Vidya Bala

Bear Stearns (BS) may well go down in Wall Street history. Not for the right reasons though. By now, most of us may be able to relate the recent happenings in investment banking to ‘sub-prime’ woes in the US. But what exactly led to a fire sale of one of the most reputed financial institutions in Wall Street? Why should the US central bank hasten to oversee this sale and why were the global markets jittery? A quick take on these issues.

Recap

On Monday, BS, one of the top five investment bankers in New York, was bought out by JPMorgan Chase & Co for $2 a share — 90 per cent lower than the former’s market value the preceding Friday. The US Federal Reserve agreed to fund JPMorgan Chase $30 million of Bear Stearn’s assets and cut interest rates by 25 basis points in an Emergency Meeting (the Fed cut rates by another 75 basis points the next day). This buyout prevented BS from declaring bankruptcy and provided reassurance to the financial markets.

Turn of events

Why did BS crumble the way it did? To put it simply, the company’s investors and clients doubted its ability to repay loans, including those borrowed in repo markets (short-term loans typically made overnight between banks).

If the company did not pay, lenders would have been forced to sell the securities pledged and repayment capabilities of other investment banks and companies may have come under a cloud.

This apart, the company had complex agreements with other bankers; the latter could have been exposed to credit risk from BS’ inability to pay.

But what set the ball rolling? As you might have guessed, the collapse of the US housing bubble set the trend for the series of mishaps. With home prices in the US climbing steadily, lenders, including banks, decided to provide loans to those who would not have otherwise qualified under the regular mortgage norms.

Known as sub prime loans, the lenders in turn reduced their risk by offloading parcels of such loans to Wall Street firms who were willing to buy them. These mortgage loans were mixed and matched with other types of debt instruments and sold to investors as complex instruments.

Trouble started when the housing market started showing signs of decline. Defaults on mortgages rose and the complex securities lost value, as banks became wary of loans backed by mortgage-backed securities. So where does BS come in?

The company was among the biggest underwriters of such mortgage-linked instruments; it was a big player in leveraged buyouts and had significant dealings with hedge funds. Last year, two of its hedge funds that invested in sub prime mortgages were in trouble. BS was soon bleeding for want of cash as investors/clients pulled out fearing that they may not get back their money. The company’ stock plunged from over $100 in December 2007 to $30 just before it was bought out.

What this means

For JPMorgan Chase, the risk lies in the true extent of Bear Stearn’s obligations and whther the assets acquired would compensate for them. However, the key attraction from the deal is that it would now own a business it did not have a presence in — the prime brokerage business of BS (which generated $1.2 billion profits last year), which lends to hedge funds and also helps them process their trades.

For the US economy: The Fed’s bailout and cut in interest rate was viewed as being imperative to prevent any ripple effect on the other bankers and the larger economy. Fear of default may have further prompted lenders and bankers to hoard cash. If this continued, the US credit market could have contracted further, curtailing household spending and consequently reducing investments and jobs.

The Fed’s continuing move to cut interest rates to spur economic activity may, however, lower yield on deposits and money market instruments in the US. Lowering interest rates could also weaken the dollar further. These factors may urge global investors to unwind their dollar investments and look for markets that generate higher returns.

For other countries: A weakening dollar affects earnings as well as growth for nations that have significant dollar denominated exports. Recent interest rate cuts may aggravate the issue, by further weakening the dollar. Similarly, the rising costs paid by the oil producing countries as a result of being pegged to the dollar may prompt them to look out for alternative currencies.

But if investors were looking for better investment destinations, why would emerging markets such as India witness FII outflows? This could well be a temporary phenomenon arising out of two reasons: One, investors such as hedge funds who look up to the likes of BS to finance their trading or who have agreements with them may be strapped for money even if they wish to invest in other markets.

Foreign investors may also prefer to encash in markets in which they have made profits. However, given that the US at present does not present a rosy picture, funds may still come into emerging markets at a later date.

For the Indian equity market: The bulk selling in stocks held by FIIs has resulted in volatility in the stock markets. Mid and small-cap stocks have taken steep cuts as a result of unwinding by FIIs. While valuations have corrected across the board, there are new concerns about earnings too. Investors need to be selective in identifying stocks that can once again bounce back driven by strong fundamentals.

(This article was published in the Business Line print edition dated March 23, 2008)
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