A Bailout for a Bear

The Fed, J. P. Morgan jump into the credit turmoil to rescue Bear Stearns. But will it be enough?

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The Federal Reserve jumped headlong into the credit maelstrom Friday by teaming up with financial giant J. P. Morgan Chase and tossing a lifeline to investment firm Bear Stearns, which is facing a full-blown liquidity crisis. Under the terms of the agreement, the Federal Reserve Bank of New York will provide cash to J. P. Morgan, which, in turn, will extend financing to Bear.

Bear—a leading player in the now-toxic business of mortgage backed debt—has been at the forefront of the housing-led credit crunch since last summer, when two of its hedge funds imploded. Controversial CEO James Cayne resigned in early January, shortly after the firm reported a fourth quarter loss of $854 million—the first quarterly loss in its history. Bear's stock was already trading at five-year lows before news of the bailout sent shares tumbling more than 40 percent in trading Friday.

What's the problem with Bear?

Bear is the nation's fifth-largest securities firm and a key issuer of mortgage-backed bonds. But with home prices falling and foreclosures rising, the value of such securities has plummeted, leading to massive writedowns at Wall Street firms like Bear. As a result, lenders have become less willing to provide financing to the firm, choking off the supply of cash Bear needs to fund its operations. "They cannot get the money to facilitate their business," says Matthew McCormick, a bank analyst at Bahl & Gaynor Investment Counsel. "They are having to pay more to get more and they are getting stuck," McCormick says. McCormick calls Bear's liquidity crisis a "near-death experience," and argues that the firm's problem are—ironically—similar to those of struggling American homeowners. "They do not have easy access to capital, their creditors want to get paid regardless of their past economic situation, and if they are going to get access to capital, they are going to have to pay more for it," McCormick says.

What happened this week?

In recent days, Bear Stearns President and CEO Alan Schwartz denied widespread rumors that the company was having a tough time obtaining cash. But Schwartz changed his tune in a press release Friday that announced the financial arrangement, admitting that the firm's "liquidity position in the last 24 hours had significantly deteriorated." So what's next for Bear?

Punk Ziegel analyst Dick Bove expects Bear to survive the crisis, albeit in a much different form. He says the company will have to shrink to about half its current size and could spend the next five to seven years just trying to get back to where it is now. "It's been dealt what is pretty close to a death blow and you simply cannot recover from this quickly," he says. Still, he does not believe the Fed will allow the firm to fail because of the ripple effects such a failure would have on the financial markets as a whole. "It's one of the most serious risks to the financial system that we have seen since 1929," Bove says. "I think it will be handled, but one should not downplay the seriousness." How unusual is the Fed's involvement?

It's unusual, but not unprecedented. Jane Caron, chief economic strategist at Dwight Asset Management, says that the situation resembles the Fed-brokered rescue of troubled hedge fund Long Term Capital Management in 1998. "The Fed is clearly fulfilling it's 'lender of last resort' function," says Robert Brusca of FAO Economics. What does this say about the state of the financial system in general?

Bear's troubles show just how unwilling lenders have become to offer financing in the midst of the uncertainty in the market. "It is demonstrating that liquidity is so restricted that it's very hard to roll your positions in the current market," Caron says. "As a result of that, even if you do have sound collateral on your books...you can find yourself in a liquidity crisis." Will the plan work?

It's tough to tell at this point. "This is a near-death experience in which the doctor has not given them a clean bill of health yet," McCormick says. "They are on the ropes, they are getting body blows and they're hoping for the bell to ring to get some respite, and I don't know if it's enough, to be honest with you."