Most investment and wholesale banks face severe constraints - Emirates24|7

Most investment and wholesale banks face severe constraints

(AP)   

 
 

The dramatic rescue of Bear Stearns through emergency funding provided by JP Morgan Chase and the US Federal Reserve Bank underlines clearly the still precarious state of the global financial market. Liquidity is still scarce and funding on the wholesale market is still largely closed. Most investment and wholesale banks will be experiencing funding challenges and some will be facing severe constraints.

 

The government bailout of Bear Stearns is the largest of a US securities firm. Bear Stearns’ liquidity and cash position weakened substantially over the last few days but the liquidity had been tightening at the firm for some time. The emergency funding is for up to 28 days. Bear Stearns is an important player in the securities market in the US and is the second largest underwriter of US mortgage bonds. Its rescue was necessary as its failure would have led to a systemic crisis in the US financial market as well as having an affect on global markets.

 

It is unlikely the firm will be allowed to fail with the most likely outcome a sale, possibly to JP Morgan.

 

The Bear Stearns position was similar to British mortgage lender Northern Rock, which in 2007 became the target of the country’s first bank run in more than a century after the Bank of England stepped in with an emergency line of credit. At Northern Rock, it was depositors withdrawing money and panicking. At Bear Stearns, it has been financial counterparties.

 

Bear Stearns has suffered from the sub-prime crisis with significant write-downs and losses. Its share price had been severely hit even before the rescue. As a result, traders have been reluctant to engage in long-term transactions with Bear Stearns as the counterparty. Rumours and market sentiment on Bear Stearns fed off each other, resulting in virtually the closure of market funding for the company.

 

Bear Stearns was at the forefront of the crisis at the start after two of its hedge funds collapsed in mid-2007.

 

The failure of the funds, which invested in securities linked to sub-prime mortgages, prompted a sell-off of the assets. About 15 per cent of the firm’s income came from structuring and trading mortgage bonds, a market that has been almost completely frozen since the middle of 2007.

 

The Federal Reserve voted to lend the funds through JPMorgan because it would be operationally simpler than a direct loan to Bear Stearns.

 

Through this mechanism, the Federal Reserve is giving Bear Stearns indirect access to its crisis liquidity provision facility, the discount window. Bear Stearns cannot access it directly, as it is an investment bank and not a commercial bank. By asking JP Morgan to act as the middle man, however, Bear can access the facility.

 

Bear Stearns’ problems developed this week, as counterparties in the market grew increasingly cautious about taking exposure to the bank. Management endeavoured to reassure markets the bank’s financial position was solid. However, in a week that saw the collapse of the $22 billion (Dh81bn), mortgage-focused hedge fund Carlyle Capital, those reassurances went unanswered, and Bear ultimately was forced to seek help.

 

The rescue liquidity move followed a week of persistent concerns about whether Bear could continue to meet its obligations. It is a reminder of how quickly an erosion of confidence can undermine even leading financial institutions. For credit, sentiment and reputation is hugely important.

 

To quote the nineteenth century English economic journalist, Walter Bagehot, “a bank lives on credit. Till it is trusted it is nothing; and when it ceases to be trusted, it returns to nothing”.

 
 
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