How a Lack of Faith Pounded the Markets

Last Monday morning, $2 bills could be seen taped to the inside of entrance doors at the octagonal headquarters of Bear Stearns in midtown Manhattan. It's hard to decide what was more remarkable: the fact that $2 was the price per share JPMorgan Chase had just agreed to pay to take over the company, whose stock had traded above $60 the previous week, or the fact that at a place where so many employees had suddenly become impoverished, the $2 bills lasted for more than a few minutes.

Like every other Wall Street firm, Bear had taken its lumps on subprime mortgages. But in recent months it had lost the confidence of the markets the way many marriages dissolve: slowly, and then all at once. In July, when two hedge funds it managed were melting down, Bear's septuagenarian CEO, James Cayne, was at a bridge tournament in Nashville. On Wednesday, March 12, Alan Schwartz, who had succeeded Cayne in January, reassured CNBC viewers that Bear Stearns had no problems and projected it would turn a profit in the first quarter. Within two days, Bear was telling government officials it might have to file for bankruptcy. Over that weekend, the Federal Reserve worked out a deal whereby JPMorgan Chase agreed to buy out Bear Stearns for the nominal price of $236 million—in January 2007, the company was worth $20 billion.

The collapse of Bear Stearns, the nation's fifth biggest investment bank, shows just how parlous the state of financial markets has become, as well as the corrosive effect of ebbing confidence. A lack of faith, as much as a lack of cash, killed Bear Stearns. The investment bank failed in large measure because counterparties—other banks, hedge funds and financial institutions—no longer wanted to extend credit to it, no longer felt comfortable trading with the company or leaving their assets in its custody. "A company is only as solvent as the perception of its solvency," as Oppenheimer analyst Meredith Whitney put it in a recent report. Especially when the company is leveraged up the wazoo. Bear Stearns had nearly $33 of debt for every dollar of assets it held. Think of it this way: if tomorrow you had to pay back all your student loans, your entire mortgage, the Visa bill and the $180 you owe your former college roommate, wouldn't you need a bailout, too?

While the underlying economy is stalled, and perhaps shrinking, Wall Street seems to be in near meltdown mode—for reasons that are psychological as much as economic. "Credit" comes from the Latin root credo, meaning "I believe." Money is extended with the faith that it will be paid back at some point. During the recent housing and housing-credit bubble, people came to believe that debt wouldn't go bad because it hadn't gone bad. When a bubble pops, the mood swings ferociously in the opposite direction. "We've just seen markets go from a period of astonishing credit euphoria to the worst credit crisis since the 1930s in the space of eight or nine months," says Roger Altman, chief executive officer of the investment bank Evercore. Given the collapse, it's to be expected that we will have "the questions about soundness and security which are afoot in the market now."

In the 1990s, market players the world over had an unshakable belief in Federal Reserve chairman Alan Greenspan's ability to handle crises. When trouble arose, Greenspan was backed by Treasury Secretary Robert Rubin and his deputy, Lawrence Summers, backstopped by a savvy White House team. Hence, the "Committee to Save the World." But current Federal Reserve chairman Ben Bernanke and Treasury Secretary Henry Paulson have yet to prove themselves the equals of Greenspan and Rubin. Bernanke was slow off the mark—declaring the subprime crisis contained last year even as it was metastasizing, and pooh-poohing concerns over inflation as the consumer price index climbed. In recent months, however, he has responded with alacrity and imagination, slashing interest rates and making credit available to banks and Wall Street institutions.

Paulson, the towering former CEO of Goldman Sachs, is still growing into his public role. When he spoke about the Bear Stearns rescue, says David Rothkopf, author of the book "Superclass" and a former under secretary of Commerce, "he looked like a deer caught in the headlights. He was trying as hard as he could to say, 'I have a lot of confidence.' But it was clear he didn't."

While analysts give positive marks to the aggressive stimulus package the Bush administration ironed out with Congress, the overall response has been less than stellar. "In terms of the actual subprime crisis, it became apparent about nine months ago, but this administration hasn't taken any concrete action until the last month, when it was almost too late," New York Sen. Charles Schumer told NEWSWEEK. The administration's response has been to rail against bailouts for home borrowers (while approving a bailout for Bear Stearns) and to reiterate the need to extend the Bush tax cuts beyond 2010. (Marginal income-tax rates in 2011 are the least of the problems for millions of homeowners underwater.)