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16

MARCH TO AUGUST 2008:
SYSTEMIC RISK CONCERNS

CONTENTS

The Federal Reserve: “When people got scared”.................................................
JP Morgan: “Refusing to unwind . . . would be unforgivable” ............................
The Fed and the SEC: “Weak liquidity position”................................................
Derivatives: “Early stages of assessing the potential systemic risk” ......................
Banks: “The markets were really, really dicey” ...................................................

JP Morgan’s federally assisted acquisition of Bear Stearns averted catastrophe—for
the time being. The Federal Reserve had found new ways to lend cash to the financial
system, and some investors and lenders believed the Bear episode had set a precedent
for extraordinary government intervention. Investors began to worry less about a re-
cession and more about inflation, as the price of oil continued to rise (hitting almost
 per barrel in July). At the beginning of , the stock market had fallen almost
 from its peak in the fall of . Then, in May , the Dow Jones climbed to
,, within  of the record , set in October . The cost of protecting
against the risk of default by financial institutions—reflected in the prices of credit
default swaps—declined from the highs of March and April. “In hindsight, the mar-
kets were surprisingly stable and almost seemed to be neutral a month after Bear
Stearns, leading all the way up to September,” said David Wong, Morgan Stanley’s
treasurer. Taking advantage of the brief respite in investor concern, the top ten

American banks and the four remaining big investment banks, anticipating losses,
raised just under  billion and  billion, respectively, in new equity by the end
of June.
Despite this good news, bankers and their regulators were haunted by the speed of
Bear Stearns’s demise. And they knew that the other investment banks shared Bear’s
weaknesses: leverage, reliance on overnight funding, dependence on securitization
markets, and concentrations in illiquid mortgage securities and other troubled assets.
In particular, the run on Bear had exposed the dangers of tri-party repo agreements
and the counterparty risk caused by derivatives contracts.
And the word on the street—despite the assurances of Lehman CEO Dick Fuld at
