The Bear Stearns collapse has shaken up Wall Street and may signal a prolonged and painful crisis for financial markets. By Vivek Sharma

If you have survived the worst economic crisis in recorded history, you would consider yourself strong enough to take anything that is thrown at you. You have seen the heights of exuberance giving way to the depths of despair within weeks. Besides, you have a successful track record running to many decades which has imparted superior survival skills and, you believe, wisdom. You might occasionally get carried away and play with fire, but you are confident that you are more or less immune to fatal failures. Even if you stumble, enough people have confidence in you to give you a helping hand.

The top management of Wall Street investment bank Bear Stearns must have harboured similar confidence. Bear Stearns began life before the Great Depression and was a closely held boutique firm until it went public in the '70s. Over many decades, the firm had done reasonably well and became one of the top-5 investment banks on Wall Street – even if it was the midget in that elite group. At its peak, the firm was valued at over $30 billion and was managed from a steel and glass tower – itself worth over $1 billion – in Manhattan. 

Until Sunday, that is. Faced with bankruptcy and liquidation, Bear Stearns allowed itself to be acquired by JPMorgan Chase for just $236 million - less than a hundredth of its peak value! (See: JPMorgan Chase acquires Bear Stearns for $2 per share)

First to hit trouble and first to go under
It was the collapse last year of two hedge funds promoted by Bear Stearns which alerted the world to the impending sub-prime crisis. Until then, everything was well in the world of financial markets - except for the minor distraction of falling US housing prices. The housing weakness was believed to be well 'contained' with no or little impact on other sectors or the overall economy. The financial instruments that were backed by the wobbly housing assets and home mortgages were believed to be so well structured that they were hardly considered risky. Big investors who had loaded up on such securities had no reason to loose their sleep.

Wall Street banks like Bear Stearns were making a pile of money by selling these 'mortgage-backed' securities to eager investors flush with funds. It was so profitable that the investment banks were actively searching for mortgage assets to be sliced, diced and sold as asset backed securities. They earned hefty fees for devising these 'innovative' instruments, but were not directly exposed to the underlying risks. Then things slowed down a bit and some of these investment banks had to keep large quantities of such securities with themselves. They did not hesitate to hold them as the housing downturn was supposed to be a short and mild one, in the hope of selling them at even higher prices when the market recovers.

But, the market did not recover. Instead, it slipped and slid down a steep incline – leaving behind a trail of wreckage. The mortgage-backed securities that were supposedly as risk free as the best quality corporate bonds suddenly became 'toxic'. Investors panicked and rushed to exit their positions. To their dismay, they found that there was no market for these 'damn things' – as  Fed chairman Bernanke called them.

The US sub-prime crisis, which later blew up into the global credit crisis, was born.

As the crisis worsened, large banks declared losses that were unimaginable earlier. Prices of financial stocks plummeted and heads of CEO's rolled. The US Fed went into hyperactive mode and started cutting rates and pumping billions of dollars into the market. Everyone started fretting about the 'worst crisis since the Depression'.

While there has been considerable speculation that some of the big banks would go under, that misfortune was so far limited to mortgage lenders including Countrywide which was acquired by Bank of America. Bear Stearns is the first diversified investment bank to fall and be acquired by a larger firm.

What led to the fall?
Bear Stearns had the highest exposure to mortgage business among big Wall Street firms. When turmoil hit the market for mortgage securities, Bear was thought to be the most vulnerable. But the firm was also a big prime broker with a large and diversified client base and a market share of around 20 per cent, which many thought will save it from collapse.

However, it was the sudden withdrawal of clients and counterparties in the broking businesses that led to Bear's demise. As rumours began to spread about a possible bankruptcy, clients stopped dealing with Bear.

Early last week, many large European banks stopped using Bear as the broker for trading in US markets. Some large fund management companies joined them and all these clients started withdrawing funds kept with Bear. It is rumoured that clients withdrew as much as $17 billion last week alone while creditors refused to fund the firm. As Bear Stearns admitted early last week, the firm faced a severe liquidity problem.

The US Fed swung into action. As the lender of last resort, the central bank is expected to provide liquidity to financial firms in crisis. But, Bear is not a commercial bank and the Fed could not lend directly. So, it routed the funding through JPMorgan and agreed to accept mortgage-backed securities – the kind Bear Stearns was holding – as collateral.

Obviously, that did not stem the tide and Bear was faced with just two choices – bankruptcy or an acquisition by JPMorgan. The firm picked the latter.

Shareholders wiped out
When billionaire investor Joseph Lewis pumped in more than $1 billion last year for a nearly 10-per cent stake in Bear, he must have thought of it as a bargain. The share price had corrected from its peak and if the housing weakness was going to be mild, as expected, it was bound to go up again. Unfortunately for him, that was not to be. His stake will be worth slightly over $20 million at the price offered by JPMorgan. His average acquisition cost was $107 per share, for which all he will get is $2 per share!

James Cayne, former chairman and CEO of Bear, was one of the largest individual shareholders with a stake of close to 5 per cent and will lose nearly $500 million. Alan Schwartz, Bear's CEO, will also see big erosion in his own net worth.

The biggest shareholder in Bear was a US-based money management firm which stands to lose close to $1 billion. Morgan Stanley mutual funds stand to lose close to $500 million and so do Legg Mason. Other big losers include Barclays Global Investments, Vanguard and Janus Capital. 

The worst hit would be the Bear employees who were holding on to the shares received as bonuses or otherwise. Many employees often keep a large part of their investment holdings in shares of their employer as they consider themselves to be insiders with good knowledge of the health of the company. They would have now realised that, in periods of extreme stress, even insiders will be hard pressed to have a clear idea of what is going on.

Beginning of the end or just the beginning?
With the fall of Bear Stearns, the game has changed for investment banks and other financial services companies. What has really shaken up things is the token price of $2 per share offered by JPMorgan. Bear Stearns stock price closed around $30 per share last Friday and the offer price is less than a tenth of that!

Of course, JPMorgan is keeping a wide margin for potential losses. It has already announced that it will be taking a one-time charge of $6 billion for potential legal and other client claims related to Bear Stearns business. That gives away one of the big fears currently stalking Wall Street .

When it became known that Bear was having liquidity problems last week, there were some commentators who believed that it signaled the bottom of market turmoil. A big bank had failed – the signal event for the crisis – and the Fed had intervened to prevent others from going down. Confidence would be restored and, slowly, markets would limp back to normalcy.

However, if there were to be a wave of lawsuits against Wall Street firms for losses related to mortgage-backed securities, this could just be the beginning of their troubles. The $6-billion in provisions indicated by JPMorgan makes it clear that this is a real possibility.

If some of the remaining firms suffer more losses or are slapped with huge claims, it is possible that they would also face the same liquidity problems that troubled Bear Stearns last week.

The Fed can extend support, but it won't be easy to find willing and credible buyers like JPMorgan, which was the least affected in this crisis. Most large banks are in the process of cleaning up their own sub-prime mess and are raising capital. If there are no buyers for failing firms, the risks of a contagion will increase substantially. That doesn't appear improbable anymore and that is the real fear.