Forbes: The Fed and Bear Stearns

Investors around the world are waking up to a disquieting series of events on Monday, following an astonishing weekend of activity in the United States. Bear Stearns will be bought for a song by JPMorgan Chase, a result of its mortgage-related problems, and the Federal Reserve undertook a rare Sunday interest-rate cut.

JPMorgan Chase, which on Friday rode to the rescue of the benighted Bear Stearns , bought the firm on Sunday at a fire-sale price of $2 a share, or $236.2 million. At the end of last week's trading, Bear was worth $3.5 billion; one day earlier $6.7 billion.


The move, if not the price, was widely expected after JPMorgan stepped in Friday to shore up Bear Stearns, which was reeling from a customer run on their money. The deal makes Bank of America's $4 billion acquisition of Countrywide Financial, another troubled lender, look lavish in comparison.

The boards of both firms unanimously approved the deal. JPMorgan had one and a half days to look over the Bear Stearns books. That the Bear Stearns board, which presumably was more familiar with its finances, would part with the company for so little money indicates it felt it couldn't wait any longer without the risk of getting even less.

The news got out before the opening of markets in Asia, when Bear Stearns might have been forced to divest hard-to-sell assets at painful discounts if it was trying to stay in business. Asian markets opened sharply lower on Monday, following Friday's decline in New York, which was sparked in part by the situation at Bear Stearns. In Tokyo, the Nikkei 225-stock index was 4% lower, while the Hang Seng index in Hong Kong was 5% lower and Standard & Poor's 500 futures were trading down 3%, according to TradeTheNews.com.

Gold, meanwhile, soared to $1,020 an ounce, up from $998.30 late on Friday in New York, as fearful investors sought a safe haven.

While JPMorgan was raiding its petty cash to buy Bear, the Federal Reserve took the highly unusual move of cutting the discount rate, charged on loans to banks, on a Sunday. Not only did it act over the weekend, but it cut just two days before a regularly scheduled meeting at which it was widely expected to reduce the discount and the more important federal funds rates, probably by three-quarters of a percentage point each.

The new discount rate is 3.25%, down from 3.5%, putting it just a quarter percentage point above the 3.0% of federal funds, the interbank loan rate that typically is the cheapest cost of money in the U.S. market.

The Fed acknowledged the extraordinary circumstances, including the collapse of the fifth-largest Wall Street investment house, that have hit the market in the last few days. The emergency lowering of the discount rate and the broader access to the window were "designed to bolster market liquidity and promote orderly market functioning," the Fed said in a statement Sunday. "Liquid, well-functioning markets are essential for the promotion of economic growth."

The Fed is part of the JPMorgan takeover agreement as well, agreeing to take $30 billion of Bear's less liquid assets as collateral, a move that will no doubt make it easier for JPMorgan to sell the transaction to its own investors.

By "less-liquid assets," the Fed probably meant " mortgage-backed securities." The market for these instruments has evaporated since U.S. homeowners began defaulting on mortgages in sizable numbers a little more than a year ago.

The Fed move and the Bear sale indicate that there is great fear in banking circles that the crisis that began in the U.S. mortgage market could set off a chain reaction of defaults. The central bank took an active role in the Friday bailout of Bear by JPMorgan.

Apparently to keep any of the other big brokerage houses from running into the kind of troubles seen by Bear Stearns, the central bank also created a new loan facility that seems aimed at them. Primary dealers, a group of about 20 big banks and brokers that deal directly with the Fed in its monetary policy operations and in Treasury bond auctions, can borrow at the discount rate by posting "a broad range of investment-grade debt securities" as collateral.

This move effectively extends the discount window borrowings to the brokers since the banks could already tap the Fed, although they have historically been reluctant to do so because that would send a signal that they could not borrow money from the private sector.

The run on Bear Stearns accelerated late last week, after the company had spent several days trying to calm the markets by saying its liquidity and cash positions were fine. By Friday, the company had gone hat in hand to JPMorgan, which agreed to act as its go-between with the Fed for Bear to borrow emergency cash.

Bear Stearns Chief Executive Alan Schwartz said Friday that rumors had done the damage. "We have tried to confront and dispel these rumors and parse fact from fiction," he said. "Nevertheless, amid this market chatter, our liquidity position in the last 24 hours had significantly deteriorated."

JPMorgan will take over Bear Stearns in swift order. The deal is expected to close by the end of the second quarter, and has already gotten approval of bank regulators.

The company said beginning now it is guaranteeing Bear Stearns' trading obligations, a move that would also be seen as an attempt to stop the run on customer money.

"JPMorgan Chase stands behind Bear Stearns," said Jamie Dimon, JPMorgan's chief executive officer. "Bear Stearns' clients and counterparties should feel secure that JPMorgan is guaranteeing Bear Stearns' counterparty risk."

It's not clear just how much remains of Bear Stearns for JPMorgan to acquire. In addition to a large fixed-income operation that has been hammered by the credit-market turmoil, Bear Stearns' most attractive asset would be its prime brokerage operations, which cater to the trading and assorted other needs of hedge funds. Much of the run last week is believed to have been in the prime brokerage division, with hedge fund clients pulling cash out.

Dimon has built a reputation as being less willing to go whole hog in a business than some of his peers, and as such JPMorgan has not had the magnitude of problems as its fellow banks and broker-dealers as the credit crunch works its way through the market. That made JPMorgan perhaps more capable than other banks of pulling off a rescue, or salvage, of Bear Stearns.

"We are taking reasonable risk, we have built in an appropriate margin for error, it strengthens our business, and we have a clear ability to execute," Dimon said Sunday.

In his own statement Sunday, Schwartz of Bear said, "The past week has been an incredibly difficult time for Bear Stearns. This transaction represents the best outcome for all of our constituencies based upon the current circumstances."