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Nye Lavalle
Exit Bear, pursued by its creditors
Published: March 14 2008 19:27 | Last updated: March 14 2008 19:27

The investment bank that not only survived the crash of 1929, but thrived because of it, is teetering on the brink. Part of Bear Stearns’ folklore is that it came through the Great Depression without laying off staff and without stopping bonuses. But Friday’s rescue by the Federal Reserve Bank of New York is likely to mark the end of a proud bank’s independent existence.

Bear Stearns is a leverage machine: with only $11.8bn of capital from its shareholders it supports a balance sheet of $395bn, most of it bonds, and many of those backed by mortgages. To finance that balance sheet Bear relies on short-term loans secured against its portfolio of bonds. This week those loans dried up; Bear hardly had a chance.

A poisonous cycle has taken hold. As mortgage-backed bonds fall in value – even those backed by quasi-government entities Fannie Mae and Freddie Mac – banks demand more security to lend against them. That pushes leveraged investors to sell bonds, depressing prices still further, prompting more margin calls and the collapse of some funds, such as Peloton and Carlyle Capital Corporation. Bear Stearns is not just heavily leveraged, it was a lender to CCC.

There is a whiff of 1929 about all this. One of the features of the Great Crash was the margin loans that brokers had made to their clients. As the markets fell, brokers demanded cash and sold the stocks they held as collateral when their customers could not provide it. As J.K. Galbraith put it: “Each spasm of liquidation therefore ensured that another would follow.”

But lessons have been learnt from 1929, not least by Federal Reserve chairman Ben Bernanke, who quite literally wrote the book on the Great Depression. The prompt action to support Bear Stearns is in stark contrast to the Fed’s inaction in the early 1930s, as a string of banks failed. The Fed is adamant that it will do whatever is needed.

With hindsight, Tuesday’s an nouncement of a Fed programme to lend up to $200bn of Treasuries to brokers in exchange for mortgage bonds appears custom-made to rescue a specific bank, Bear Stearns. It came too late. While access to Treasuries will make it less likely that another broker gets into trouble, it is unlikely to ease the wider problems in the credit markets. Even if they can borrow at the Fed, banks and brokers will not lend to clients they suspect to be insolvent.

Now the question is: what else is out there? Will the liquidity and solvency of other large banks and brokers be called into question? Hank Paulson, US Treasury secretary, has urged banks to raise more capital, without specifying where it is to come from. As the credit squeeze wears on, it becomes more likely that, in one form or other, the capital will have to come from taxpayers; but it should not do so until the need is realised, and it must be at the expense of shareholders.

Copyright The Financial Times Limited 2008

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Strange how nobody (including today's WSJ, NYT, this chatroom, etc.) is commenting on the late downgrade Friday by Moody's and the enormous effect that will have. Under the interest rate and FX swap ISDA agreements, Bear will now have to post additional collateral as a result of breaching the downgrade trigger. This is an asymmetric draw on liquidity (they have to post to their counterparties but they get no additional collateral on matched positions). This is certainly the silver bullet.
Moody's downgrades Bear Stearns - Mar 14, 2008
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