Financial Collapse?

Bear Stearns Cos. reached an agreement to sell itself to J.P. Morgan Chase & Co., as worries grew that failing to find a buyer for the beleaguered investment bank could cause the crisis of confidence gripping Wall Street to worsen.

The deal calls for J.P. Morgan to pay $2 a share in a stock-swap transaction, with J.P. Morgan Chase exchanging 0.05473 share of its common stock for each Bear Stearns share. Both companies' boards have approved the transaction, which values Bear Stearns at just $236 million based on the number of shares outstanding as of Feb. 16. At Friday's close, Bear Stearns's stock-market value was about $3.54 billion. It finished at $30 a share in 4 p.m. New York Stock Exchange composite trading Friday.

I am not an economist but there is something very disturbing about this latest chapter in the "sub prime mortgage" crisis.  Bear Stearns had been in business for 85 years and was one of the largest investment banks and brokerage firms in the world.  As recently as a week ago (see chart above) the stock was trading at $70 per share - now this once vaunted institution is being auctioned off for literally pennies on the dollar. What happened?

Again, not being an expert - what I am able to gather is that Bear Stearns was one of the first firms to experience a direct blow from the subprime mortgage crisis when two of its hedge funds collapsed last summer. The funds were invested in very esoteric securities called collateralized debt obligations (CDO's) which were found to be worth far less than Bear had been reporting. The incident sparked concern that hundreds of billions of dollars of these securities (and perhaps trillions of dollars), owned by all of the major Wall Street investment firms,  may in fact be only worth a fraction of their stated value.

This series of events lead to rumors of a liquidity crunch, which started an old fashioned "run on the bank" stampede. This erosion of confidence was ultimately devastating for Bear Stearns, which had a leverage ratio of over 30 to 1, meaning it borrows more than 30 times the value of its hard assets.  And apparently, this degree of leverage is very common for most of Wall Street, especially since the increased profile of Hedge Funds started in the late 1990's.

So we now seem to be on the edge of unchartered territory?  Or is this a repeat of the 1920's: the last time banks and brokerage firms used leverage to such an insane degree - which ultimately lead to the Great Depression?  Many experts have suggested that the Government should let Bear Stearns fail, that this is the time to "set an example," and let the consequences of the "Free Market" play themselves out.  Unfortunately, it seems that allowing a major player to fail may have devastating consequences for the rest of the economy:

If Bear Stearns failed, for example, it would result in a wholesale dumping of mortgage securities and other assets onto a market that is frozen and where buyers are in hiding. This fire sale would force surviving institutions carrying the same types of securities on their books to mark down their positions, generating more margin calls and creating more failures.

As of last Nov. 30, Bear Stearns had on its books approximately $46 billion of mortgages, mortgage-backed and asset-backed securities. Jettisoning such a portfolio onto a mortgage market that is not operative would, it is plain to see, be a disaster.

But, who knows what those mortgages are really worth? According to Bear Stearns’s annual report, $29 billion of them were valued using computer models “derived from” or “supported by” some kind of observable market data. The value of the remaining $17 billion is an estimate based on “internally developed models or methodologies utilizing significant inputs that are generally less readily observable.

In other words, your guess is as good as mine...

HERE is the bind the Fed is in: Like the boy who puts his finger in the dike to keep sea water from pouring in, the Fed finds that new leaks keep emerging.

Regulators must do whatever they can to keep the markets open and operating, and much of that relies upon the confidence of investors. But by offering to backstop firms like Bear, who were the very architects of their own — and the market’s — current problems, overseers like the Fed undermine a little bit more of that confidence.

Another worry? How many well-capitalized institutions remain at the ready to take over those firms that may encounter turbulence in the future? Banks just do not have the capital that is needed to rescue troubled firms.

That will leave the taxpayer, alas. As usual.