Money WhizDom: Demystifying the Bear Stearns fallout: The week that prevented global financial calamity.
The US hasn’t been confronted by an economic tsunami of this proportion since the Great Depression. Although the downturn in the Indian stock markets was evident, the global repercussions could have intensified if the Fed’s antidote was considered insufficient. Many around the world failed to realize the gravity of the crisis because the Feds actions prevented a sudden and sharp downturn.
Never before has the US economy been confronted by so many issues that are affecting their fiscal and economic report cards, businesses, individuals and government. Its facing declining stock and real estate prices, increasing food, commodity and energy prices, weakening dollar, trade and fiscal deficits, increasing unemployment and inflation, decreasing investment, stagnant productivity levels, low confidence levels, decreasing consumption, low saving level, increasing cost of debt in a credit dependent economy, and to top it all off the failure the world’s fifth largest investment bank, Bear Stearns.
Many on Wall Street were aware of the pessimism surrounding Bear Stearns, but the severity of the fallout was what shocked investors and caught them by surprise. The implosion of Bear Stearns indicated a lot more than the dampened psychology on Wall Street. This fallout clearly showed how financial engineering and innovation outpaced the federal financial market regulators who were caught off guard, desperately trying to save face and avert a lock down of the financial system in the country (and around the world).
To understand what exactly happened at Bear Stearns, one has to put together a few pieces of the puzzle. The crisis that unfolded here was primarily driven by a liquidity crunch or in simple terms a lack of cash to meet day to day activities. Complex financial trades performed by investment banks require them to put up and receive large amounts of money (tens of billions) on a day to day basis, making them heavily cash dependent. The fluctuating values of its investments are why large sums of money flow in and out daily.
Investment banks are unique in their practice of using extremely high leverage to maximize their returns. A Lehman Brothers or a Goldman Sachs can approach a bank, put up $1 billion in assets as collateral to receive say $30 billion dollars to invest with, and this would be 1:30
This fallout clearly showed how financial engineering and innovation outpaced the federal financial market regulators who were caught off guard, desperately trying to save face and avert a lock down of the financial system in the country (and around the world)
leverage. Although it sounds outrageously risky, investment banks thrive on this luxury, something that banks and investment firms in India don’t completely indulge in. Bear Stearns in particular was highly leveraged, as high as 1:40 in some sections of its business.
The commercial banks like JP Morgan, Bank of America or Wachovia, who provide highly leveraged cash, can anytime call upon the investment bank to put up more collateral if they feel the investment bank has immersed itself in bad investments that are rapidly losing value.
Bear Stearns was whacked with a double whammy, when distressed investors started to pull out cash and some of their investments started to decline rapidly, the commercial banks demanded more collateral. Bear Stearns slowly drained their cash reserves to meet collateral demands, handicapping them on a daily basis. Their cash reserves declined from $17 billion to less than $2 billion in just four days, sparking a bank run. Having run out of cash they couldn’t clear trades on a daily basis, were unable to provide more collateral and couldn’t repay many investors.
This is when the Federal Reserve stepped in via JP Morgan to bail them out by providing emergency funds to continue daily activities, without which the complete financial system could have gone into a seizure.
It's important to distinguish an investment bank from a commercial bank to understand JP Morgan's involvement. Individuals park their savings in commercial banks which are insured in USA by the Federal Depository Insurance Corp (FDIC) for up to $100,000 per account. It’s common knowledge that the central bank of a country (in this case the Federal Reserve) is the
After starving off a bankruptcy at Bear Stearns and realizing the severity of the liquidity crisis surrounding investment banks, for the first time in 95 years (since its inception in 1913), the Federal Reserve opened the discount window to investment banks.
primary source of money and the lender of last resort, but only commercial banks have direct access to these funds via the discount window (i.e. rate at which they can borrow from the central bank). Commercial banks can borrow directly from the Federal Reserve, something an investment bank cannot do. Investment banks are not closely regulated by the government, which is why they cannot borrow directly from the central bank.
This is precisely why the Fed had to allow JP Morgan to borrow massively, who then turned around and lent to Bear Stearns just to keep the company alive. The Feds couldn’t have lent to Bear Stearns directly and had to lend via a commercial bank. One could ask why not Citigroup or Wachovia or Bank of America, as they are also commercial banks. Unfortunately, these banks were preoccupied with cleaning up their own sub-prime mess, and JP Morgan was the only unscathed banking still standing tall on Wall Street.
When JP Morgan acquires Bear, it will primarily be for Bear Stearns' highly successful prime brokerage and clearing businesses. The two other divisions: investment banking and investment advisory are of little value to JP Morgan as its own investment banking division is a world-class setup. There was a lot of clamoring when the takeover price of $2/share was announced (now increased to $10/share), saying the company has been tremendously undervalued. Many critics might be proved wrong because the amount of garbage on the balance sheets of Bear Stearns might actually mean the company is negatively valued at say negative $10-$15 billion affecting JP in the future. But because JP Morgan has a $30 billion backing from the Fed, it might siphon off all the bad investments onto the Fed and retain the good ones eventually having little to no affect on JP.
After starving off a bankruptcy at Bear Stearns and realizing the severity of the liquidity crisis surrounding investment banks, for the first time in 95 years (since its inception in 1913), the Federal Reserve opened the discount window to investment banks. This revolutionary move has so far warded off failures at other investment banks and also reflects enormity of the crisis. Clearly the Fed realized that desperate times call for desperate measures.
Regulating investment banks and hedge funds is extremely tricky. The quantitative and mathematical nature of their operation requires them to trade equities, bonds, debt, forex, futures and options in large quantities at lightning speed. The positions on their balance sheet change literally every day making the risky and highly leveraged nature of their positions complicated for regulation. Although the Federal Reserve knew of the threats posed by this due to their closely intertwined nature to the financial system, they never saw the need to regulate because of the high level of counterparty surveillance at investment banks and hedge funds. The
The most apparent global impact is the severe dent on the psyche of the investors from Wall Street to the Great Wall. Besides the increased cost of debt, the cost of insuring and securitizing debt has also gone up.
last time counterparty surveillance failed was the 1998 collapse of Long Term Capital Management hedge fund. Although the Bear Stearns collapse was primarily driven by a liquidity crisis, it can partly be blamed on failure of counterparty surveillance.
The impacts of this event have been widespread. The increased cost of capital has had a major blow on the investment banks forcing them to decrease their leverage significantly in the recent weeks. The most apparent global impact is the severe dent on the psyche of the investors from Wall Street to the Great Wall. Besides the increased cost of debt, the cost of insuring and securitizing debt has also gone up. Decreased liquidity in these markets is also a valid concern.
One disturbing parallel this crisis draws with the Great Depression is that in both cases banks caved in. The Great Depression saw widespread failures of commercial banks (this is when the FDIC was introduced) and this time an investment bank which specialized in advanced investment strategies like sub-prime mortgages and quantitative trading fell through. Despite their functionary difference, in both cases they perilously threatened to crumble the complete financial system and freeze liquidity. Note that the Great Depression witnessed widespread failures of banks; in this case, we have only seen one investment bank fail. Any more nasty surprises could cripple the already strained financial system, fueling speculation of a depression or a longer-than-anticipated recession.
History has proven that the US economy is one of the most resilient and nimble structures around the world. It has braved diverse problems from accounting scandals to bank failures and continued to roar forward. This is largely attributable to the strong foundations and competent regulatory institutions. Although this down phase is looking different one can be sure that when the bad times pass, investment opportunities will open up.
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