By Neil Irwin and Tomoeh Murakami Tse
Washington Post Staff Writers
Saturday, March 15, 2008
The Federal Reserve took the extraordinary step yesterday of providing emergency funding to one of Wall Street's venerable firms, Bear Stearns, after it ran out of cash to repay its lenders.
The Fed used a little-known power it last exercised in the 1960s to stem a run on Bear Stearns that could have sent multibillion-dollar losses cascading across the world financial system, causing more failures on Wall Street and threatening to choke off global economic growth.
The Fed's action, arranged in a series of pre-dawn deliberations yesterday, is one of the most significant government efforts to save a private firm in modern times. The nearest parallels are the New York Fed-engineered buyout of the hedge fund Long-Term Capital Management in 1998 and the bailout of Continental Illinois Bank in 1984.
Critics characterized the Fed's move as a bailout that inappropriately intrudes on the free market and could lead banks to keep taking risks like those that imperiled Bear Stearns. Other analysts said the action was necessary, given the precarious state of world financial markets.
"We're on a knife's edge," said Eugene White, an economics professor at Rutgers University who studies financial crises. "The danger is if people's confidence is lost in a place like Bear Stearns, no one will lend to anybody."
But while the Fed may have contained the immediate crisis, the move reinforced widening anxiety over the health of other banks and investment funds exposed to the credit meltdown. Markets tumbled in the hours after the funding plan was announced, with the Dow Jones industrial average finishing the day down 1.60 percent, or nearly 195 points.
Bear Stearns struggled to manage a flood of calls from clients who were trying to redeem their investments. Its stock fell more than 47 percent.
The firm is actively shopping itself to other big Wall Street firms and has scheduled high-level talks over the weekend, said a company official with knowledge of the matter. Bear is also open to selling major divisions to raise cash, the official said. J.P. Morgan Chase, which played a crucial role in yesterday's cash infusion, is a possible suitor.
As Bear's troubles deepened in recent months, it increasingly turned to overnight loans. But on Wednesday and Thursday, its lenders lost faith, and many refused to lend it any more money. That set off a frantic search for cash, including negotiations between executives of Bear and other Wall Street titans.
In the middle of the night, Bear and J.P. Morgan struck a deal. Bear would be willing to put up some of its assets as collateral in exchange for cash from the Fed. The transaction would be routed through J.P. Morgan, which, as a commercial bank, has access to the Fed's discount window. That would give Bear time to raise financing through the private sector.
"What this is is a bridge to more-permanent solutions," Bear Stearns chief executive Alan D. Schwartz said during a conference call yesterday afternoon.
But the deal still needed the Fed's approval. In a series of conference calls from about 3 till 7 a.m., leaders of the central bank discussed whether to exercise an authority granted the Fed in the 1930s -- and not used in four decades -- to approve the loan to Bear Stearns.
Fed Chairman Ben S. Bernanke, Vice Chairman Donald L. Kohn, New York Fed President Timothy F. Geithner, and Fed Governor Kevin M. Warsh conferred in those early-morning hours on calls, which also included Treasury Secretary Henry M. Paulson Jr. and Undersecretary Robert K. Steel. The Treasury Department had no formal role in the plan, but Fed leaders consulted Paulson and Steel for their financial markets expertise and to get their support.
If they allowed Bear to fail, the rest of Wall Street could have been dragged down with it. A major financial institution would have gone from being worth $8 billion to worthless, overnight.
In normal times, they would be inclined to let capitalism do its work. But markets are so jittery that the policymakers concluded that investors would refuse to make short-term loans to the other big Wall Street banks that rely on such debt, driving them under, too. The stock market could have experienced a collapse of 1987 proportions, and untold damage may have been done to the U.S. economy.
They weighed those fears against the fact that making the loan would put government money at risk. The New York Fed will accept collateral from Bear -- long-term investments viewed as safe -- in exchange for the short-term loan. In theory, that should protect the government against losses. But if the value of the collateral drops, the Fed could end up losing money.
And Fed officials worried about "moral hazard," the notion that other companies might behave irresponsibly if they think they too could get government help if they get into trouble.
The Fed's board of governors voted 4 to 0 in favor of the loan at its Constitution Avenue NW headquarters at about 9 a.m. (The fifth Fed governor, Frederic S. Mishkin, was traveling).
Some analysts said the Fed's effort, coupled with two major actions in the past week to restore order to credit markets, has undermined its credibility.
"There is a growing sense in the market that the Fed is becoming increasingly inept or unable to really do much about this situation," said James Paulsen, chief investment strategist at Wells Capital Management.
For Bear, it is the latest foray into the financial upheaval that began in the summer. Bear was one of the leading packagers of the exotic securities linked to subprime mortgages at the heart of the crisis. In June, two Bear-controlled hedge funds helped spark the worldwide credit squeeze.
The company, founded in 1923, has long been one of Wall Street's most profitable, but smaller and underappreciated, firms. The Bear, as it's known, "has always been the Rodney Dangerfield of investment banks," Fortune magazine once wrote. "It made money but never got much respect."
Its former, longtime chief executive, Alan "Ace" Greenberg, ran its trading floors with hands-on flair and charismatic bravado. But his employees were not drawn from the Ivy League upper crust who inhabited so many other financial firms. They were what Greenberg called "PSDs," people who grew up poor, smart, and with a desire to become wealthy.
Bear Stearns has a reputation for paying its senior executives top dollar. It has also had occasional run-ins with the law.
Federal securities regulators and the U.S. attorney in Brooklyn are investigating what Bear executives told investors about the health of its hedge funds in a pivotal April 25 conference call. Investigators are also looking at the transfer of personal funds by two Bear managers into safer investments about the same time. The executives have, through their attorneys, denied wrongdoing, and Bear Stearns has said it is cooperating.
William F. Glavin, the secretary of the Commonwealth of Massachusetts, sued Bear late last year over alleged conflicts of interest that he says allowed the company to dump risky financial instruments into the accounts of unsuspecting investors. That case has not been resolved.
Meanwhile, Barclays Bank, the British financial institution, has sued Bear and some former employees, accusing them of hiding dire financial problems and soliciting new funds from business partners in an effort to make Bear's failing hedge funds appear healthier than they were.
Over the years, Bear has often gone its own way, breaking with the rest of the Wall Street club. In 1998, the New York Fed cajoled all the large Wall Street firms into buying up assets of the failed hedge fund Long-Term Capital Management to avert a global financial meltdown.
All the large firms, that is, except one, which refused to participate: Bear Stearns.
Tse reported from New York. Staff writers Jeffrey H. Birnbaum, David Cho, Carrie Johnson and Alejandro Lazo and researcher Richard Drezen contributed to this report.