March 14, 2008 3:18

Paper clip reuse may not be enough to save Bear Stearns

We're back to Bear Stearns, where it all began. Last summer, it was the collapse of a couple of mortgage-security hedge funds run by the investment bank that sent credit markets into their first true tizzy. Now a Fed-backed temporary bailout of Bear means the 85-year-old firm may not survive much longer as an independent entity.

Bear Stearns's problem is that, like all securities firms, it borrows lots of money, and has to roll over those borrowings on a daily basis. As the smallest and least diversified of the five big surviving independent Wall Street firms (Goldman Sachs, Morgan Stanley, Merrill Lynch and Lehman Brothers are the other four), and perhaps the most exposed to the mortgage market, Bear is particularly susceptible to worries about its status as going concern. Basically, if people start worrying about whether Bear will be around to pay back its loans, they stop lending--which makes it impossible for Bear to pay back its loans.

Which is exactly what happened this week. To quote Roddy Boyd and Colin Barr at Fortune:

It's unclear what exactly started Bear Stearns' nightmare this week. Veteran repurchase agreement traders told Fortune.com that a major European bank last week refused to accept Bear Stearns as a counterparty to a large swap trade. By late Monday and early Tuesday, traders at hedge funds told Fortune that they were being charged a premium by the swaps desks at Deutsche Bank, UBS and Citigroup to execute trades with Bear Stearns as the counterparty or which involved its credit.

The bottom fell out on Thursday, Bear Stearns CFO Molinaro told investors. The demands for cash came from counterparties as well as hedge fund clients who wanted to close out their prime brokerage accounts. The market voted with its feet and wallets.

It was to stave off this self-fulfilling panic that the Federal Reserve Bank of New York stepped in this morning together with JP Morgan Chase to offer short-term financing to Bear Stearns. The idea was to "restore confidence in us in the marketplace," is how Bear Stearns CEO Alan Schwartz put it. But the news that Bear needed help from the Fed to keep people lending it money was anything but confidence-inspiring for those who own the firm's shares--which is why its stock price is down 40% today.

Basically, the people at the Fed are afraid that a disorderly collapse of Bear Stearns would wreak all sorts of havoc--the firm is a big broker and lender to hedge funds, for example. But as Felix Salmon points out, the Fed doesn't really care if Bear's shareholders lose most or all their money. Which is why so many people have been selling Bear shares today.

All of which leaves Bear Stearns in quite a pinch. The firm has a reputation as a quirky, go-it-alone place. Former CEO Ace Greenberg used to urge employees to reuse paper clips to save money, which was charming, in a weird sort of way. But Bear also refused to chip in to the 1998 Fed-organized effort to keep the hedge fund Long Term Capital Management from collapsing. It wouldn't be at all easy to integrate Bear's traders into another, bigger operation.

And so while CNBC reports that current CEO Schwartz is shopping Bear around, it's not clear to me why anybody would buy it at anything but a giveaway price.

Update: Economist Willem Buiter has a withering take:

[T]he shareholders of Bear Stearns are eating their cake and having it. Shares may have dropped 43 percent in value, but what is left still beats nothing. And nothing seems the only possible fair value for what Bear Stearns would be worth without Fed assistance. Why was Bear Stearns not taken into public ownership, preferably at a zero price?

One would hope that, as soon as the rescue was announced, the existing management and board of Bear Stearns would have resigned en-masse, and without any golden handshakes of the CEO of Citigroup and Merrill Lynch -variety. This should have been a condition of the loan being made. The argument that only the existing management understands the business well enough to see it through the storm is unconvincing, as these are the very people that screwed it up in the first place. Why are the old top management and board members still in their jobs?