The past six days have shaken American capitalism.
Between Tuesday, when financial markets began turning against Bear Stearns Cos., and Sunday night, when the bank disappeared into the arms of J.P. Morgan Chase & Co., Washington policy makers, federal regulators and Wall Street bankers struggled to keep the trouble from tanking financial markets and exacerbating the country's deep economic uncertainty.
The mood changed daily, as did the apparent scope of the problem. On Friday, Treasury Secretary Henry Paulson thought markets would be calmed by the announcement that the Federal Reserve had agreed to help bail out Bear Stearns. President Bush gave a reassuring speech that day about the fundamental soundness of the U.S. economy. By Saturday, however, Mr. Paulson had become convinced that a definitive agreement to sell Bear Stearns had to be inked before markets opened yesterday.
Bear Stearns's board of directors was whipsawed by the rapidly unfolding events, in particular by the pressure from Washington to clinch a deal, says one person familiar with their deliberations.
"We thought they gave us 28 days," this person says, in reference to the terms of the Fed's bailout financing. "Then they gave us 24 hours."
In the end, Washington more or less threw its rule book out the window. The Fed, which has been at the forefront of the government response, made a number of unprecedented moves. Among other things, it agreed to temporarily remove from circulation a big chunk of difficult-to-trade securities and to offer direct loans to Wall Street investment banks for the first time.
The terms of the Bear Stearns sale contained some highly unusual features. For one, J.P. Morgan retains the option to purchase Bear's valuable headquarters building in midtown Manhattan, even if Bear's board recommends a rival offer. Also, the Fed has taken responsibility for $30 billion in hard-to-trade securities on Bear Stearns's books, with potential for both profit and loss.
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Tuesday, March 11
On Tuesday, officials unveiled what they thought came close: a promise to lend up to $200 billion in Treasury bonds to investment banks for 28 days. In return, the Treasury would get securities backed by home mortgages, whose uncertain values helped spark the current crisis, and other hard-to-trade collateral. The first swap was scheduled for March 27. At first, the firms were elated. [This is action prompted the Dow to rise 400 pts]
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At Bear Stearns, Chief Financial Officer Samuel Molinaro, along with company lawyers and Treasurer Robert Upton, were trying to make sense of the situation. They felt comfortable with their capital base of roughly $17 billion and were looking forward to reporting Bear Stearns's first-quarter earnings, which had been respectable amid the market carnage.
One theory began developing internally: Hedge funds with short positions on Bear -- bets that the company's stock would fall -- were trying to speed the decline by spreading negative rumors.
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Thursday, March 13
On Thursday evening, after customers had continued to pull their money out of Bear Stearns, the bank reached out to J. P. Morgan, looking to discuss ways the Wall Street giant could help ease Bear's cash crunch.
By then, Bear Stearns's cash position had dwindled to just $2 billion. In a conference call at 7:30 p.m., officials at Bear Stearns and the Securities and Exchange Commission told Fed and Treasury officials that the firm saw little option other than to file for bankruptcy protection the next morning.
Bear Stearns's hope was that the Fed would make a loan from its discount window to provide several weeks of breathing room. That, the firm hoped, would perhaps halt a run on the bank by allowing it to swap bonds for the cash necessary to return to customers.
The Fed's standard preference in dealing with a troubled institution is to first seek a private-sector solution, such as a sale or financing agreement. But the possibility of a bankruptcy filing Friday morning created a hard deadline.
A trigger point was looming for Bear Stearns in the so-called repo market, where banks and securities firms extend and receive short-term loans, typically made overnight and backed by securities. At 7:30 a.m., Bear Stearns would have to begin paying back some of its billions of dollars in repo borrowings. If the firm didn't repay the money on time, its creditors could start selling the collateral Bear had pledged to them. The implications went well beyond Bear Stearns: If other investors questioned the safety of loans they made in the repo market, they could start to withhold funds from other investment banks and companies.
The $4.5 trillion repo market isn't a newfangled innovation like subprime-backed collateralized debt obligations. It is a decades-old, plain-vanilla market critical to the smooth functioning of capital markets. A default by a major counterparty would have been unprecedented, and could have had unpredictable consequences for the entire market.
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