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http://www.businessweek.com/stories/2008-03-14/bear-stearns-big-bailoutbusinessweek-business-news-stock-market-and-financial-advice

Bear Stearns' Big Bailout


JPMorgan Chase and the federal government team up on a bailout of Bear Stearns, a last-ditch move to save the investment bank

Bear Stearns (BSC) is clawing to stay alive, with many on Wall Street now betting the storied investment bank may not survive the weekend as an independent shop.

Bear's stock was in a free fall Mar. 14—hitting an 11-year low—following the news that JPMorgan Chase (JPM) and the New York Federal Reserve had stepped in with an emergency cash bailout for the New York-based investment firm. The bailout was engineered after days of denials by Bear executives that the firm was facing a liquidity crisis and lacked sufficient funds to continue operating. Bear's stock finished down 47% at 30, on volume that was more than 18 times normal trading. JPMorgan dipped 4% to 36.54.

Bear Stearns CEO Alan Schwartz says the situation at Bear took a turn for the worse during the past 24 hours and the firm's liquidity situation had "significantly deteriorated." In a conference call Friday afternoon, Schwartz says "nervousness in the market" prompted clients and lenders to "get cash out" of the firm. Schwartz says, "A lot of people wanted to act from the possibility of the rumors being true." He says before the turmoil, Bear had been working with investment firm Lazard (LAZ) to explore "alternatives" and those discussions will continue. Bear officials also said the decision to seek aid from JPMorgan was their decision. Sources say one reason Bear may have turned to JPMorgan stems from the fact that the bank is already one of the investment firm's main lenders and the big bank has an incentive to see Bear remain in business.

Schwartz and other top executives at Bear are trying to put on a brave face, saying the firm will be able to weather the current storm. But many on Wall Street, and even some within Bear, aren’t sure. Oppenheimer (OPY) brokerage analyst Meredith Whitney says Bear’s prospects are bleak, noting: "A company is only as solvent as the perception of its solvency." One source says many employees at the 85-year-old investment firm are worried about the future and what will happen on Monday. The fear is the longer the firm is perceived as existing on life support, it will be hard to retain wealthy customers—both individuals and hedge funds.

As recently as Mar. 12, Schwartz had taken to the airwaves, appearing on cable channel CNBC (GE) to shoot down rampant rumors that Bear was facing a liquidity crisis. Earlier in the week, Bear had issued a press release denying the rumor. Even Alan "Ace" Greenberg, Bear's legendary former chairman and CEO, had put out a statement denying the investment firm was in trouble.

Bear Rescued from Failure

It's not clear what had changed so dramatically at Bear to necessitate the emergency bailout, in which JPMorgan is providing a secured line of credit to the beleaguered investment firm. But events appear to have moved quickly on Mar. 13. People familiar with the situation say Bear officials called the Fed late in the day, saying the firm had a funding problem. Officials from the Fed were at Bear's spacious offices on Madison Avenue all night, scouring its books and trying to devise a rescue plan. The Fed and Bear then reached out to JPMorgan, seeing if the big bank led by CEO Jamie Dimon could help out. JPMorgan, which has multiple business relationships with Bear, was inclined to do so. But only with some guarantee from the Fed that it would make JPMorgan whole if Bear were to fail and couldn't make good on its obligations. So if Bear fails, everyone in the U.S. will indirectly own a little piece of the company.

It would have been highly risky for other Wall Street firms if Bear Stearns had been allowed to go under because Bear is tightly interconnected with them as both a borrower and a lender. Any firms that are owed a lot of money by Bear would have fallen under suspicion, on grounds that they might not be able to pay their own debts if Bear failed to pay them. That could have triggered a dangerous wave of defaults. The rescue by JPMorgan Chase gives the financial system breathing room to pay off Bear's debts gradually.

Rumors about a funding crisis at Bear had spread like wildfire all week on Wall Street—pummeling the stock in the process. With shares of Bear trading around $30, the stock has lost more than half its value in the past week.. It was only a year ago that shares of Bear were trading around $150—just a few dollars below its all-time high. But then came the collapse of two giant Bear hedge funds that bet heavily on securities backed by subprime mortgages—an event that helped trigger the credit crunch and prompted Wall Street banks to take more than $150 billion in writedowns.

JPMorgan Could End Up Buying Bear

The Fed apparently contacted JPMorgan because it was in a much better position to come to Bear's aid than other big banks, such as Citigroup (C), Bank of America (BAC), and UBS (UBS), all of which are dealing with their own subprime-related woes. Under the terms of the deal, JPMorgan is providing a secured loan to Bear for an initial 28 days. The Fed has agreed to stand behind the loan and to make JPMorgan whole if Bear fails and the collateral it has put up cannot cover the outstanding debt.

The move by JPMorgan to come to Bear's rescue has raised speculation that the big bank may ultimately buy the struggling investment firm. Indeed, a sale of Bear may be the only way it can survive. A source familiar with the situation tells BusinessWeek that Bear executives are now talking to JPMorgan about "exploring strategic initiatives."

If JPMorgan doesn't assume Bear outright, one option is for Bear to be broken into pieces, with rivals cherry-picking groups of traders, bankers, and brokers. There could be some heated bidding for Bear's prized prime brokerage and clearing group, which provides loans and back-office services to hedge funds and small brokerages. But Wall Street observers say the value of those operations will continue to decline the longer the funding crisis goes on, as hedge funds seek to move their business to other Wall Street firms. There is speculation that Citadel Investment Group, the big $20 billion hedge fund run by Ken Griffin, could make a run for the prime brokerage operation. Citadel, which excels in going after distressed properties, has been looking to diversify its operations and move into hedge fund administrative services.

Even with the emergency funding, there's little confidence in Bear on Wall Street, especially after the firm's management was out all week denying financial trouble. Once Wall Street loses confidence in a brokerage, it can be a death sentence because other firms are reluctant to lend it money or trade with it. All week there have been rumors about some investment firms being reluctant to trade or lend money to Bear because they were uncertain about its ability to make good on its commitments. In recent days, a number of hedge funds that are prime brokerage clients of Bear have taken steps to move their lucrative business to other Wall Street banks.

Subprime Toll

The subprime mess has taken a big toll on Bear. The collapse of the hedge funds has spawned a myriad of lawsuits from investors and investigations by the Securities & Exchange Commission and federal prosecutors. Sources say federal prosecutors and the SEC are investigating allegations that the former managers of the Bear hedge funds may have misled investors. The firm has seen its bread-and-butter work in underwriting and trading mortgage-backed securities dry up.

No matter what comes of the investigations, the hedge fund debacle was a big blow to Bear's reputation. Late last year, James Cayne, Bear's chairman, stepped down as CEO because of criticism of his slow response to the hedge fund collapse. In the fourth quarter of 2007, Bear also reported its first quarterly loss in its history. Just this week, Schwartz was saying he expected Bear to return to profitability in the first quarter. The firm has also pushed up its earnings report by three days, to Mar. 17.

Analysts are saying that Bear's business model is broken in the wake of the mortgage meltdown. The firm never has been a leader in advising on corporate deals, and the rocky stock market has put a big chill on underwriting activity for new stock offerings. For Bear, its most valuable business may be its hedge fund prime brokerage operation. The firm also is a leader in clearing and processing trades for hundreds of small brokers. With Bear's shares trading well below the firm's stated book value, a rival bank may be tempted to buy Bear just to get its hands on the valuable prime brokerage and clearing business.

Business Exchange related topics:

Fed Bailing Out Bear Stearns

Bear Stearns

Bailout

Credit Crunch


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