If Bear Stearns was in dire straits, how many other financial institutions are too?
March 18, 2008
Louise Armitstead and James Quinn in New York reveal the inside story of Friday's near-collapse of US bank Bear Stearns......
SHORTLY after lunch on Thursday, James Cayne settled down at a card table in Detroit and eyed his opponents. He was one of 4000 people who had come to play in the North American Bridge Championship, but the chairman of Bear Stearns, seeded fourth in a group of 130 in the Imp Pairs, had every reason to be confident. The session was scheduled to last until 5pm and, although Cayne's mobile phone was ringing constantly, there was no way the competitive 74-year-old could be disturbed.
Some 800 kilometres east in Bear Stearn's office in New York's Madison Avenue, Alan Schwartz, its chief executive, was racing to keep up with the numbers in front of him, too. But this was no game. Bear Stearns's share price was tanking and, even by the roughest estimation, the bank that Cayne had built into Wall Street's fifth largest was in big trouble.
Schwartz, who just the day before had appeared on US television to confirm his bank was not running out of money, called an emergency meeting with top management. Sam Molinaro, the chief financial officer, gave a frank summary. Schwartz's statement had made no difference: over the previous 24 hours Bear Stearns's biggest customers had effected a run on the bank. Millions of dollars had been demanded by hedge funds, banks and traders, and the total was simply more than the bank had.
One glance at the share price screamed that the situation would not improve: by 4pm $US3.8 billion had been wiped off the bank's value and the stock closed 47 per cent down at a nine-year low of $US30.
Schwartz, who had taken over the helm from Cayne in January, knew that without an immediate cash injection the 85-year-old institution, which had survived the Great Depression, was bust.
He called his key adviser, Gary Parr, the deputy chairman of Lazard and one of a handful of men on Wall Street able to raise serious cash at short notice. Parr immediately drew up a list of those who could help. One of his first calls was to Jamie Dimon, the chairman and chief executive of JPMorgan. Once Dimon heard the extent of Bear Stearns's difficulties, it was clear he would have to help somehow.
The President, George Bush, was notified and Chris Cox, the chairman of the Securities & Exchange Commission, was put on alert. Calls were made to Tim Geithner, the president of the New York Federal Reserve, and Ben Bernanke, the chairman of the Fed. The men gathered their teams and began trying to work out how they would react.
In an attempt to improve liquidity, just three days earlier the Fed had pledged to make $US236 billion of credit available to the financial system. But it was not going to be available until March 27. With Wall Street in the grip of the credit crisis, few banks could be called on to help.
Discussions between Schwartz and Dimon were struggling to make progress. Insiders said the pair had recently talked about a tie-up but, with worsening markets and investor fears, it would be a huge risk for JPMorgan to buy its rival. Then Parr devised a plan: if the New York Fed would provide the funding, JPMorgan could be a conduit through which a government-backed cash injection could be delivered. The loans provided by JPMorgan would be backed with collateral guaranteed by the Fed.
It was not an easy decision: not since the 1960s had the US central bank authorised the provision of funds to institutions other than a regulated depository bank. Bear Stearns, a brokerage, was not one.
At 7am on Friday, after a long night of talks, another conference call resumed to pull together the lending agreement. At 8.38am the announcement was made that the Fed, in conjunction with the Treasury and the SEC, had authorised a rare lifeline to Bear Stearns.
Horrified traders soon grasped the reality: the Fed had been forced to throw out four decades of monetary history in order to support Bear Stearns. Its justification was not that Bear was too big but that it was too "interconnected" to be allowed to fail with the markets in such as fragile state.
As advisers work to find a long-term solution by tonight, bosses on Wall Street and in the City of London are trying to gauge what all this means for the market. Will panic, limited so far to the credit markets, transfer to equities? And if Bear Stearns was in dire straits, how many other financial institutions are too?
Bear Stearns's fall from grace has been spectacular. Just nine months ago its three main areas - mortgages, prime brokerage and clearing - were riding high on the global financial boom, particularly in housing and hedge funds. But last summer two of the bank's hedge funds, which were heavily exposed to mortgage-backed securities, imploded. The losses of $US1.6 billion were the first signs of the crisis in the credit markets. One insider said: "From that moment, Bear was almost synonymous with the crisis. Any rumours of write-offs or liquidity issues hit us first."
The pressure, exacerbated by criticism of the bank's risk controls, led to tensions between Cayne and his senior managers. Cayne formed an alliance with CITIC, the Chinese banking group, whereby the two banks would invest $US1 billion in each other.
But it wasn't enough. The subprime crisis got worse and that Bear Stearns, the second largest trader in such loans, had a sizeable problem was no secret. At its fourth-quarter results, released just before Christmas, Bear Stearns was forced to write down a further $US1.9 billion in subprime and leveraged assets, leading to a $US854 million loss.
Change was urgent and under extreme pressure Cayne relinquished power to Schwartz.
By mid-February some hedge funds were beginning to grow suspicious of its balance sheet. As one of the biggest prime brokers, Bear Stearns looks after and administers millions of dollars of hedge fund money. As rumours mounted, managers started demanding their money back.
Bear Stearns relies on short-term funding, particularly lending securities for cash in the "repurchase" market. As markets have deteriorated, interbank lending has got tougher for everyone, but particularly for Bear Stearns. It has been forced to stump up more collateral and accept lower margins for its business, heaping yet more pressure on its image and its balance sheet. The situation was exacerbated by the fact that, as a pure investment bank, it had no customer deposits to call on.
As the credit crunch took another savage turn, some of the world's best-known hedge funds were the new victims. Peloton imploded three weeks ago; Focus Capital started liquidating its funds days later. But the biggest calamity came last week when Carlyle Capital, the Amsterdam-listed arm of the US private equity giant, announced a $US16 billion debt default. Suddenly a crisis in the high-rolling hedge fund sector seemed on the cards.
Once again Bear Stearns was hit the hardest. Hedge funds and other counter-parties scrambled to reclaim their money.
One hedge fund manager said: "Explaining to investors that you're down 10 per cent on the year is hard enough. Telling them you've lost 90 per cent of their cash because you left it with a bank that was obviously screwed would be a nightmare. We weren't taking the risk."
Brad Hintz, an analyst at Sanford Bernstein, the Wall Street firm, said on Friday: "Bear Stearns was the weakest player and as lenders demand their money a broker has no choice but to sell assets and shrink its balance sheet. At some point the liquid assets are all gone and the firm cannot sell the illiquid ones."
At the beginning of last week, rumours that Bear Stearns had a liquidity crisis swirled around the market. On Monday Alan Greenberg, a former chief executive of Bear Stearns and current board member, said the rumours were "totally ridiculous". Bear released a statement to back him up. Henry Paulson, the Treasury Secretary, joined senior Fed officials in trying to persuade other banks to keep the lines open and trade with Bear Stearns.
On the weekend, stunned Bear Stearns managers were working with bankers, politicians and regulators to salvage the bank and market confidence.
In London, traders are concerned that this could be the tipping point that knocks the US economy into a full-blown recession.
"Is this a step forward in the resolution of the credit crunch - with a move towards greater clarity - or a step back, with banks and financial institutions becoming even more reluctant to lend money?" said Jeremy Tigue, the head of global equities at F&C Investments.
Last week few were taking chances: as investors fled stocks, money washed through the commodities market, where assets such as gold, wheat and oil are considered safer bets.
The worry is that if Bear Stearns is in trouble, it is not the only one. And that sentiment, more than any billion-dollar writedowns or hedge fund collapses, could yet plunge the entire financial system into a meltdown the like of which would make Schwartz's problems pale in comparison
-- Sucheta Dalal