There is a relevant scene in the movie Braveheart. While pondering the fact that William Wallace had just sacked York, the King fretted, "If Wallace can sack York, he can invade lower England." And, if he can invade lower England, he can take his throne.
There's a similar dynamic going on in the markets. If the credit crisis can sack one of the financial world's most venerable institutions, it can destroy any financial company. And, if it can destroy any financial company, it can threaten the entire financial system.
Bear Stearns
Last week, Bear Stearns endured Wall Street's version of a bank run. Rumors that Bear Stearns was experiencing liquidity problems frightened the firm's clients and they began withdrawing their money from the investment bank in droves. Unable to remain solvent without help, Bear Stearns turned to the federal government and JPMorgan to save it from certain demise. A loan deal was worked out so that the federal government would in effect loan Bear Stearns money through JPMorgan.
Then Sunday night, Bear Stearns agreed to be sold to JPMorgan for the astounding price of $2 per share. The stock closed at $30 on Friday. It had been more than $60 mere days ago and is down from $170 per share last year. Just last week, Bear Stearns claimed a book value of around $80 per share. The fact that Bear Stearns was willing to sell for $2 indicates that its choice was between selling at any price or declaring bankruptcy. Bear Stearns may have technically been sold, but it was, in fact, destroyed by the credit crunch.
The fact that Bear Stearns was "the biggest buyer and packager of mortgage securities in the boom years" (per an article in Forbes) and carried high levels of debt made the firm vulnerable in this market. The Federal Reserve actively sought the buyout. In fact, the Fed even went so far as to guarantee $30 billion in debt for the deal to prevent Bear Stearns from going bust and undermining the already-diminishing confidence in the financial markets.
What's next for the markets?
The markets have moved into a new phase of the credit crisis. We are in what I would describe as the "who's next" phase. The buzz on the Street is already about which firms might be under the gun next. Lehman Brothers
The frightening thing is that rumors can be a self-fulfilling prophecy. As in the case of Bear Stearns, as liquidity rumors circulate, a firm's clients get nervous and start pulling their money out, thus making the liquidity rumors a reality. This could cause a snowballing effect from firm to firm, and the crisis could spread into a full-blown financial disaster.
Maybe there's a silver lining
There could be a positive note in all of this. There has been a palpable sense on Wall Street that we won't move beyond this credit crisis until "the other shoe drops." It has long been anticipated that large firms may have to go under before we can overcome the crisis. Assuming that Bear Stearns' issues and the potential for similar problems don't catch fire and wreak havoc among the world markets, we could finally be seeing the "other shoe drop."
So, which is true? Are we witnessing the beginning of a worldwide financial calamity? Or, are we cleaning out the financially unwise and moving beyond the crisis? Nobody knows. Stay tuned for the continuing saga that is the 2008 credit crisis.
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