Adhvith Dhuddu, CT regular columnist
Wednesday, March 26; 12:00 AM
The U.S. hasn't been confronted by an economic tsunami of this proportion since the Great Depression. Our financial report card looks bleaker than ever with declining stock and real estate prices, increasing food and commodity prices, increasing unemployment and inflation, weakening dollar, decreasing investment, stagnant productivity levels 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 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 lockdown 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 (cash, building, money in the bank, etc.) as collateral to receive say $30 billion dollars to invest with and this would be 1:30 leverage. Although it sounds outrageously risky, investment banks thrive on this luxury. Bear Stearns in particular was highly leveraged, as high as 1:40 in some sections of its business.
The commercial banks such as JP Morgan, Bank of America or Wachovia, which 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, prompting the commercial banks to demand more collateral.
Bear Stearns slowly drained its cash reserves to meet collateral demands, handicapping them on a daily basis. Its cash reserves declined from $17 billion to less than $2 billion in just four days, sparking a bank run. Having run out of cash, it couldn't clear trades on a daily basis, was unable to provide more collateral and couldn't repay many investors. This is when the Feds 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 money in savings and checking accounts in commercial banks, which are insured by the Federal Depository Insurance Corporation for up to $100,000 per account. It's common knowledge that the Federal Reserve is the primary source of money, but only commercial banks have direct access to this money via the discount window. Commercial banks can borrow directly from the Feds, something an investment bank cannot do.
This is precisely why the Feds had to allow JP Morgan to borrow massively, which then turned around and lent to Bear Stearns just to keep the company afloat. 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 in cleaning up their own sub-prime mess, and JP Morgan was the only unscathed banking giant still standing tall on Wall Street.
If and when JP Morgan acquires Bear, it will primarily be for Bear Stearns' highly successful prime brokerage and clearing businesses. The other two divisions, investment banking and investment advisory, are of little value to JP, as its own investment banking division is a world-class setup.
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 that specialized in advanced investment strategies such as 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 our already strained financial system, fueling speculation of a depression or a longer-than-anticipated recession.
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