Wall Street giant gets Fed bailout

The battered global financial system looked a lot more fragile Friday as one of Wall Street’s biggest investment houses was forced to get an emergency loan from the Federal Reserve, raising the specter of more giant securities firms laid low by the global credit crisis.

Bear Stearns Cos. said its ability to finance its operations had “significantly deteriorated” in the preceding 24 hours, compelling it to borrow an undisclosed amount of money from the Fed.

The disclosure sent the stock market down sharply and underscored how vulnerable the global financial system has become since a wave of defaults on home loans given to people with bad credit led to the collapse of the sub-prime mortgage market.

Bear Stearns is heavily exposed to faltering securities tied to sub-prime mortgages, and as credit markets seized up in recent weeks, confidence waned that the company would be able to make good on its own obligations.

That triggered a classic run on the bank, with clients pulling out money and other financial firms refusing to do business with the company.

“A lot of people wanted to get cash out,” Alan Schwartz, Bear Stearns’ chief executive, said in a conference call with analysts.

A lack of confidence is undermining much of Wall Street and is threatening to become a self-fulfilling prophecy that could intensify the country’s credit squeeze, doing more damage to an economy that many experts say is already in a recession.

“This transcends Bear Stearns,” said Bruce Foerster, a Wall Street veteran and president of South Beach Capital Markets. “It shows the fragility of all these institutions, particularly investment banks and commercial banks.”

Bear Stearns’ stock plunged $27, or 47%, to $30. It has plummeted 79% in the last year.

The Dow Jones industrial average sank 194 points, or 1.6%, to 11,951.09. Other major indexes fell more sharply. At one point, the Dow was down 313 points.

Despite word early Friday of the cash infusion from the Fed – in the form of a 28-day loan – it was unclear if confidence in Bear Stearns would recover.

“We’ve received plenty of directives from our clients today telling us to do no business with Bear Stearns,” said Jeffrey Gundlach, chief investment officer at TCW Group, the large Los Angeles-based investment management firm.

Because of such sentiment, “Bear Stearns as we know it is gone,” said Allen Sinai, a veteran Wall Street economist and head of Decision Economics Inc. in New York.

The state of California sought assurance from Bear Stearns on Friday that it would deliver $1.3 billion in cash the state raised this week in two bond sales managed by the firm.

Samuel Molinaro, Bear Stearns’ chief financial officer, replied in a letter to the state that the emergency funding the firm received from the Fed gave it “sufficient liquidity to continue normal operations … and meet all obligations.”

Nonetheless, the company’s cash shortfall generated speculation that the firm might have to sell itself to a larger securities firm – although some analysts doubted that anyone would be interested in a deal.

“Nobody’s going to buy it,” said Richard X. Bove, an analyst at Punk Ziegel & Co. “That you can forget.”

Bear Stearns was the second ailing financial player to make headlines in recent days.

An overseas investment fund formed by Washington-based private equity behemoth Carlyle Group virtually collapsed this week, after the value of its holdings – mostly high-quality mortgage-backed bonds – declined and the firm couldn’t raise the additional capital required by its lenders.

Other banks have taken steps to avoid a Bear Stearns-like funding squeeze. Lehman Bros. Holdings Inc. announced Friday that it had set up a $2-billion line of credit.

Many other banks and brokerages, including Citigroup Inc. and Merrill Lynch & Co., have suffered enormous sub-prime losses. The industry has collectively written off more than $150 billion in sub-prime-related investments.

But the credit squeeze caused a bigger hit for Bear Stearns largely because it is smaller and less diversified than its Wall Street brethren. Unlike close competitor Lehman, which has moved into new business lines and has branched out globally, Bear Stearns, which was founded in 1923, was far more reliant on creating and trading mortgage-backed securities.

In fact, Bear Stearns helped kick off the credit crunch in earnest last summer, when two investment funds it managed for large clients suffered enormous sub-prime losses and collapsed. In the fourth quarter of its 2007 fiscal year, which ended Nov. 30, the firm wrote down the value of its sub-prime holdings by $1.9 billion, leading to a net loss of $854 million.

In the fallout from those results, the firm’s top four executives received no bonuses for the fiscal year. And James “Jimmy” Cayne, Schwartz’s predecessor as CEO, stepped down from that post in January but stayed on as board chairman.

Bear Stearns is getting its loan from the Fed via an intermediary. Rival securities firm JPMorgan Chase & Co. is borrowing the money from the Fed at the central bank’s “discount window,” then lending it to Bear Stearns, with the Fed responsible for any losses.

Normally only commercial banks can borrow from the discount window. That would exclude Bear Stearns because as an investment bank it mostly acts as a financial advisor to corporate clients and doesn’t offer traditional checking and savings accounts. JPMorgan Chase operates both a commercial bank and an investment bank.

The Fed acted Friday under a section added to the Federal Reserve Act in 1932, during the early stages of the Great Depression. The section, not used since that era, authorizes the Fed to make discount window loans to “individuals, partnerships and corporations” in emergency situations.

“There’s no way the Fed is going to let any major firm go under,” said Michael Madden, managing partner at BlackEagle Partners, a New York private equity firm. “They’d be afraid there would be another panic somewhere.”

The Fed’s move was the latest in a series of increasingly aggressive and creative steps to address the credit crisis, including cutting its key short-term interest rate five times since September.

On Tuesday, the Fed said it would lend $200 billion in Treasury securities to major banks and brokerages, accepting mortgage-backed bonds as collateral. The move was an effort to prevent the value of mortgage securities from eroding further and make financial institutions more willing to lend.

The Fed’s program might have helped Bear Stearns, but the first such swap won’t occur until March 27, apparently too late for the company.

walter.hamilton@latimes.com

tom.petruno@latimes.com

Times staff writer Peter G. Gosselin in Washington contributed to this report.