R  I  V  E  R   P  O  I  N  T 

R  E  P  O  R  T

 

 

   March 20, 2008

 

BEAR STEARNS AND RECENT FED POLICY ACTIONS

 

Recent events have left many investors feeling unsettled, to say the least.  As experienced long-term investors, we know that at times like these it is difficult to sift through the noise in the financial press when there are so many sensational reports and rumors.  The following provides a synopsis of the current situation.  We always welcome questions, so please feel free to contact a RiverPoint professional for additional insight or assistance.    

 

BEAR STEARNS

 

During the summer of 2007, Bear Stearns announced that two in-house hedge funds would file for bankruptcy protection because their holdings had become essentially worthless.  This came just a few weeks after the company had committed over $3 billion of its own capital to serve as a lifeline for the funds.  This move seemed to put the company’s future in doubt following disappointing earnings in the previous two quarters.  Shortly after these hedge funds filed for bankruptcy protection, Co-President and Co-COO Warren Spector resigned, raising another red flag in the investment community.  At this time, Bear Stearns shares were trading around $115, and the company had a market capitalization of over $13 billion.

 

During the firm’s fourth quarter, ending November 30, 2007, it lost $854 million – the first quarterly loss in the firm’s history.  This led to long-time CEO James Cayne being replaced by Alan Schwartz on January 8, 2008.  At that time, rumors were circulating that the firm’s sub-prime mortgage-backed security business, one of the largest on Wall Street, was experiencing massive problems and that these problems could escalate.

 

On March 10th, investors began to speculate that Bear’s financial condition was deteriorating rapidly and its cash position was weakening.  These rumors became almost self-fulfilling in nature, as Bear’s customers and lenders began to withdraw funds.  The stock lost 11% on March 10th as a result.  The next day, Schwartz appeared on television, saying that “there is absolutely no truth to the rumors of liquidity problems.”  Unfortunately for the new CEO, the firm’s clients and lenders did not believe him. 

 

On Thursday, March 13th, Bear’s trading partners started making margin calls, and the $17 billion in cash that Bear had at the beginning of the week had shrunk to $2 billion.  At a firm like Bear Stearns, liquid assets are needed each day to settle trades and pay back overnight loans to other financial institutions and investment firms.  These overnight loans typically use fixed income securities as collateral.  The problem for Bear was that the recent turmoil in the credit markets had rendered many of these fixed income securities difficult to trade, which consequently lowered their value.  As Bear Stearns ran low on cash, it was forced to sell these securities at depressed prices in order to pay off these overnight loans.  This selling action caused the value of the securities to decline further, reducing the value of the collateral Bear had committed to its overnight loans.  Bear Stearns’ customers, fearing the firm did not have sufficient cash or collateral to fully repay their overnight loans, began pulling their funds from Bear’s coffers.  What happened next was similar to an old-fashioned bank run, except that in this case it was the large financial firms who panicked and rushed to remove funds.

 

At 5 AM on Friday morning, Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson, among others, decided via conference call to lend Bear Stearns enough cash to make it through the weekend.  Following the call, the Fed announced that it would lend Bear Stearns funds via JP Morgan for up to 28 days in order to help the firm through this cash crunch.  When word of this deal leaked out, Bear Stearns shares dropped 40% on Friday as investors realized the magnitude of Bear’s predicament.  By Friday night, virtually no financial institutions were willing to do business with the mortally-wounded Bear.  Over the weekend, CEO’s of other large financial institutions expressed concern that Bear’s troubles could spread.  This led Paulson and Bernanke to push for JP Morgan – one of a handful of interested buyers – to buy Bear Stearns by the time the Asian markets opened on late Sunday.  Eventually, a deal was struck and disaster, it seems, was narrowly averted.

 

FEDERAL RESERVE POLICY ACTION

 

The Fed’s recent actions have calmed the markets somewhat and have helped to ease some of the stress in the financial system.  We are closely monitoring the situation for any new developments.  What follows is a brief rundown of the steps the Federal Reserve has taken so far.

 

The Federal Funds Rate and the Discount Rate

The Federal Reserve uses changes to both the federal funds rate and discount rate as its main policy tools.  The federal funds rate is the rate at which banks can lend funds to each other, while the discount rate is the rate at which banks can borrow directly from the Fed.  When the Fed decides to lower these rates, the intent is to spur lending among financial institutions.  Since August 2007, the Fed has lowered the federal funds rate six times and the discount rate eight times.  The federal funds rate currently stands at 2.25%, while the discount rate is 2.5%. 

 

Term Auction Facility (TAF)

The TAF, unveiled in December 2007, is a credit facility that allows banks to bid on funds from the Fed.  These bids can be backed by a wide range of collateral and are designed to get funds to those institutions that need them the most.  These funds have a term of 28 days.  The initial TAF auctions were to be set at $20 billion, but that amount has since been increased first to $30 billion and then to $50 billion.  So far in 2008, five auctions have taken place and $170 billion in funds have been distributed through this program.

 

Term Securities Lending Facility (TSLF)

This program allows primary government bond dealers (20 large banks and brokerage firms, such as Goldman Sachs and Morgan Stanley, that buy Treasury securities directly from the Fed) to borrow up to $200 billion of Treasury securities for a term of 28 days.  Borrowers can borrow these Treasury securities against a wide range of collateral, including residential mortgage-backed securities which have become increasingly difficult to trade.  This program is designed to encourage lending among financial institutions by exchanging “bad” collateral for Treasury securities, which are always accepted as collateral due to their ease of sale and the backing of the U.S. government.

 

Primary Dealer Credit Facility (PDCF)

Announced March 16th, this initiative provides primary government bond dealers with a virtually unlimited amount of renewable overnight loans against a wide range of investment-grade securities (corporate and municipal bonds, mortgage-backed bonds, and asset-backed bonds) for which a price is available.  This program will likely prevent another Bear Stearns-type meltdown from happening.

 

 

 

          Market Summary

 

3/19/08

 

      YTD Price Change

 

Dow Jones Industrial Average

                 12,100

             -8.8%

Nasdaq Composite

                   2,210

                        -16.7%

Standard & Poor’s 500 Index

                   1,298

           -11.6%

 

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