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Crises of Confidence in the Markets
Federal Reserve's Rescue of Bear Stearns Exposes Cracks in Financial System

By David Cho and Neil Irwin
Washington Post Staff Writers
Tuesday, March 18, 2008

Investors dumped stocks of the nation's major investment firms yesterday after a rescue plan for one of the biggest, Bear Stearns, exposed unexpectedly large cracks in the foundation of the financial system.

Even after the Federal Reserve on Sunday night offered an unprecedented credit line to investment banks, their shares plummeted. Lehman Brothers was down 19 percent. Europe's largest bank, UBS, which has recorded huge losses from mortgage investments like those at its U.S. counterparts, suffered its sharpest drop in European trading in nearly 10 years.

U.S. currency traders launched a furious sell-off of the dollar immediately after the Fed acted Sunday, some staying up all night on concerns, they said, that major U.S. bank failures could be on the horizon. Major stock market indicators swung wildly, with the Standard and Poor's 500-stock index falling as much as 2.4 percent but ending 0.9 percent lower. The Dow Jones industrial average rebounded from early losses, finishing up about 0.2 percent on the strength of J.P. Morgan Chase, which has agreed to purchase Bear Stearns for a fire-sale price.

President Bush said his administration is "on top of the situation" in dealing with the slumping economy, praising the Fed for its steps. "One thing is for certain -- we're in challenging times. But another thing is for certain -- that we've taken strong and decisive action," he told reporters after meeting with Treasury Secretary Henry M. Paulson Jr. and other economic advisers.

But critics accused Bush of bailing out big Wall Street firms while ignoring ordinary homeowners.

The wild ride came after the Fed offered Bear Stearns a financial lifeline but demanded control over the bank's fate in return for keeping it out of bankruptcy. The arrangement, which involved J.P. Morgan agreeing to buy Bear Stearns for only $2 a share, signaled that investment banks may be even more vulnerable than had been previously known. Bear Stearns shares closed at $30 on Friday.

"Bear Stearns's demise should probably be viewed as the first of many," Richard Bernstein, chief investment strategist for Merrill Lynch wrote in a research report. "Sentiment is just beginning to catch on as to how broad and deep the credit market bubble has been."

Just a week ago, top Treasury officials said they opposed any plan that put taxpayer dollars at risk by buying up troubled mortgage securities or bailing out investment firms. But when these officials examined Bear Stearns's books, they discovered the bank was essentially out of cash and urgently decided to back the Fed taking on these securities to save the banks.

"Last week, the position of the Bush administration was to let markets correct themselves and to allow no bailouts and no subsidies," said William W. Beach, senior fellow of economics at the Heritage Foundation. "Somewhere over the last four days, that policy changed. They discovered the rules of the road just didn't apply."

Paulson bristled at the notion that the Fed had bailed out big banks, telling reporters: "If you would ask the Bear Stearns shareholder in terms of what has happened to their value, then I don't think any of them would think that this has been a good outcome for them."

The Bear Stearns debacle has revealed a central reality of Wall Street: Investment firms live and die on confidence.

Bear Stearns made most of its money by providing loans and services to hedge funds so they could make massive investments. Bear Stearns's clients include some of Wall Street's top investors, such as George Soros, the billionaire hedge fund manager.

Like many investment banks, the firm relied on short-term loans from money market mutual funds and other lenders to pay off its obligations to its customers. But as it incurred huge losses on its holdings of mortgage-related securities, the lenders lost faith in Bear Stearns. Cash ran dry.

Bear Stearns would have had to file for bankruptcy Friday morning but for an unusual emergency loan from the Fed. Leaders of the central bank told Bear Stearns that by taking government money, the bank would be ceding control of its own fate. They didn't want Bear Stearns to accept government money, make risky investments and leave the government holding the bag if these investments failed.

Throughout that day, things went from bad to worse. Bear Stearns customers started abandoning the company: Investors who had brokerage accounts canceled them, hedge funds that relied on Bear Stearns to execute transactions looked elsewhere, and the Fortune 500 companies that relied on it for advice on mergers and acquisitions ran from its tainted name.

A bankruptcy at Bear Stearns would have led to big losses by the money market mutual funds and other investors who lent it money. It also would have triggered a sell-off of its mortgage securities, depressing prices across the market. Because nearly all investment funds and financial firms hold similar securities, that would have caused losses across the banking system.

So Fed leaders pressed Bear Stearns executives to sell the firm to a buyer who could take over the company's liabilities immediately, while avoiding new strains in the market. Bear Stearns executives huddled with their advisers, investment banking firm Lazard Freres, in conference rooms at their Madison Avenue headquarters through the weekend, considering offers from various bidders.

By Sunday, it became clear there was only one bidder that could pull off the deal quickly enough to prevent a disruption to world markets. With no other serious options, Bear Stearns accepted a low-ball offer from J.P. Morgan.

Because J.P. Morgan was unwilling to take the risk of about $30 billion worth of assets on Bear Stearns's books, in particular bonds linked to troubled mortgages, the Fed agreed to guarantee those securities. The central bank was eager for the deal to close before the Asian markets opened yesterday.

Any profit from the sale of these assets would go to the federal government. But if there is a loss, tax payers would be on the hook. Fed leaders estimate the gain or loss would be no more than a few billion dollars in either direction, depending on how financial markets fare in the coming months.

Some analysts have argued that Bear Stearns investors took a bath on the deal, given that J.P. Morgan is purchasing a business that was worth $8 billion on Thursday for only $236 million. But J.P. Morgan is also taking on Bear Stearns's massive debts and the risk of shareholder lawsuits and government investigations, which could cost billions of dollars.

The acquisition of Bear Stearns is not a done deal because it still needs the approval of shareholders. Some are already expressing their unhappiness. An institutional shareholder called Eastside Holding filed a lawsuit yesterday in Manhattan federal court, claiming the bank misled investors about its finances.

Leaders of the Fed and the Treasury said they were pleased by how the U.S. financial markets responded yesterday. Part of the reason may have been the decision by the Fed on Sunday to make billions of dollars available in short-term loans to investment banks, an option ordinarily available just to commercial banks.

"There's been a lot of focus on Bear Stearns," Paulson said. "But the Fed took, I believe, dramatic and very important, powerful action to make liquidity available to . . . the investment banks."

The Fed is closely watching whether its weekend actions successfully restore investor confidence in other major investment firms. A crucial test of market reaction comes today when Lehman Brothers and Goldman Sachs, two of Bear Stearns's rivals, report their quarterly earnings.

"Lehman may have to follow Bear into the confessional before Good Friday,'' Michael McCarty, an options strategist at Meridian Equity Partners in New York, said during an interview with Bloomberg Television on Friday.

Other financial analysts said they worried the federal government was setting a precedent of pledging tax payer money to bail out private investment houses.

"How do you convince people in the market that this is a one-time deal, you're never going to do it again, you're swearing off demon rum and you're going to stay on the wagon in future?" asked Daniel J. Mitchell, a senior fellow at the Cato Institute. "Capitalism without losses is like religion without hell."

Staff writers Jeffrey H. Birnbaum, Dan Eggen and Lori Montgomery and researcher Richard Drezen contributed to this report.

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