Jeremy Warner's Outlook: Bear Stearns rescue has Rock parallels

Has the US Federal Reserve learnt nothing from the disaster of Northern Rock? To Americans, the Rock must have seemed a parochial, North-east of England problem of no wider significance, yet it contained the universal lesson that once a distressed bank goes cap in hand to the "lender of last resort", that's essentially the end of it.

Anyone with any exposure then rushes to get their money out while the central banking facility still holds good, causing the support to mushroom in size until eventually the central bank has assumed responsibility for virtually all the liabilities. That's what happened with Northern Rock, and it now seems all too possible that it will be repeated in the US with Bear Stearns.

In his conference call with analysts yesterday, Alan Schwartz, the chief executive, admitted that the parallel announcements from JP Morgan Chase and the Fed of rescue finance had failed to stabilise nerves and stem the outflow of funds.

The run remained at the same level as prior to the announcements. As with the Bank of England's bail-out of Northern Rock, the Fed seems temporarily to have dealt with the immediate crisis in the financial system, but it may only be creating a new one for itself.

After days of denying the self-evident – that it is in serious trouble – Bear Stearns has admitted the game is up and surrendered itself into the arms of Jamie Dimon, chairman of JP Morgan Chase. Not that he's providing the money for the bail-out. Indeed, he's absolutely insistent that not a penny of his own shareholders' money is being put at risk.

Rather, the funds come indirectly from the Federal Reserve discount window. In essence, this is a central bank rescue, with JP Morgan acting as intermediary, for which, presumably, it gets first call on the assets as the Bear Stearns carcass is picked over. As an investment bank, Bear Stearns has no direct access to the discount window, but as a commercial bank, JP Morgan does.

In a back-to-back deal, JP Morgan passes on the emergency finance it has raised from the Fed to the distressed Bear Stearns. The operation could not have been done secretly, in that markets would have thought that it was JP Morgan that was in trouble if it had been seen to be borrowing heavily from the Fed without anyone knowing the true purpose.

The emergency funds were needed because in an extreme example of what's been happening in the banking system as a whole, everyone had stopped lending to Bear Stearns, fearing they wouldn't get their money back if they did. The consequent absence of liquidity meant that Bear Stearns couldn't pay its liabilities as they fell due.

Sounding a bit like Adam Applegarth, the deposed chief executive of Northern Rock, Mr Schwartz blames his problems all on mischievous rumour-mongering. There was no capital or liquidity problem, he insists, until the rumours of trouble started. As they in-tensified, there was a stam-pede of prime brokerage and repo clients trying to get their cash out, causing the bank to run out of liquidity.

So is this America's Northern Rock moment? More importantly, is this the big one, the calamity averted that comes to mark the nadir of the crisis, or is it just the start of a number of similar runs as investors lose confidence in the banking system, necessitating an eventual, all-embracing Fed bailout of massive proportions?

Does the Bear Stearns rescue mark a pronounced step towards crisis resolution, or more of a heightening of the crisis with worse to come? Is this the final denouement, or just another staging post?

The parallels with Northern Rock are striking, but there are important differences too. Central banks only intervene when there is a perceived systemic risk involved in allowing the bank or financial institution to go to the wall.

That certainly would have been the case with Bear Stearns, notwithstanding the fact that it is an investment bank with-out retail deposits of any significance. Even so, it stands as counterparty to myriad different derivative and credit contracts, particularly in the area of mortgage-backed securities, where it was one of the biggest operators. Potential therefore existed for multiple defaults through the financial system.

The Rock was rescued primarily because of the risk to depositors' money, and the likely loss of confidence the failure would have caused in the banking system as a whole. In the case of Bear Stearns, it was concern over the possibility of a fire sale of mortgage assets across the system that prompted the Fed to come riding over the hill, like the Seventh cavalry.

The Seventh came to a sticky end in Custer's Last Stand. Likewise, it is by no means certain that yesterday's rescue will do the trick. Massive and repeated injections of liquidity by the central banker have so far brought only temporary relief, with the credit squeeze soon reasserting itself. Sharp cuts in interest rates have similarly failed to get the credit markets working normally.

The Fed is expected to cut again sharply next week. It's seat of the pants stuff, with no way yet of projecting how it might play out. I've already explained the risks of – like the Bank of England with Northern Rock – the Fed getting itself into a position where eventually it has to assume all of Bear Stearns' liabilities. Yet, as with Northern Rock, it's hard to see what the alternatives might have been. If the Fed had done nothing then the resulting mess would almost certainly have been a great deal worse.

An industry-wide Federal bailout beyond liquidity infusions, not dissimilar to the Savings and Loans rescue of the early 1990s, seems ever more probable. A solution in which the toxic loans are essentially nationalised sounds extreme, but it may be the ultimate outcome. After all, we have already had a not-so-dissimilar nationalisation here in the UK – Northern Rock.

Quite what the cost of such an exercise would be, or how it would be paid for, is anyone's guess. The estimated size of the mortgage securities problem in the US seems to grow bigger by the day.

What started out as a $200bn problem in the sub-prime sector of the mortgage market, is now estimated by some mainstream analysts to be a $1trn liability (George Magnus, UBS), while wilder voices put it at as high as $3trn (Nouriel Roubini, Rou-bini Global Economics), equal to a fifth of annual national income in the US.

These latter estimates assume that with growing unemployment and falling house prices, the mortgage problem spills out from sub-prime into what was previously considered to be less risky, prime lending. The higher numbers seem extreme, but they are not altogether implausible, in that already 2 per cent of all US home loans are in some form of default.

As for Bear Stearns, Mr Schwartz claims to be confident that the emergency Fed funds are only "a bridge to a more permanent solution". Once investors know the facts, instead of the fiction, then things will settle. In the meantime, a range of alternatives is being explored with the bank's advisers, Lazards, to safeguard the interests of clients and shareholder value.

If all this sounds familiar it is because something similar was said when Northern Rock availed itself of the Bank of England's lender-of-last-resort facility last September. There was no solvency problem, Alistair Darling, the Chancellor, insisted, but only a temporary liquidity issue which the emergency funding would bridge. How wrong can you be?

Bear Stearns was the bank that marked the start of the credit crunch last July when two of its hedge funds ran into difficulty. It would be heartening to think that its rescue would signal the end. Regrettably, that's unlikely to be the case.