FAQ on Investment Banks

They differ from commercial banks, but the Fed's latest move blurs the line between the two.

By SHARE

JPMorgan Chase has agreed to buy distressed investment bank Bear Stearns for a bargain-basement $236 million in a Federal Reserve-backed agreement. To help JPMorgan finance the purchase, the Fed is guaranteeing up to $30 billion of Bear Stearns's riskier assets. Here is the lowdown on the players and the bailout:

First of all, what is an investment bank?
Think of it as a bank for the big guys: corporate and institutional clients, governments, and financial intermediaries. Investment banks offer a range of services for these clients, such as buying and trading securities, assistance in raising capital, advice on mergers and acquisitions, and asset management. Leading investment banks include Merrill Lynch, Goldman Sachs, Morgan Stanley, and Lehman Brothers. Bear Stearns is the fifth-largest U.S. investment bank.

How do investment banks differ from traditional banks?
Most people are familiar with commercial banks, which collect deposits from clients and issue direct loans to businesses and individuals. At one point in time, banks were required to be of either the investment or commercial variety. But in 1999, the Gramm-Leach-Bliley Act allowed commercial and investment banks to consolidate. This is why JPMorgan, the nation's third-largest commercial bank, is also able to operate as an investment bank.

JPMorgan's dual role is important when it comes to the Bear Stearns deal. As a commercial bank, JPMorgan can borrow from the Fed, while Bear Stearns—as a pure investment bank—cannot. But now, even that is changing: As of today, the central bank is temporarily authorizing the New York Federal Reserve Bank to open up the discount window (where banks borrow directly from the Fed) to primary dealers, which includes investment banks. In essence, the Fed is extending direct lending to securities firms for the first time since the Great Depression.

Why is Bear Stearns in so much trouble?
Bear is heavily exposed to subprime mortgages. Plus, the firm has less capital and is less diversified than its rivals, which are supported by large asset- or wealth-management businesses. On Friday, Bear said its ability to finance operations—and service jittery clients who were cashing out—had "significantly deteriorated." Allowing the company to go under would have meant huge losses for banks and other Wall Street firms, which are tightly interconnected. Investors are now closely watching Lehman Brothers Holdings, which shares some of Bear Stearns's characteristics.

What will JPMorgan get out of the deal?
Plenty. JPMorgan will be able to expand its operations and acquire Bear Stearns at a dirt-cheap price with little risk.

How does this move affect the average investor?
Obviously, this is terrible news if you're a Bear Stearns shareholder. The deal also sparked another major sell-off of the broader market, severely punishing the shares of investment-bank stocks. Writes Tobias Levkovich of Citigroup: "We suspect that investors remain fearful that other weaker securities firms could follow this path, with extreme concern over financial institutions now." Of course, continuing spillover from the credit crunch means that banks finding it harder to raise money may charge higher rates of interest on loans.