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This chapter is from the book

Liquidity-Squeezed Broker-Dealers

The financial shock hit Wall Street’s so-called broker-dealers in spring 2008, when rumors swirled over their potential liquidity problems. These are investment firms that buy and sell securities both for customers and for themselves. They often are highly leveraged, borrowing to make big bets on securities ranging from U.S. Treasury bonds to exotic and risky securities backed by mortgages. When they bet right, their profits can be huge—but when they bet wrong, they can end up like Bear Stearns.

Bear Stearns bet big on the residential mortgage market. It not only issued mortgage securities, but it had acquired mortgage-lending firms that originated the loans that went into those securities. Bear “made a market” in mortgage securities, meaning it would either buy or sell, whichever a customer wanted. It prospered during the housing bubble, but as the housing and mortgage markets collapsed, each of Bear’s various business segments soured in turn, and confidence in the firm’s viability weakened. Unlike commercial banks that collect funds from depositors, a broker-dealer relies on other financial institutions to lend it the money it invests. If those other institutions lose faith and begin withdrawing their money, the broker-dealer’s only options are filing bankruptcy or—as in Bear Stearns’ case—selling out.

Over a tumultuous weekend in mid-March, the Federal Reserve engineered the sale of Bear Stearns to JPMorgan Chase. The Fed acted out of fear of what a bankruptcy could have meant for the financial system, given Bear’s extensive relationships with banks, hedge funds, and other institutions around the world. Policymakers were legitimately worried that the financial system would freeze. To make the deal work, the Fed had agreed to absorb any losses on tens of billions of dollars in risky Bear Stearns securities that JPMorgan Chase had acquired in its takeover of the failed firm. The Fed also established new sources of cash for these hard-pressed institutions to forestall a similar fate befalling another one.

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