Markets: Margin Call
New York: March 17, 2008
By John R. Stephenson

"A lot of people, it seemed, wanted to act to protect themselves from the possibility of the rumors being true, and to wait later to see the facts."

--Alan Schwartz, president and CEO of Bear Stearns

"It's liquidity that takes a firm down."

--Joseph Mason - finance professor, Drexel University

"It ain't over till it's over."

--Yogi Berra, major league baseball player and manager

The reverberations are being felt all around the world from the greatest ever margin call in history. Last week, Bear Stearns, an 85-year old investment bank, was spared from insolvency by the U.S. Federal Reserve, which tapped a depression-era financial tool to save the cash-strapped firm. This action was unprecedented and has caused many people to wonder, "who's next?"

Facing a possible run on the bank, executives at Bear Sterns had little choice but to tap the U.S. Fed for an emergency loan to shore up the firm's capital base. The loan made to Bear Stearns through JP Morgan Chase & Co., is the first time in its history that the U.S. Fed has stepped in to save a U.S. investment bank.

For weeks, rumors had been swirling around Wall Street that the firm was facing a liquidity crisis because of its exposure to a whole raft of shaky subprime mortgages. The firm was forced to accept this liquidity bailout plan less than one week after its CEO, Alan Schwartz, declared that rumors surrounding the possibility of a liquidity crunch at the firm were "totally ridiculous."

Investors were less than impressed when the news of the bailout plan hit the airwaves as they sent Bear's stock down some 47 percent — the largest one-day fall in the firm's history. But by stepping in to bail out Bear Stearns, the Fed may have signaled that things are far worse within the U.S. financial system than many investors were led to believe.

Bear Stearns stock has been under pressure for some time as a spate of bad news has engulfed the company. On August 1 st 2007, the firm announced that two of their hedge funds that were linked to subprime mortgages had filed for bankruptcy. The firm was ultimately forced to write down $1.9 billion of investor's capital as a result of the bankruptcies. And most recently, the firm was cited as a major creditor to Carlyle Capital, a $21 billion hedge fund that collapsed last week.

But the truly worrying part of the Bear Stearns saga is the implications it has for the health of the U.S. financial system and the stock market generally. The popping of the greatest credit bubble of all times has necessitated the greatest bailout of a financial institution ever by the U.S. Federal Reserve. The Fed took this unprecedented action to save Bear Stearns, fearing that if the fifth-largest investment bank in the country were to fail, it could set of a domino effect that might bring the U.S. financial system to the brink of collapse. Yikes!

The bailout may have stemmed the tide at Bear for now, but there may be worse news to come. Reportedly, its financial advisor, Lazard Ltd. is shopping the firm to potential buyers, including JPMorgan and others. Still, other reports have suggested that Bear Stearns may be wound down, with its various parts sold to others.

Already, the street is awash in rumors that Lehman Brothers might be the next major U.S. investment bank to fail because of its exposure to subprime mortgages. Shares of Fannie Mae and Freddie Mac, the two government sponsored mortgage-finance firms, have been under pressure as concern has mounted over their financial health.

Facing a possible U.S. recession, a worsening housing slump and a freeze-up of the credit markets, the Fed is under tremendous pressure to cut interest rates again — and hard, at this Tuesday's rate-setting meeting in Washington. Already, the Fed's key rate-setting interest rate has fallen from 5.25% to 3% since August of last year.

The Fed has been hard at work for some time, trying to boost liquidity and keep the U.S. financial system humming. Just a week ago, the Fed announced a $200 billion revolving 28-day lending arrangement for banks to tap, to boost liquidity in the banking system.

So far, the results of such actions have been mixed. Skittish investors have been fleeing the shares of financial institutions in droves and have been sending oil and gold futures higher, as concern over a deepening financial crisis and possible U.S. recession has spread.

Investors are scared and rightly so. Valuations are still too high on most U.S. equities and the news flow is anything but encouraging. As the problems, writedowns and earnings misses continue, investors are becoming increasingly pessimistic about the prospects of the U.S. economy and the stock market. Many investors are beginning to apply the cockroach theory to their U.S.-based investing — there's never just one.

With problems and pessimism on the rise, the stock market is an increasingly uncertain place to hide. The biggest credit bubble in history has finally burst, which has resulted in the largest margin call in history. Is the recent action of the Fed enough to stem the tide? Who knows? But one thing is for certain, it ain't over till it's over.

For my money, I would overweight cash in any investment portfolio. The financial services sector, both domestically and overseas, is to be avoided until the bottom has been reached and the U.S. bank index (BKX — KBW Bank Index) has outperformed the S&P Index for at least a few months. Then, and only then, will it be safe for stock investors to jump back into the market.