By now you all must be up on the news about Bear Stearns being sold for $2 a share to J.P. Morgan Chase. That’s roughly $236 million for an 85-year-old investment bank that was worth $20 billion only a few weeks ago. If you read the top dailies today — The Wall Street Journal, The New York Times and The Washington Post — you will get a 360-degree view of the crisis.
However, the big question is why did the Federal Reserve decide to underwrite $30 billion of its less liquid assets in order to get J.P. Morgan to buy Bear Stearns? It’s a big risk the Fed is taking, and I want to know why. After all, it’s the American taxpayer who would be left holding a bag of rocks if things go sour.
Given that the intricacies of Wall Street, the credit markets and other such big money topics isn’t something I write about on a day-to-day basis, I turned to Paul, who in a previous life was an investment banker. He pointed me to this article in the Money & Investing section of today’s Wall Street Journal that essentially said: prime brokerage.
Bear Stearns is the second-largest prime brokerage firm in the country, with a 21 percent market share. As part of the prime brokerage business, hedge funds would use their stock holdings and borrow money, many times the value of their stock from Bear Stearns, and then redeploy it in the markets. Bear Stearns, thanks to its stellar credit rating, could easily raise gobs of money that it in turn loaned to hedge funds. They had built up a portfolio of around $136 billion of these assets. (I am not sure how they are really assets, but maybe I am just way too skeptical.)
In the days leading up to the financial crisis, the hedge funds had started to get worried about the credit worthiness of Bear Stearns and decided to pull their money. Now had Bear Stearns gone bankrupt, there would be a lot of hedge funds out there being forced to dump their stocks into the market just to meet their obligations. In other words, the downward spiral that would have ensued would have become a vortex that would have sucked down entire financial markets.
And that would have put the confidence in the entire financial system at risk. Sooner or later that would start to impact Main Street, and then things would get ugly. Fears of a depression were trotted out just last week.