Bear Stearns

Bear’s pits From

JPMorgan Chase takes over stricken Bear Stearns. Panic is in the air

THE credit crunch is a man-made disaster and, like its counterparts in nature, where and when devastation and chaos will strike is hard to predict. Few could have expected the speed and severity with which Bear Stearns collapsed. On Sunday March 16th, two days after the announcement of an emergency funding package made its predicament clear, the bank succumbed to its rescuer: JPMorgan Chase, again with backing from the Federal Reserve. The vast universal bank agreed to buy Bear Stearns for $236m, a fifth of the value of its shiny headquarters office block. The world’s markets plunged on Monday morning as the quake on Wall Street reverberated around the globe.

JPMorgan Chase will guarantee all of Bear’s trading obligations. It was clearly a priority for the Fed to ensure that Bear’s buyer commands trust if it is to step in as counterparty in trades that have a notional value, reportedly, of a staggering $10 trillion. Although Bear is but a middling-sized broker, the tightly bound financial system (thanks to derivatives) means that far more institutions, and not just commercial banks, are in effect too big to fail. No one is sure how much chaos would ensue if a big counterparty like Bear went bust. The Fed clearly did not want to find out—it even agreed to grease the deal by making $30 billion available to fund some of Bear’s less liquid assets, which would otherwise damage JPMorgan Chase’s balance sheet.

Bear’s price might look like a bargain. At the close of business on Friday, even after news of the emergency rescue had frightened investors rather than reassuring them, the bank was still worth over $3.5 billion. But the huge uncertainties and opacity of its balance sheet—rumours abound that its mortgage book could be set for some whopping further losses—mean that judging the deal as a brilliant coup for JPMorgan Chase and its boss, Jamie Dimon, must wait.

If Bear had been allowed to go bust, it would have put huge pressure on its counterparties, including the likes of JPMorgan Chase (which is the biggest credit-default swap player, one reason it was keen to do a deal). They would have held back from doing new business, including lending, until it was clear what their exposures were. It would also have made them more likely to call in collateral from other counterparties. Both of these things would have exacerbated the crunch.

Bear’s shareholders will not benefit from the Fed’s largesse. Bear, a firm known in the past for its canny risk management, failed badly in its mortgage business and investors will take the full hit. Regulators are desperate to avoid a situation where shareholders bank private profits but losses are borne by the taxpayer. And the Fed has perhaps learned that it is better to act swiftly rather than dither. The British government earned deserved criticism for its failure to act speedily and decisively over the collapse of Northern Rock.

The Fed’s decision to introduce loans to brokers as well as regulated banks marks a significant shift in policy, and raises the question of whether the former should now be subject to more stringent regulation in return. But the Fed’s widening role is a sign of its fears that other pins might fall. Merrill Lynch looks decidedly wobbly. Lehman has lots of toxic mortgage securities on its books. Lehman's shares plunged on Monday morning but it is not the only one facing trouble. All the other big investment banks will be under intense funding pressure in the coming days. And when trading partners start to pull away, a rapid chain reaction can begin. In effect, with Bear Stearns being sold for such a low price, including its valuable office property, the price of the securities portfolio is zero.

Bear’s demise has rammed home the full risks of the hefty leverage and funding mismatch at big investment banks. Holding a lot of long-term, illiquid assets and using very short-term markets for funding seemed fine when times were good. But confidence can leak away rapidly. The sudden shutting of the overnight repo market to Bear contributed to its downfall.

Now the Fed has extended its area of operation, where will it stop? Investment banks are not the only parts of the financial system showing the strain. Can the Fed afford to get entwined with hedge funds that are big derivatives counterparties or embattled money-market funds? By ditching its longstanding rule about lending only to commercial banks and extending this facility to investment banks, the Fed is in effect admitting that it faces a different sort of financial system—one in which dealers pose as much of a threat to stability as lenders. The regulatory regime for investment banks may now have to be rethought to make them more resilient to financial catastrophe.