A Red Flag for Bank Liquidity

In the wake of the Bear Stearns bailout, investors are taking a closer look at the capital positions of other big investment banks

by David Bogoslaw

Bear Stearns' (BSC) liquidity shocker sounded a piercing alarm in financial markets on Mar. 14 and sparked nervous speculation about how thin other large investment banks' capital positions may be getting.

There seemed to be a broad understanding that Bear's dilemma stemmed only partly from its actual capital position, with a collapse of confidence in the troubled firm also a significant part of the issue. However large a part public perception played, the bank's desperation was real enough, prompting a call to the Federal Reserve on the night of Mar. 13 for an emergency bailout.

Bear Stearns shares lost nearly half of their value on Mar. 14, after investors knocked down the stock to an 11-year low, before finally closing down 47.4%, at 30. Even that sharply diminished valuation was unsustainable. On Mar. 16, Bear agreed to sell itself to JPMorgan Chase (JPM) for $2 a share, valuing the devastated firm at about $236 million. At the end of Friday, Bear's market capitalization was about $3.54 billion.

Other investment bank stocks were punished as well on Mar. 14, with Citigroup (C) tumbling 6.1%, to 19.78; Goldman Sachs (GS) falling 5.2%, to 156.86; and Morgan Stanley (MS) down 4.9%, to 39.55.

Diversified Firms Are Better Positioned

Despite the battering other banking stocks took on Bear's Black Friday, there are some critical distinctions between them and the beleaguered firm that are keeping most analysts sanguine, at least for now, that its liquidity crisis isn't in imminent danger of spreading across Wall Street. For one, Bear is essentially a single-line business. Unfortunately for the company, that business—mortgage-backed bonds—has been the center of the credit meltdown until recently.

"We've been telling clients since November that larger, more diversified financial-services firms that are well-capitalized are in a better position to weather this turmoil," says Tom Kersting, analyst who covers the major banks for Edward Jones & Co. in St. Louis, Mo. That statement probably rings true today even more than it did a few months ago, he adds.

Unlike some of its peers, Bear Stearns doesn't have a brokerage business and doesn't have the international presence that would have helped reduce its exposure to the subprime-based credit crisis, which has largely been concentrated in the U.S., Kersting says.

Not Just a Bear Problem

In a research note on Mar. 14, Standard & Poor's Equity Research said the liquidity crisis is specific to Bear Stearns, as concerns about ample liquidity have motivated other large banks to conserve capital within their various businesses and even raise money in some cases. Still, S&P upheld its negative outlook on the investment banking and brokerage group, citing the challenges these companies face across their business lines, particularly in investment banking volume and ongoing problems in the mortgage markets.

Although Bear Stearns had been particularly aggressive in expanding its prime brokerage business, which caters to hedge funds, its exposure to the toxic securities backed by subprime mortgages, such as collateralized debt obligations (CDOs), has hardly been unique. Citigroup wrote down a total of $24.5 billion of the asset value in its portfolios during the second half of 2007, much of it because of bad subprime bets.

But Citi has also raised about $30 billion in new capital to replenish its balance sheet. "The reason [Citi is] different is that they were very proactive about going into the market and getting that capital," says Kersting. And because it has a more diversified business model than traditional banks, he believes Citi is in a significantly better position to weather the credit crisis, vs. firms with a single line of business.