Zaks Investment Advisory Service

Bear Stearns and Other Events: Second Week of March 2008

Last time, we started talking about India. Although I planned to continue on with this subject today, I’m afraid that we will not be able to get to India. Instead, I would like to analyze what happened on our markets last week, for it was an unusual one indeed. More things happened in the course of seven days than usually occur in a month. Last Tuesday, the market went up 3.7 percent: it was the largest single-day gain since October 2002. It closed up on Thursday as well, but the market still fell three out of the five days. As a result, the market closed on Friday, March 15 at practically the same level as where it stood on Friday, March 7: for the week, the Dow Jones gained 0.4 percent while the S&P 500 lost nearly the same 0.4 percent – it was as if nothing had happened at all. But how deceiving those figures are!

As you know, the market has lost its confidence over the past few months, seeing risks where none had apparently existed before. This state of affairs led to a sharp rise in the so-called “risk premium” and, accordingly, a drop in the price of stocks and numerous other financial instruments. The financial markets are structured so that crises eventually resolve themselves – but this may take a long time to do. In such a situation, the Federal Reserve is the only institution that may actually help speed up the process. All of these realities were played out last week.

On Tuesday, the Federal Reserve announced it was increasing the amount of credit that banks may borrow directly from the Federal Reserve (the so-called “credit facility”) to $200 billion. It did this in yet another attempt to put out the crisis raging on the credit markets. The Federal Reserve has tried doing this on many other occasions, but without much success. But this time, the market reacted positively and soared, as we have said, by 3.7 percent. Every other time the Federal Reserve had made similar moves in the past, the market would rise and then start settling back down almost immediately. This time, the market’s reaction was more lasting. But unfortunately, two other events broke before the end of the week that put a hamper on the newly-found confidence. On Thursday, Carlyle Capital, a gigantic hedge fund that invested in mortgage-backed securities, announced that it stood on the verge of bankruptcy. Carlyle Capital only purchased the highest-quality bonds. Its business was built on the following model: the fund would borrow money to buy bonds using very low-rate short-term loans, constantly refinancing these loans, while receiving much larger returns from the purchased bonds. Everything would have been fine had the prices of mortgage-backed securities not begun to fall. Accordingly, the fund’s assets started to go down as well. Subsequently, the banks that lent Carlyle money started to demand ever greater collateral. At a certain point, the banks simply stopped financing the fund, and it collapsed. The market accepted this piece of news with relative calm, but Carlyle’s story turned out to be a footnote to what happened Friday.

Bear Stearns, the fifth-largest investment bank that had survived depressions and wars, recently found itself in a spot of bother. But no one knew just how much bother it was until Friday, when the Federal Reserve organized a special line of credit for the bank. Investment banks are not allowed to borrow directly from the Federal Reserve, so the role of intermediary was assigned to JP Morgan Chase: it would borrow money from the Federal Reserve and then immediately lend it to Bear Stearns. How did investors react to this news? One might think that the Federal Reserve’s support would fill them with confidence. Instead, they saw this move as evidence that Bear Sterns was actually in catastrophically sad shape. The company’s shares fell by 47 percent. So what happened to Bear Stearns? As usual, mortgage-backed securities found themselves to be the culprit. However, even though the company held more of these than other investment banks, that was not its main problem. The fact of the matter is that investment bank trade with each other using all sorts of often incredibly complicated financial instruments. All financial relations are founded on two things: trust and collateral. If a certain firm’s trading partners are starting to have doubts about ever seeing their purchased assets again – fearing that there is a possibility that they will not be fully compensated by the collateral or, worse yet, that the firm itself may soon disappear – then no one is going to trade with this firm. From the Wall Street firm’s perspective, there is just no reason to enter into risky transactions when there are plenty secure counterparties on the market. That is approximately what happened to Bear Stearns. A large portion of the firm’s assets were made up of mortgage-backed securities, which no one currently knows quite how to appraise or want to take on as collateral. Meanwhile, other firms did not want to offer Bear Stearns short-term loans, fearing that these may simply be lost. It seems that even the Federal Reserve was too late in coming to the rescue: toward the end of Friday, the market decided that the firm would either be sold off or announce bankruptcy within the next few days. And that is exactly how things turned out: on Sunday, we learned that Morgan Chase purchased Bear Stearns at the price of $2 per share. On Friday morning, those shares were worth $55. Such a discount promises nothing good for the market as a whole.

The story with Bear Stearns reminded me of a similar one that happened in 1990 to another investment bank. It was called Drexel Burnham Lambert. In its best years, Drexel, like Bear Stearns, was the country’s fifth-largest investment bank. Its collapse came in a flash when it lost Wall Street’s trust. Drexel was famous because of Michael Milken, who almost single-handedly created a market for a new class of financial instruments – high yields (or junk, as are also known) bonds. It is an interesting story and we might devote a program to it in the future.

There was one silver lining amid last week’s events: inflation, for all intents and purposes, is almost non-existent at the moment. This is positive in many respects, not least of which is that it allows the Federal Reserve to lower rates without fearing inflation. One week ago, I said that the market believes that the federal fund rates will be cut by another 50 basis points. But now, the market feels that rates may be reduced by 75 points or more.

And with this, we will have to draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.