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Banking

Credit crunch: Novelty Bear is no toy

The Fed is finding innovative ways to fund US financial institutions to combat the systemic risk that has done for Bear Stearns.

Bear Stearns’s supply of repo funding – the lifeblood of any financial institution – was curtailed and the broker ran out of cash because of liquidity being withdrawn by institutions concerned about its exposure to both mortgages and hedge funds.

Brokers have illiquid balance sheets and depend on the markets’ perception of their creditworthiness in order to operate. So when margin calls led to the forced liquidation of credit fund Carlyle Capital, and forced sales at other credit hedge funds, market rumours of liquidity problems at Bear became widespread. They became a self-fulfilling prophecy.

The Federal Reserve stepped in with an unprecedented (at least since the Great Crash in 1929) emergency line of funding via JPMorgan. The latter then agreed initially to pick up Bear at a cut-price $2 a share, a fraction of book value and with the additional benefit of a $30 billion back-up line to fund Bear’s illiquid assets.

Meltdown

It was news that the fundamental state of the US housing market was worsening that triggered the latest downturn in the credit crisis, with falls in house prices now forecast in the 20% to 30% range. Unsurprisingly, the sub-prime index fell further.

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