this is still a bit above the 2% or lower level the Fed would really like to see. And that means it is not good news for a Fed that has decided to focus on a slowing economy, rather than our escalating inflation.


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