This week, Bear Stearns (NYSE:BSC) finds itself on the front lines of the credit crunch. Rumors permeate Wall Street that BSC faces an impending liquidity crisis. Bear Stearns says the rumors are nonsense. The market says otherwise. Whom do you believe?

BSC has had a hellish time of late. Bear Stearns was "the biggest buyer and packager of mortgage securities in the boom years," according to an article in Forbes. They also don't have the most well diversified business model. Already, they've written off more than $2 billion. The stock is down over 30% in March and over $100 from its 52-week high.

Man, that's ugly
This week, Punk Ziegel & Company analyst Richard Bove lowered his earnings estimates on BSC and cut his price target in half to $45 (the stock closed yesterday at $61.58), suggesting that BSC may not be sufficiently diversified to weather the impending credit storm. Bove also cut 2009 and 2010 estimates on investment banksGoldman Sachs (NYSE:GS), Lehman Bros. (NYSE:LEH), and Morgan Stanley (NYSE:MS).

In addition, Moody's (NYSE:MCO) downgraded much of the mortgage debt on BSC's books, helping to trigger speculation on Wall Street that BCS is facing liquidity problems. There was a general sense that BSC, with its limited business model and high exposure to mortgage-backed securities, might be the next domino to fall in the credit crunch (and the first major investment bank).

Gimme that microphone
Bear Stearns President and Chief Executive Alan Schwartz begged to differ with Wall Street. "There is absolutely no truth to the rumors of liquidity problems," he said, adding that Bear's "balance sheet, liquidity, and capital remain strong." He also said that BSC's first-quarter earnings, to be announced March 20, will fall within analysts' range of forecasts.

On Tuesday, the Federal Reserve acted to help ease the credit crisis and provide mortgage liquidity. The Fed made $200 billion available for financial institutions, lending Treasuries with riskier loans like mortgage-backed securities as collateral. The market rallied on the news to its biggest single-day gain since 2002. However, Bear Stearns didn't participate in the rally. Many observers believed the Fed moved specifically to help BSC and its possible liquidity problems.

Meanwhile, option interest for BSC on the downside has been huge. Far-out-of-the-money puts have seen extremely high trading volume this week, indicating that many investors are willing to bet that Bear's stock price will collapse.

He said, they said
So who's right -- the CEO or the market? They can't both be correct. The market is essentially saying that all hell is about to break loose. The CEO says everything's fine. I really want to believe the CEO. But my experience tells me that while people lie, the market generally doesn't.

Further ursine Foolishness:

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