The rumours had been swirling around for days. Early last week America’s
Federal Reserve led other central banks by announcing the injection of $280
billion (£138 billion) into the markets to help ailing banks.
Was the Fed acting out of general concern for the economy and credit markets,
or was it trying to save one or more troubled financial institutions?
On Friday the answer came. While the Fed’s move was aimed at easing strains in
the markets, Wall Street’s instincts were right. One of its brethren, Bear
Stearns, for more than 80 years one of the street’s blue-blooded names, was
in deep trouble.
In a dramatic move, JP Morgan Chase and the Federal Reserve Bank of New York
stepped in with emergency funds to keep the beleaguered Bear afloat using a
legal provision brought in during the great depression era. While Northern
Rock was the victim of a run by retail customers, Bear Stearns’s money
drained away when bankers and big-time investors made so many withdrawals
that it could no longer meet its obligations.
Early last week its chief executive Alan Schwartz said there was “absolutely
no truth” to the speculation that the brokerage firm had liquidity problems.
On Friday, he conceded, things had moved on.
“We have tried to confront and dispel these rumours and parse fact from
fiction,” he said in a statement. “Nevertheless, amid this market chatter,
our liquidity position in the last 24 hours had significantly deteriorated.
We took this important step to restore confidence in us in the market-place,
strengthen our liquidity and allow us to continue normal operations.”
The previous evening after crisis meetings at the firm’s sleek Madison Avenue
headquarters, Schwartz had called Jamie Dimon, head of JP Morgan and the man
who recruited Tony Blair as an adviser, requesting a bail-out. The two were
said to have discussed JP Morgan taking over Bear.
Bear has been hard-hit in the credit-market meltdown. It has written down more
than $2 billion in exposure to mortgage securities. In January chief
executive James Cayne resigned. Though it is the smallest of Wall Street’s
big five investment banks, it is still a significant player, particularly in
the debt markets.
Larger rivals, including Citigroup and Merrill Lynch, have lost more money
than Bear but were big enough to absorb the blows. Bear may be the first big
Wall Street firm to fall to the crisis in confidence in the financial
markets, but will it be the last?
Carl Lantz, interest-rate strategist at Credit Suisse, said: “Bear illustrates
the extent of the problems that are out there. I think we are going to
continue lurching from one crisis to the next.”
Lantz said the Fed had been right to step in. Financial markets were now so
complex, he said, with banks lending to and borrowing from each other in
such elaborate fashion, that the collapse of one bank could have a
significant impact on the whole banking system. “If one player goes down, it
can cause a real mess. At the least we want an orderly unwind,” he said.
But he added that this is unlikely to be the last time the Fed is called on to
make the same decision. “I don’t see light at the end of the tunnel yet.
This is beyond [the sub-prime mortgage disaster].” Credit Suisse estimates
that banks could lose up to $125 billion in so-called Alt-A and options
ARMs, mortgages once seen as less vulnerable than sub-prime. A further $150
billion is at risk in nonresidential loans, he said.
For some there was a neat symmetry to Bear Stearns signalling a deepening of
the credit crisis. In June last year, when the crisis was brewing and the
firm announced that two of its hedge funds were in trouble after investing
heavily in sub-prime mortgages, it had to pump in $1.6 billion to prop them
up. A month later the firm announced that the game was up for the funds,
which had effectively lost all their value, and that it was seeking an
“orderly wind-down”.
With comparisons being drawn with Britain’s Northern Rock, Bear Stearns’s
difficulties are not just being felt by its 14,000 employees. Joe Lewis, the
secretive 71-year-old British billionaire, began building a stake in the
firm last September when its share price was more than $100, reportedly
because he thought pessimism about the firm was overdone. He now has just
under 10%. On Friday, after the announcement of the emergency help, the
share price dropped at one point by nearly 40% to $27, implying a paper loss
of several hundred million dollars for Lewis.
This weekend, Bear Stearns’s days as an independent firm appear numbered. “It
would not be a surprise to see a merger announced over the weekend,” said
Andrew Brenner, senior vice-president of MF Global in New York. Another
analyst said: “JP Morgan might buy it for a dollar. Ultimately you have to
ascertain if the assets are worth more than the liabilities.”
Sources at JP Morgan suggested that the bank might be interested in buying
Bear’s prime brokerage business, and part of its mortgage business, but not
the whole firm.
Jeff Houston, a bond fund manager at American Century Investments in San
Francisco, said the future looked bleak for Bear. “I think they will get
sold off or taken apart. I don’t see how they can come through this whole.”
He said that Bear, like many investment banks, operated like a “black box”,
with investors and trading partners unsure of what the bank was investing
in. Once that confidence was shaken it became harder and harder for the firm
to get it back, said Houston. “If you don’t have transparency, then if there
are rumours, they are difficult to get rid of. The paradox is that
transparency can also make this worse once people do know what’s in there.
Liquidity can disappear in a moment.”
THE wider implications of the Bear Stearns crisis are still sinking in. The
Fed’s announcement of a huge injection of liquidity earlier last week was
initially greeted with euphoria on Wall Street, with the Dow Jones
industrial average leaping by more than 400 points. An announcement by
Standard & Poors, the ratings agency, that write-downs from sub-prime
mortgages were past the halfway mark and likely to be limited to $285
billion also helped sentiment.
All that, however, was forgotten on Friday. “People are having to get out
their history books,” said Nick Stamenkovic, an economist with RIA Capital
Markets. “The debate was about whether America would have a recession. Now
it is about how deep it will be.”
One prominent Wall Street adviser described the credit crunch as “a five-act
Shakespearean tragedy” with a long way to run. There would be times when the
mood appeared to be lightening but people should not be fooled by them, he
said. “I think we’re still in act one.”
Next year is likely to see large-scale consolidation among American banks and
financial institutions, he suggested, with a flurry of mergers and
takeovers, as those weakened by the credit crunch get picked off by their
stronger competitors. “There will be more Bear Stearns,” he said. Capital
from sovereign wealth funds, which troubled banks have already drawn on,
would continue to be needed.
Others see further changes down the line. Nonfinancial firms like GE and
Rolls-Royce have been big providers of credit to commercial customers and
consumers, but that was likely to change. “Industrial companies that have
credit-pro-viding arms are going to be looking to get out of that business,”
said John Studzinski, a senior managing director at Blackstone, a private
investment and advisory firm. THE longer and deeper the credit crunch
becomes, the more it will weigh down on an already reeling American economy.
The National Bureau of Economic Research is regarded as the official arbiter
of US recessions. By careful analysis of the data, it pinpoints when the
American economy dips in and out of recession, usually many months after the
event.
This time, however, Martin Feldstein, its president, is not waiting.
Feldstein, a former chairman of the White House’s Council of Economic
Advisers under Ronald Reagan, said on Friday that America was in a recession
that could be “substantially more severe” than recent ones.
“The situation is bad and getting worse,” he said in a speech in Florida.
“There’s no doubt that this year and next year are going to be very
difficult years.”
America was not heading for a rerun of the great depression, Feldstein added,
but could be facing its worst recession since the second world war, partly
because aggressive cuts in interest rates by the Federal Reserve - with
another expected this week - are prevented by the credit crisis from having
their normal impact.
“There isn’t much traction in monetary policy these days, I’m afraid, because
of a lack of liquidity in the credit markets,” he said. “There is a lack of
confidence leading to a lack of liquidity. Without credit creation, we can’t
have economic growth.”
Ken Goldstein, economist at New York’s Conference Board, is far less gloomy.
“We’re not even close to going to hell in a hand basket,” he said. “The sky
is not falling in.”
Goldstein said the economy was in for a period of slower growth but the
doom-laden prognostications of his peers were overdone and he was
“absolutely convinced this is panic and overreaction”.
“What we have seen to date is a $200 billion loss in the mortgage market from
a total mortgage market that is worth $10 trillion. Maybe the losses will be
as big as $400 billion, say they were $4 trillion - which I doubt very much.
In 2000 we lost $6 trillion in the tech wreck and the markets didn’t freeze
up. This is overreaction and panic.”
Stephen Lewis, an economist with the fund manager Insinger de Beaufort, said
the big question was the degree of “contagion” from the financial sector to
the wider economy. “What we are seeing is a very big problem for the global
financial sector,” he said. “Whether the economic effects are as serious,
even in America, remains to be seen. The question is whether we need
investment banks as much as they think we need them.”
That is the big question, and not just in America. Gerard Lyons, head of
research at Standard Chartered, the international bank, said emerging
economies were still holding up well. “I don’t like to use the word
decoupling, but there is a degree of insulation from America’s problems.” he
said. “But the dollar is the real issue.”
The US currency fell to record lows against the euro and Swiss franc on Friday
and dropped below 100 against the yen for the first time in 12 years. The
fear is that the falling dollar is spreading America’s woes to the wider
world.
The surge in the gold price to a record of more than $1,000 an ounce last week
and a new oil-price peak of $111 a barrel were directly linked to the
dollar’s plunge. In Britain, with sterling well above $2 again thanks to the
weak dollar, a lot is riding on how far those American woes spread.
FOR WEEKS, Treasury officials in Britain have been grappling with the effects
of the credit crunch and how to shore up our battered system of financial
regulation. Last month the government was forced into the nationalisation of
Northern Rock, a victim of the crunch.
The crunch formed the grim backdrop to Alistair Darling’s first budget last
week. According to the Treasury’s own analysis, contained in its budget “red
book”: “Conditions in credit markets have deteriorated and a number of
markets remain effectively closed. There has been further evidence of this
feeding through to tighter credit conditions facing households and
companies.”
The crisis had increased funding costs for the banks, the Treasury said, and
“strains on banks’ balance sheets” caused by write-downs of assets were
likely to continue to result in both a reduction in the availability of
credit and an increase in the price of that credit.
These tighter credit conditions were likely to “reduce the ability of
households in aggregate to maintain spending in the face of slower income
growth” and hit investment by firms “since higher financing costs lower the
net return from investment”. The Treasury also warned that, while conditions
in credit markets were likely to improve in the second half of this year,
they would not “normalise” until the middle of next year.
In the money markets on Friday, figures from the British Bankers’ Association
(BBA) showed that three-month Libor (the London interbank offered rate) rose
to more than 5.93%, its highest this year. It was the surge in Libor rates
last summer that provided the most concrete evidence of the credit crisis,
as banks scrambled for liquidity. Libor is important because 60% of bank
borrowing by businesses in Britain is directly linked to it.
Despite this, Darling revised down the Treasury’s growth forecasts only
modestly, having already trimmed them in his prebudget report in October.
Critics said he was unrealistically optimistic in the light of the
escalating credit crisis.
“The chancellor argued in the budget that the UK economy is better placed than
other economies to withstand the slowdown in the global economy,” said
Michael Saunders, an economist with Citi. “We disagree. With high household
debts, low private savings and the worsening financial market crisis, we
expect the UK economy this year to slow more sharply than any other G7
country.”
Others, however, pointed out that Darling was broadly in line with independent
economists. “Everyone has pretty much the same forecast. Some describe a
slowdown to 1.5% or 1.75% growth this year as an apocalypse, but the
Treasury describes it as a slowdown,” said Geoffrey Dicks, an economist with
Royal Bank of Scotland Financial Markets.
“We have all taken our cue from the Bank of England, which predicts a slowdown
this year but a bounceback next.
“This is a seismic financial crisis, the biggest for decades, but we just
don’t know how big an effect it is going to have on the real economy. It
will affect the supply of credit, but the demand for credit was falling
anyway. We are all primed for the music to stop but it hasn’t yet.”
Peter Spencer, economic adviser to the Ernst & Young Item club, which uses
the Treasury’s own model of the economy, warned that Britain would suffer
because of the so-called twin deficits, the fact that both the budget and
overseas trade are heavily in the red.
“The obvious risk is that tax revenues will follow the credit markets and the
economy down, bringing a large overshoot in public borrowing,” he said.
“But the real worry is that the whole UK economy relies on the international
wholesale banking markets for finance. The Treasury forecast shows balance
of payments deficits of more than £70 billion. It is hard to see how these
deficits can be financed even if wholesale funding routes are reopened. If
they are not, the consequences for sterling, the housing market and
ultimately the public finances could be catastrophic.”
That is not the only area of vulnerability. Robert Barrie, an economist with
Credit Suisse First Boston, said the chancellor was “probably right” to say
Britain’s economy is well-placed to weather the difficult year ahead.
The real story for the City, however, was the announcement that, partly as a
result of Northern Rock, a record £80 billion of government bonds -
gilts - will need to be sold to fund public borrowing over the coming year.
“The government plans to sell more gilts than it ever has before,” he said.
“The problem may come if liquidity and the market more generally isn’t up to
it.”
The way in which it could all go wrong is sketched out by the Treasury. “The
extent and duration of the disruption and the feed-through to credit
conditions faced by households and companies, and thus private-sector
spending, remain highly uncertain,” it said. Consumer spending and
investment could weaken sharply. Unemployment, which the Treasury assumes
will edge up in line with independent forecasters’ projections, could surge.
The dangers are there.
In presenting his outlook for the economy last week, Darling said Britain’s
economy was resilient enough to survive the credit crunch and avoid being
sucked into the vortex. Most economists agree that Britain should avoid the
worst but they admit that they do not really know.
Chancellors do not have the luxury of being able to say they do not know.
Darling will hope for the best. The worst, from his point of view, does not
bear thinking about.
BEAR ESSENTIALS
STATUS: Bear Stearns is one of the world’s largest investment banks.
STAFF: It employs more than 15,000 staff worldwide in offices in New York,
London, Sao Paolo, San Francisco, Tokyo and Singapore.
MANAGEMENT: Alan Schwartz, the company’s chief executive, has been in the post
just over two months. His predecessor, James Cayne, resigned in January
after huge write-downs from mortgage-backed investments.
FINANCES: Bear Stearns announced a net loss of $854m (£422m) for the fourth
quarter of 2007, as it wrote off $1.9 billion tied to mortgage-backed
securities and was forced to close two of its hedge funds. Despite claims
that it was not facing a liquidity crisis, Bear Stearns announced on Friday
it has been bailed out by emergency funding from the Federal Reserve and
fellow Wall Street bank JP Morgan.
SHARE PRICE: Last week Bear Stearns’s shares plummeted to $26.96, their lowest
since April 1997; 12 months ago they were trading near $160. They closed on
Friday at $30.
HEDGE FUND BITES THE DUST
ON PAPER, it looked as safe and respectable as a hedge fund could be, writes
Ben Laurance.
Less than three weeks ago Carlyle Capital Corporation (CCC) assured its
shareholders that every scrap of its portfolio was in AAA-rated assets, as
solid as they come.
And the company, domiciled in Guernsey and quoted in Amsterdam, was, after
all, the brainchild of Carlyle Group, one of the most blue-chip of
hedge-fund managers.
Carlyle is an organisation that at various times has been able to decorate its
letterhead with the names of a former president of America (George Bush Sr),
a former secretary of state (James Baker), a man who presided over the
Bundesbank (Karl Otto Pohl) and a former British prime minister (John Major).
Carlyle Group was CCC’s creator. It was its adviser. A clutch of its partners
sat as directors on the board. Within the past few weeks Carlyle Group had
pledged $150m (£74m) to tide CCC through its period of difficulty.
Yet last Thursday, despite all this and the pledges of support of its
distinguished parent, CCC collapsed. The process of unwinding the fund’s $22
billion of assets got under way.
CCC’s problem was not that it held poor-quality assets: they were, within the
context of mortgage-backed securities, as safe as they come. Sub-prime they
weren’t.
But the fund was hugely leveraged. Of every $32 that it invested, roughly $31
was borrowed money.
Last month CCC’s directors, writing in the annual report, pointed out that
leverage can be useful in increasing profit, or it can be a problem.
They said: “While borrowing and leverage present opportunities for increasing
total return, they have the effect of potentially increasing losses as well
. . . Any event which adversely affects the value of our investments would
be magnified to the extent leverage is employed.
“Increased leverage also increases the risk that we will not be able to meet
our debt service obligations, and consequently increases the risk that we
will lose some or all of our assets to foreclosure or sale.”
The words were prophetic. By the beginning of last week it was obvious that
CCC was in trouble.
In New York Carlyle Group met the banks that had, until now, lent the money to
keep CCC ticking over. Carlyle said it would be prepared to put up some more
money; exactly how much is not clear.
But the markets were moving against it. Banks did not want to lend any more
cash – on the contrary, they wanted their money back. And all the time the
mortgage-backed securities that CCC had bought and borrowed against were
falling in value.
By Wednesday evening it was clear that a deal could not be done. The banks
were reluctant to roll over loans. CCC could not find the money to meet
margin calls (demands for further collateral) of more than $400m.
Carlyle Group realised that the hole in CCC’s finances was too large to be
filled. The following day it would face margin calls for a further $97.5m.
CCC issued a statement: “It has become apparent . . . that a successful
refinancing is not possible.”
Part of the pain is being felt by partners and employees of Carlyle Group:
they owned 15% of the fund. David Rubenstein, who co-founded Carlyle group
21 years ago, gave vague indications that investors might be offered some
redress. The group later firmly refused to elaborate.
