JPMorgan, N.Y. Fed step in to rescue Bear Stearns

NEW YORK -- After fighting off rumors all week that it was facing a crippling cash crisis, Bear Stearns bsc on Friday roiled financial markets with news it had to turn to the Federal Reserve and JPMorgan Chase for a bailout.

Shares of the USA's fifth-largest investment bank plunged more than 50% in the first half hour of trading Friday and at the close were still down more than $26 to $30.92 — a 46% drop that erased more than $3 billion in market value.

The selling spread to the broader market, and the Dow Jones industrial average dropped 300 points, rebounded and then headed back for another 300-point drop before rebounding again.

Bear Stearns said it sought emergency funding after realizing it would not be able to keep up with a spike in demand from lenders and others trying to get their cash back.

Those demands have forced the 85-year-old investment bank to reach a financing agreement with JPMorgan Chase jpm so it can continue operating.

CEO Alan Schwartz said had the bank not taken steps to secure temporary financing, the pace of customer withdrawals would have outstripped the company's ability to make payments.

Bear Stearns also said it has hired Lazard to help it consider alternatives, amid talkthat it's up for sale.

Rumors persisted throughout the week that Bear Stearns was facing major cash flow problems, although Schwartz initially denied those rumors. Through Thursday's close, shares of Bear Stearns had already dropped 18%.

"Bear Stearns has been the subject of a multitude of market rumors regarding our liquidity," Schwartz said in a statement Friday. "Amidst this market chatter, our liquidity position in the last 24 hours had significantly deteriorated."

In the world of high finance, perception not only trumps reality, it reshapes reality. Bear Stearns became an object lesson this week when the crisis of confidence spawned the equivalent of a "run on the bank," and forced the firm to go begging to the Federal Reserve for a loan.

The Fed complied Friday morning, in a deal struck with JPMorgan Chase, giving Bear access, through Chase, to additional cash from the Federal Reserve Bank of New York for 28 days.

In doing so, the Fed is stepping in to maintain confidence in the financial sector for a second time this week.

Earlier, the Fed took a dramatic decision to let securities dealers and banks swap up to $200 billion in currently out of favor mortgage-backed bonds and other products for ultrasafe Treasury securities, hoping that would rebuild creditors' confidence in those institutions.

The Fed's moves recall previous attempts to rescue financial institutions deemed "too big to fail," says Hugh Johnson, chairman of Johnson Illington Advisors.

"Some will say that by doing so the Fed is encouraging financial institutions to continue take very high risks knowing they will be bailed out," says Johnson. "That's a very good argument, one that's been going on since the 1700s and 1800s. In my opinion, they've exercised good judgment."

According to Brad Hintz, who follows Bear Stearns for Sanford Bernstein & Co., the central bank's actions are similar what the Fed did in 1987 in the wake of "Black Monday," when market makers on the New York Stock Exchange were desperate for capital.

"This is not a capital issue, it's a confidence issue," says Hintz. "The brokers are adequately capitalized. But the bond market and creditors are apprehensive about lending to the brokers..."

Bear Stearns was more vulnerable to a panic mentality, Hintz says, because the firm had more exposure to mortgage-backed securities, and has been under pressure to sell those securities at fire-sale prices.

The company has struggled since the middle of last year because of subprime fallout in the mortgage and credit markets. Last summer, two hedge funds worth billions of dollars managed by Bear Stearns collapsed because of bad bets on securities backed by subprime mortgages — mortgages given to customers with poor credit history.

"Bear Stearns was the weakest player with the lowest ratings and the greatest percent of revenue exposed to mortgage-backed securities," Hintz says. "As lenders demand their money back, a broker has no choice but to sell securities in the market and shrink its balance sheet. At some point, the liquid assets are all gone and the firm can not sell the illiquid ones. And unless the Fed steps in, the firm runs out of money."

In a memo to employees, Schwartz said the temporary financing would allow the company to "get back to business as usual."

Contributing: The Associated Press