Page last updated at 15:42 GMT, Monday, 17 March 2008

Q&A: Bear Stearns banking crisis

Sign above the door to the Bear Stearns offices
US investment bank Bear Stearns, on the verge of collapse, has been bought by JP Morgan for a fraction of its former value, with backing of the US Federal Reserve.

How serious is this development for the future of the banking system, and what does it say about the credit crunch?

How big is Bear Stearns?

Bear Stearns is one of the major US investment banks which have dominated Wall Street for generations.

Founded in 1923, it is one of the leading global banking firms that operates at the wholesale level, dealing with governments, companies and other financial institutions.

Its core business lines include buying and selling stocks, government and corporate bonds, investment banking, global clearing services, asset management, and private client services.

Before the crisis, it had a market capitalisation of $17bn and assets under management of $385bn, and a global workforce of 15,000.

The collapse of its share price, from a peak of $169 to $2, means that it has lost more than 98% of its value in the stock market.

Why was the bank in such trouble?

Bear Stearns has been severely affected by the loss of confidence in credit markets.

The company had invested heavily in sub-prime mortgage instruments and other securities which are now seen as highly risky, and which have fallen sharply in value.

Bear Stearns admitted that it owned $48bn in mortage-backed securities, of which $17bn might be difficult to value.

And it had less capital than its rivals, such as Citigroup and Merrill Lynch, who were also heavily exposed, to plug the gap.

Last summer, two of Bear Stearns' hedge funds had to be bailed out, partly precipitating the first stage of the global credit crunch.

Now other banks have become unwilling to invest money in Bear Stearns to keep its operations going.

And that has meant that it no longer has enough cash on hand, known as liquidity, to fund its operations.

How dangerous is the situation?

The worry is that if Bear Stearns collapsed, it would be forced to sell its assets, such as sub-prime mortgage securities, into the market at cut down prices.

This would have lowered their value even further.

And that could have affected the solvency of many other big US banks.

And if other big banks went bust, then credit would dry up rapidly across the whole economy, slowing economic activity.

This is what is known as "contagion."

That is why the New York Federal Reserve felt it had no choice but to intervene to support a short-term rescue deal

But there may be other banks that are already at risk of reaching a similar position to Bear Stearns.

Why was JP Morgan Chase interested in buying the bank?

As a large commercial bank, JP Morgan was hoping to take advantage of the credit crunch to expand its operations - as long as it did not face any risk.

Since the Fed has guaranteed that JP Morgan Chase can borrow up to $30bn against the value of its assets, there is little risk of losing money in the takeover.

In return, it is guaranteeing that it will meet all the payments due to other banks.

But it is unlikely that the majority of Bear Stearns activities will continue at its current level, so there may be major job losses.

The Fed has also lowered the interest rate on overnight lending to banks to 3.25% and allowed other investment banks to borrow money against their dodgy assets.

The Fed had already announced a new $200bn emergency loan facility which comes into effect on 27 March.

What is likely to happen now?

The Fed is already planning another rate cut on Tuesday that could be as large as 1%, in order to stimulate the economy.

This will take interest rates to below the rate of inflation, and may make it difficult to cut further.

But stock markets are falling on the worries that the problems in the financial sector are deeper and wider than previously thought.

Whatever happens to interest rates, it could be some time before confidence returns to financial markets.

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