- The Washington Times - Saturday, March 15, 2008

The Federal Reserve yesterday rescued Wall Street powerhouse Bear Stearns from imminent failure by backing a loan from JP Morgan in the first of an expected string of federal bailouts of banks and investment houses drowning in the mortgage morass.

Rumors of a cash crisis at the investment house this week turned into reality as investors started to pull funds out of Bear Stearns accounts, quickly depleting its $17 billion cash cushion and forcing the company to seek a credit line that will tide it over for 28 days while it looks for a buyer, said the company’s chief executive, Alan Schwartz.

JP Morgan is the leading candidate to take over the failing firm.

The Fed’s second emergency bank rescue action this week triggered another bout of market turmoil, with the Dow Jones Industrial Average plunging 195 points. It came as the Federal Deposit Insurance Corp. warned of a rash of failures among 76 troubled banks on its watch list costing at least $1.5 billion in coming months.

“We are facing a potential black hole,” said Neil MacKinnon, chief economist at ECU Group, a London hedge fund. “This is being labeled as perhaps the worst financial and banking crisis since the Great Depression. While that sounds fairly apocalyptic, I think it is a realistic assessment of what is happening at the moment.”

President Bush acknowledged the “tough time” for the economy and markets and urged confidence in a speech to the Economic Club of New York.

“In a free market, there’s going to be good times and bad times. That’s how markets work. There will be ups and downs,” he said.

Bear Stearns is one of the smallest Wall Street investment houses, but it is the one most exposed to spiraling losses in the mortgage market that was its niche. The company presaged the mortgage crisis last summer when it rocked markets with highly publicized bailouts of two hedge funds invested in subprime mortgages.

Since that time, Bear Stearns reported mounting losses like other financial firms but remained in the background as more publicized problems broke out elsewhere. Its latest troubles appear to be linked to loans it provided Carlyle Capital Corp., a $17 billion hedge fund that went belly up Wednesday after informing Bear Stearns and other creditors it could not pay its loans.

Bear Stearns’ sudden insolvency only days after Mr. Schwartz vociferously denied it was having liquidity problems raised fears that other institutions that are seemingly sound could be harboring deeper losses than they have admitted.

“It shows how bad things are,” said Carl Lantz, a market strategist at Credit Suisse Group. “I have a feeling that this is not an isolated incident.”

One reason the troubles of firms like Carlyle and Bear Stearns provoke so much anxiety is because they are so highly leveraged, as has become typical on Wall Street. The Carlyle fund took out $34 in loans for every dollar in cash it put into investments — and Bear Stearns has nearly as high a leverage ratio.

Just as the Carlyle fund’s failure helped precipitate Bear Stearns’ woes, the failure of a highly leveraged investment bank such as Bear Stearns has the potential to touch many other lenders and financiers — threatening to set off a cascade of failures around the world. That is probably the reason the Fed jumped in, analysts say.

“Was Bear too big to be allowed to fail? Not on paper,” said Dwight Cass, analyst with Breakingviews.com. “The broker is a fraction the size of its rivals. But unlike when, say, Drexel or First Boston were on the brink, the fates of today’s financial firms are tightly bound by webs of counterparty exposure. If one failed, the fallout would be keenly felt by all.”

Bailout critics say regulators such as the Fed, the Treasury and the Securities and Exchange Commission, which participated in yesterday’s rescue, are not cracking down hard enough on troubled banks and securities firms. They could, for example, demand that banks raise more capital and stop wasting the spare cash they have by offering dividends to stockholders and big bonuses to top executives.

Bear Stearns executives, for example, received millions of dollars in bonuses and stock compensation in recent years. Former Chief Executive Officer James E. Cayne received total compensation of $32.15 million in 2006, according to the latest figures from the SEC, while Mr. Schwartz received $30.5 million as co-president that year.

Beyond the merits of the rescue attempt, critics note that the Fed’s own war chest of funds for rescue operations — about $700 billion in reserves stashed in Treasury bonds — is limited and getting rapidly depleted by the massive operations announced since December — including a $200 billion infusion into the mortgage market announced this week.

“Bear Stearns and Carlyle are certainly not alone in massive exposure to bad debt. Given the unprecedented leverage that many of the biggest financial firms used to play in this market, there will be many more failures to come,” said Peter Schiff, president of Euro Pacific Capital. “Does the Fed stand ready to bail out all comers?” he asked.

The Fed said it stands ready to provide further liquidity as necessary, but stressed that its motive is not to save individual institutions but rather to “promote the orderly functioning of the financial system.”

Many Wall Street observers said the Fed had little choice but to step in.

“I don’t think they can afford to let Bear go,” said Charles Geisst, the author of “100 Years on Wall Street,” noting that a collapse of Bear Stearns would be the biggest financial failure since Continental Illinois Bank went under in 1984. “At this particular moment in time, it would be a devastating blow to the markets.”

In light of the quickly accumulating financial problems, an FDIC staff memo said the agency expects increased bank failures to cause $1.5 billion in insured losses this year and next. But as the assets of banks on the insurance agency’s watch list total $22 billion, the losses could go considerably higher, staff members warned the FDIC’s board of directors.

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