Grin and Bear it

Alan D. Schwartz, the CEO of Bear Stearns seemed stoic as he conducted a conference call Friday to explain the nation’s fifth largest investment bank’s dramatic move: it had received emergency funds from J.P. Morgan Chase & Co. and the Federal Reserve Bank of New York to meet its obligations and to protect against rumors that have been swirling around the firm for the past week. Whether or not the rumors became self-fulfilling prophecies are not yet known, but what is crystal clear is that Bear’s liquidity has fallen so much that it needed cash.

The mainstream media jumped on the story with headlines that repeatedly said the government is “bailing out Bear”. How unfair, said CNN’s Lou Dobbs! Your taxpayer money should not be used to ease the pain of Wall Street-ers! Before you go too crazy with that line of thought, let’s remember that a liquidity crisis that is not contained at Bear could easily spread to other banks, investors or industries, which is why the Fed, the Treasury Department and the SEC were all involved.

Authorities needed to step in because Bear does business with so many large firms (counter-parties) and is a significant player in markets for debt, particularly for securities backed by mortgages. If Bear were to fail, many of the counter-parties would become ensnared, prompting a potential domino effect throughout the brokerage and banking industries. And to the “rescue” of Bear, let’s remember that the stock fell 47% on Friday to a nine-year low of $30 per share and is down a staggering 79% from 52-weeks prior. That seems like a healthy dose of pain and suffering.

The mechanics of the deal involve using a little-used Depression-era provision of the Federal Reserve Act. J.P. Morgan will borrow directly from Fed's discount window and relend to Bear Stearns for 28 days. (Unlike investment banks like Bear, JP Morgan has the advantage of being able to borrow directly from the Fed.) The money that is borrowed will be secured by collateral furnished by Bear, but here is where the accusations of “bail-out” come to light. Under terms of the deal, the Fed, not J.P. Morgan, bears the risk of losses if the Bear Stearns collateral falls in value.

CEO Schwartz noted that the firm is seeking sources of permanent financing “or other alternatives for the company.” In other words, Bear needs a buyer-and fast. The assumption is that this deal is likely to lead to JP Morgan’s acquisition of Bear Stearns, and in a broader sense, perhaps this is the beginning of the bottoming process of the credit crunch.