Bear Stearns Headed for Hibernation or Worse

This bear never hibernates — is how Bear Stearns once proudly described itself. One of the largest global investment banks, Bear Stearns was hit by a savage but not totally unexpected bank run which led to a loss of more than 50% of its share value in just a few days. At its closing price of $30 a share on Friday, Bear Stearns was trading at a gaping discount to its reported book value of $80 a share. JPMorgan Chase and the Federal Reserve Bank of New York (Fed) had to step in on Friday with a financial rescue package intended to keep the firm afloat. The size and terms of the bailout package were not disclosed. JPMorgan will borrow the money from the Fed and lend it to Bear Stearns, and the Fed will ultimately bear the risk of the loan.

Bear Stearns, which boasts that it has never had a losing year in its 85 years, was plagued by rumors that it had developed liquidity problems which would keep it from meeting its obligations. Its core mortgage business flourished during the housing boom from 2003 to 2006. Then two of its hedge funds which were heavily hit by the subprime mortgage crisis collapsed and it was all downhill from there.

Subprime mortgages are loans made to homebuyers with poor credit ratings and are therefore high credit risks because they are more likely to renege on their housing loans.
Lending banks usually sell these subprime loans to investors, like mutual funds and hedge funds. Bear Stearns was heavily exposed through its hedge funds which went bankrupt when U.S. homeowners started defaulting on their loans and the housing market crashed.

By late Thursday, Bear Stearns’s top lenders and its hedge fund clients were calling the firm and demanding their cash back, in an effort to protect their money from the investment bank’s precipitous downward slide. The Fed had to step in to prevent a domino effect which could spread across the entire U.S., and ultimately global, financial system.

As explained by the New York Times:

Wall Street firms like Bear Stearns conduct business with many individuals, corporations, financial companies, pension funds and hedge funds. They also do billions of dollars of business with each other every day, borrowing and lending securities at a dizzying pace and fueling the wheels of capitalism.The sudden collapse of a major player could not only shake client confidence in the entire system, but also make it difficult for sound institutions to conduct business as usual.

Why should we care then if another capitalist enterprise should go under ? Banks like Bear Stearns serve a worldwide clientele of corporations, institutional investors, governments, and wealthy individuals. Its almost a given that the Philippine government has done business with investment banks like Bear Sterns and its kind and will continue to do so in the future. In a globalized economy, the fallout from a U.S. financial crisis will impact us adversely. The resulting volatility and panic in the US stock market will send shock waves to European and Asian markets. These fears and uncertainties are driving world stock markets to their recent lows. Furthermore, the US, one of our major trading partners, is already experiencing a de facto economic recession. This will dampen our prospects for continued economic growth.

The Wall Street Journal considers the risks to the larger financial system of not letting Bear Stearns fail against the necessary discipline of seeing bad risk management punished by the marketplace.

You say, my goodness, how could subprime mortgage loans take out the whole global financial system? Here’s how.

Paul Samuelson explains why the culture on Wall Street is to blame for the present financial crisis.

How complex derivative instruments, virtually hidden from investors and little understood by the public, contributed to the financial crisis.

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