Bear Stearns: The domino effect?

Fancy a game of dominoes? It has been the pursuit of choice on Wall Street for the past week, after Bear Stearns began its death spiral, the one question on everyone's lips. Which bank is next?

On different days, there have been different answers. Lehman Brothers, most often. UBS, perhaps. For the first time yesterday, the most common answer was: no one.

Where investors had been bracing themselves for horrors in the latest round of quarterly financial results from brokers, the figures yesterday from the first two out of the traps – Lehman and Goldman Sachs – proved a little less bad than feared.

More importantly, executives at both banks focused heavily on setting out just how much cash and liquid assets they have on the books, relative to their short-term trading liabilities.

The collapse of Bear Stearns has changed the picture, in two important ways. Firstly, the Federal Reserve has learnt what to do. As well as promising to underwrite JPMorgan Chase's takeover of Bear, it has re-activated a Depression-era rule allowing securities firms to borrow directly from the Fed.

Bear couldn't do that, meaning it had nowhere to go to offload the illiquid mortgage securities its toxic balance sheet was laced with. Any bank in a jam from now on will be able to go directly to the Fed's discount window and trade in its hard-to-sell assets as collateral for highly liquid government bonds or cash, which it can in turn use to fund its short-term liabilities and keep trading.

Secondly, Bear's rivals have learnt what not to do. The hapless Alan Schwartz, chief executive of Bear, fulminated about the "fiction" and "innuendo" scaring clients and trading partners away last week, but in neither his stock exchange statement insisting all was well on Monday, nor his television appearance on Wednesday, could he offer more than broad-brush promises that Bear's liquidity position was strong.

Lehman Brothers was touted last week as the "next weakest" of the Wall Street titans, a close rival of Bear and also one of the leading players in mortgage-related derivatives and in other esoteric corners of the battered credit markets.

But in the last few days, and again on a conference call with investors and analysts yesterday, Lehman has provided a masterclass in how to prevent stock market rumours from turning into a crisis of confidence that engulfs the bank. To borrow a phrase: education, education, education.

Traders at Lehman were issued with a list of "talking points" last week, advising them on the details of the firm's liquidity position and suggesting some reassuring things to say if a trading partner was considering pulling its business. If anyone really did pull their business, there would be calls between more senior executives of the two institutions and a lot of cajoling to get the business back. Over the weekend, regulators also appear to have stepped in, and the Federal Reserve bank of New York is understood to have put out the word that spreading rumours about a rival's liquidity position would be viewed as tantamount to market abuse.

Across Wall Street, banks have put in place "rapid response" strategies that have echoes of a political campaign machine. When Meredith Whitney – the bearish financial sector analyst from Oppenheimer & Co, whose star has been in the ascendant since she correctly predicted Citigroup would have to cut its dividend – was playing dominoes on business television yesterday, she answered a question on who might be most a risk of being "the next Bear" by pointing to UBS. Within minutes, UBS officials were in email contact with her, to question her reasoning and correct what they said were mistakes she had made.

Lehman has insisted to anyone who would listen that it learnt useful lessons from the financial markets crisis of 1998, when the Russian debt default caused a convulsion in the credit markets that caused it massive losses, raised questions of its future and almost triggered a run on the bank. The company is much more conservative in its liquidity position, more diverse and, crucially, more pro-active in informing the market about its finances, Lehman chief executive Dick Fuld said in a string of interviews.

Yesterday, Lehman said it earned $489m in the three months to the end of February. That is a vicious haircut from the $1.15bn in the same period last year, but that was when the credit market bubble was at its most expansive. Even the mighty Goldman posted a similar 50 per cent collapse in earnings yesterday, in what its chief executive, Lloyd Blankfein, called "very difficult" market conditions.

Lehman cut the value of its holdings of mortgage-related derivatives, commercial real estate interests and leveraged loans by $2.4bn, but that was not a shock to analysts who have seen all these markets weaken sharply since the start of the year.

Most important of all, on its call with Wall Street analysts yesterday, Lehman's chief financial officer Erin Callan went beyond the end of its financial rep-orting period and set out the business's liquidity position as of the previous evening. "We have structured our liquidity framework for a decade to cover expected cash outflows for 12 months. And we do so without expecting to be able to raise new cash in the unsecured markets, or without having to sell assets."

And Ms Callan concluded the call by thanking analysts for supporting the company – a nod to the ease with which inaccurate or loose comment can cause serious crises of confidence.

Analysts themselves had been painstakingly picking through the minutiae of the balance sheet statements from the major finance houses, looking at liquidity ratios (that is, the amount of cash and liquid assets versus short-term liabilities) and coming up with their mathematical version of dominoes. Merrill Lynch "riskiest after Bear" was the headline one news agency put on news of one analysis by Wachovia's Douglas Sipkin, which pointed to Merrill's $30bn exposure to sub-prime mortgage derivatives and its top-of-the-industry level of leverage.

However, Mr Sipkin does not mean to suggest a run on Merrill is likely. "We believe going concern fears regarding the investment banks are misguided. While liquidity conditions are more challenging than at any time in recent history, the failure of Bear Stearns was more a management issue than a market issue, in our opinion. In addition, we view the Fed's action which allows dealers to access the discount window as a major development in the liquidity freeze saga for investment banks."

Still, not everyone agrees that Bear Stearns will certainly be the last major casualty, since the additional writedowns announced by Lehman and Goldman yesterday show that there is no clarity yet on the losses feeding through the system from defaulting mortgages and falling US house prices.

Paul Niven, head of asset allocation at F&C Investments, said: "While we take comfort from the proactive policy response being undertaken by the Federal Reserve, investors need to see evidence of its effectiveness to avoid speculation that the US is falling into a Japanese-style liquidity trap. This all leads towards heightened levels of volatility remaining in financial markets over the coming quarters."