The Bear Trap

It was, no question, one of the most dramatic episodes in American financial history. A famously scrappy Wall Street investment bank, Bear Stearns, went from seemingly healthy to dead meat in about five days. Federal Reserve Chairman Ben Bernanke, desperate to avoid a sudden collapse that might cause a full-fledged market panic, invoked a little-known 1930s legal provision to engineer a Sunday fire sale of Bear Stearns to banking giant JPMorgan Chase for a mere $2 a share. (Bear's stock price was $57 a week before, $171.51 in early 2007.)

With Bear shareholders virtually wiped out, half the firm's employees slated to lose their jobs and no golden parachutes offered to the top executives, it wasn't a bailout. But it did take a $30 billion loan from the Fed to seal the deal. This was a truly extraordinary use of the central bank's powers and an indication that the subprime-mortgage crisis that erupted last summer has evolved into something bigger and more ominous--possibly the greatest challenge to the American way of financial capitalism since the Depression.

The immediate market reaction to the deal--and to the three-quarter-point interest-rate cut announced by the Fed two days later--was positive. Stocks rose nearly 4%; credit markets calmed a bit; the global financial system lived to fret another day. And fret it surely will, for the troubles that mauled Bear are far from over.

What Went Wrong

The troubles began, as you've already heard a thousand times, with the boom earlier this decade in subprime mortgages, unconventional home loans sold to people with dodgy credit or with incomes that just weren't big enough to buy the house they wanted. In what you might call a virtuous circle--except that far more greed than virtue was at work--lower lending standards helped fuel an unprecedented rise in house prices, and those rising prices meant borrowers could refinance their way out of any trouble they had making payments.

The speculative bubble in housing reached its peak in the summer of 2006. As of last December, house prices were down 10.2% from that peak, according to the S&P/Case-Shiller National Home Price Index, and are still falling. Defaults are way up, and with the collateral behind even formerly sound home loans losing value by the day, defaults will surely keep rising.

This is what you call a bad-debt problem. The U.S. banking system had a couple of big bad-debt problems in the 1980s (remember S&Ls? Latin-American debt?) and slowly, grindingly, expensively worked its way through them. But now most mortgages aren't sitting on the books of the lenders who made them. Instead they've been chopped up and combined into securities--with values contrived by complex mathematical models--and sold to banks, pension funds and other investors around the world. This securitization was supposed to spread risks more widely and more efficiently.

But a decade and a half of good times in real estate seemed to lull many buyers of this paper into ignoring risk completely. Ever since investors began discovering to their horror early last year that it is in fact possible to lose money on mortgages, the market for mortgage securities has been gripped by distrust and disagreement. That distrust has since spread to other investments previously advertised as virtually risk-free: insured bonds, auction-rate municipal bonds and the structured investment vehicles (SIVS) that banks used to get ugly stuff off their balance sheets.

Nevertheless, all those mortgages that started the problem are still worth something. House prices are headed downward, but they're not headed to zero. What turned a simple price decline into a crisis that killed Bear Stearns was the way many financial firms (hedge funds and investment banks, especially) generate their profits: by making bets with borrowed money. To borrow that money, they have to put up collateral--for example, mortgage securities. Lately, many firms have been simultaneously beset by bets gone bad and skittish lenders' calling in loans or demanding more collateral.

Several big hedge funds had already been driven out of business by such lender squeezes, starting last summer with two mortgage funds run by Bear Stearns. But Bear itself still turned a small profit in 2007. As late as the first week of March this year, there was no reason to think it was in imminent danger. Then rumors began flying that it was. Lenders refused to lend, clients refused to trade, and suddenly Bear was out of money. It was a bank run, more or less. And the scary thing was that there is no entirely satisfactory explanation for why it hit Bear. One may emerge as JPMorgan Chase's bean counters dig through the books, and some have fingered rumor-mongering short sellers who stood to gain as the stock dropped, but for now it mainly looks like just a sudden crisis of confidence. Which could conceivably happen to anybody. "It's a good old-time panic," says Scott MacDonald, co-author of Separating Fools from Their Money: A History of American Financial Scandals and director of research at Aladdin Capital, a fixed-income investment manager in Stamford, Conn. "We haven't had one in a while."

Can the Fed Fix Things?

The greatest power of the fed is that it can create dollars at will. It gets those dollars into the economy by buying Treasury securities on the open market. When you hear the Fed is cutting rates, that usually means it's ordering the traders at the Federal Reserve Bank of New York to start buying, and that drives short-term Treasury rates down.

Economist Milton Friedman argued--and eventually convinced most of his colleagues--that it was the Fed's failure to keep enough dollars in circulation that made the Great Depression such a great disaster. No Federal Reserve chairman will ever let that happen again, so we probably shouldn't worry too much about bread lines and Hoovervilles in the near future. But the money supply is a blunt instrument, one that comes nowhere near addressing all of today's problems. "The issue is not one of liquidity but one of solvency," says Richard McGuire, a strategist at RBC Capital Markets in London. "It's not the cost of money but the unwillingness of banks to lend to one another owing to uncertainties ... that is the root of the credit crunch." That is, the Fed can drive down interest rates all it wants, but if lenders are charging their clients and one another much higher rates or are refusing to lend at all, you've still got a credit squeeze.

Bernanke, himself an authority on the Depression, has been pushing ever more creative and aggressive means to avoid this, mostly by lending cash or Treasuries in exchange for mortgage securities. The Fed persuaded JPMorgan Chase to buy Bear Stearns in part by agreeing to lend $30 billion against hard-to-sell mortgage securities on Bear's books.