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Nye Lavalle
Bear Stearns: a bridge too far

Andrew Clark in New York
Monday August 6, 2007
Guardian Unlimited

In Wall Street terms, it was a display of quite remarkable cool. As the investment bank Bear Stearns scrambled to deal with losses of $1.5bn (£740m) at two of its hedge funds last month, the troubled brokerage's top two executives were competing in a week-long national bridge tournament in Nashville.

On the Tennessee card tables, Bear Stearns' co-president, Warren Spector, did particularly well - totting up masterpoints, he came 95th in a field of 4,822, justifying his reputation as the financial industry's "king of bridge". His boss, veteran chief executive Jimmy Cayne, was down the field, yet still respectable, in 347th position.

The pair were rising early to stay in touch with events at Bear Stearns by phone. Still, they may not have grasped the gravity of the situation. The bank's two troubled hedge funds were victims of a collapse in America's high-risk sub-prime mortgage market - and investors took fright, fearing Bear Stearns' exposure could be far wider.

By Friday, these alarm bells had prompted Standard & Poors to put Bear Stearns on a "negative" credit outlook. As its shares plummeted, the $15bn bank felt obliged to hold a conference call assuring investors that it remained solvent.

Mr Spector has paid the price. After a 24-year career at Bear Stearns, it emerged this weekend that the 49-year-old had been shown the door. The New York Post quoted an insider explaining: "Warren never got out in front on this - in fact, it got worse on a daily basis and eventually put the firm at risk."

In early trading on the New York Stock Exchange today, Bear Stearns's shares were down $4.49 to $103.85. Its stock has fallen by 27% in a month, wiping $5bn off its market capitalisation.

The 84-year-old firm is facing its worst crisis for a generation. As a leading dealer in bonds backing American home loans, it is on the frontline of the country's lending meltdown.

America has been on a borrowing binge - and the consequences are kicking in. A dip in the housing market has left borrowers high and dry with millions of inappropriate loans sold to low-income consumers who cannot afford to keep up repayments. The Federal Reserve chairman Ben Bernanke has suggested defaults could reach $100bn. Merrill Lynch estimates that it could be higher, perhaps reaching $120bn to $170bn.

William Wheaton, an economics professor at the MIT Centre for Real Estate, forecasts that the housing market could drop by an unprecedented 10% to 20% - which, he says, would slow America's annual economic growth to 1%.

"Investors in the sub-prime market, to be perfectly honest, deserve everything they get," he says. "If they couldn't see that these loans were abusive, that the risk cover was pathetic, then they deserve to take a bath."

At one point, Prof Wheaton says that between 25% and 30% of all new mortgages being issued were sub-prime. The losers from a housing slump will include the construction industry, low-income homeowners who could lose their houses and be forced back to renting - and the financial sector.

"Expect several million people to go back from owning to renting as we get foreclosures," says Prof Wheaton.

The stock market is severely rattled. The Dow Jones Industrial Average has fallen by 5% since its mid-June record high, although it rallied slightly by lunchtime in New York today, rising 79 points to 13,261.

The Nasdaq technology market has fallen 7% over the same period, while the Standard & Poors 500 benchmark is on track for its worst quarter since autumn 2002. European stock markets have also suffered losses from the fall-out in the US.

A New York lender, American Home Mortgage, today filed for bankruptcy a week after warning that it had defaulted on its loan covenants. The firm, which has shed 90% of its 7,000 employees, has had to borrow $50m from a business recovery fund in order to go into chapter 11 protection.

"It is unfortunate that American Home Mortgage, a company which we built into a highly successful business, experienced this sudden reversal of its fortunes due to the unanticipated and rather sudden deteriorations in the secondary and national real estate markets," said chief executive Michael Strauss.

Although it was not a specialist in sub-prime loans, American Home has suffered from a dramatic credit crunch. For economists, the question is how big the knock-on effect on the economy may become. Some are hoping for intervention from the Federal Reserve, which meets to set interest rates tomorrow.

Richard Iley, senior US economist at BNP Paribas, says the economic jitters are yet to reach the "pressure point" for the Fed to intervene - and he adds that the situation is yet to match the crisis of 1998, when the Fed bailed out hedge fund Long Term Capital Management to ease alarm of a wider market collapse.

"The Fed is clearly watching developments very closely," says Iley. "But there's no clear evidence of the markets really seizing up - of the type of arthritis, the drag on liquidity in the markets that we saw in 1998."

He says consumers are yet to feel the pinch on the high street, with spending still "exceptionally high" relative to incomes. But a sustained, nationwide drop in home prices would change that.

"If we see nationwide falls in housing prices, which we haven't quite seen yet, and we get no offset from rising equities, then the stage is set for much, much more sluggish growth in consumers' spending."

At Bear Stearns, the former Whitewater special prosecutor Robert Fiske is leading an internal investigation into how its funds got into such disastrous positions.

Chief executive Jimmy Cayne admitted to CNBC that the next 72 hours would be crucial in rebuilding Wall Street confidence in his firm - but the 73-year-old New Yorker scorned suggestions of his own departure, saying: "In 2018, I'll be calling it a day."
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