Bear Stearns’ Collapse Affects Main Street America

 

As a result of the subprime securities crisis and the ensuing credit crunch, a “run on the bank” at Bear Stearns forced the company to sellout to J.P. Morgan for just $10 a share, far below its reported book value. Once the country’s fifth-largest investment bank, the sudden collapse of Bear is the latest sign that America’s financial system has overheated.

In a desperate attempt to get the financial markets humming again, the Federal Reserve is trying to stabilize the credit market before a failure of confidence contaminates the entire financial system. Otherwise, further economic decline could spread to other banks and beyond.

Steve East, chief economist for FBR Capital Markets says, “As far as Wall Street securities houses go, Bear Stearns wasn’t too big to fail. It was too interconnected to fail.”

Bear Stearns failed because investors no longer believed the bank could repay its loans (short-term, overnight, etc.). Investors also believed Bear could no longer stand behind the agreements it had with other financial institutions. Hence the Fed’s agreement to provide $30 billion of financial support to Bear Stearns.

Prior to the housing market collapse, Wall Street was eager to buy subprime loans and mix them with other types of debt before packaging them into complex securities and selling them to investors. As long as housing prices continued to soar, everything was fine. From a mortgage broker’s point of view, the deal was sweet: banks and brokers collected fees for closing deals but faced no risk once they sold the loans to Wall Street. Investors in the new securities created by Wall Street enjoyed rich interest payments while borrowers in exotic loans refinanced their loans or sold their homes for large gains.

Once the housing market began to decline, borrowers began to default on mortgages. Outstanding subprime mortgage defaults caused the complex securities that Wall Street created from those mortgages to crumble. Bear Stearns was among the biggest underwriters of complex investments linked to those mortgages thus, the bank’s swift demise.

More than a Wall Street failure, Bear’s demise reveals problems that exist within the nation’s economy. How does the Bear Stearns’ story impact ordinary Americans?

  • If investment banks cannot function, the financial system could halt. Companies and municipalities who rely on the public sale of their stock would have a hard time raising money to fund construction projects such as roads, bridges and airports or finance ongoing operations. Also, businesses would be unable to expand and create jobs.
  • The Fed was not concerned that Bear Stearns would go bankrupt as much as they feared Bear would take other companies down with it and cause a financial meltdown. As complex derivative securities have permeated the financial markets, there has been a loss of transparency. Today no one knows where the risk is.
  • The collapse of such an enormous financial institution stirs uncertainty, and uncertainty rattles Wall Street. If lenders think there is a chance that borrowers will default, they won’t make loans. Lender refusal to loan can shut down the economy as well as the financial system.
  • As the Fed continues to cut interest rates, yields on money market mutual funds and bank deposits will fall. Stock prices will also continue to be extremely volatile. Gold will also rise in value since many investors view gold as the ultimate investment shelter.
  • Lower interest rates cause the value of the U.S. dollar to continue its decline. As interest rates fall in the U.S., global investors sell their dollar holdings to find investments with higher returns. Doing so pushes the dollar’s value lower, which in turn causes Americans to face higher prices.
  • The U.S. needs foreign cash to finance huge trade deficits. As private investors vanish, the U.S. government grows increasingly reliant on foreign central bankers who have become more selective about which U.S. assets they buy. The shift to move into super safe U.S. Treasuries from other types of investments is escalating the credit crunch.

How serious is the financial crisis? “It’s going to go from bad to worse. ‘ This is certainly the worst financial crisis in the last 50 or 60 years,” says Kenneth Rogoff, a former chief economist at the International Monetary Fund.

East summarizes the situation best, “The financial system is what provides the funding for all the other sectors of the economy and if you have a broken financial system, you have a broken economy.”

Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. Page Perry’s attorneys are actively involved in representing individual and institutional investors regarding their subprime problems. For further information, please contact us.