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The Wall Street Journal has an excellent recap of the crisis that led to JPMorgan’s purchase of Bear Stearns. As this story initially broke, you got the feeling that this simply had to happen and there wasn’t much else policy makers could so. Yet, as I read the story, it becomes clear how arbitrary the whole mess was. I’m not sure it had to happen.

The more the sources stress the urgency, the more skeptical I become. Why was time so critical? If the problem is liquidity, then I would think that some breathing room could help out. Also, if tax dollars can be used to facilitate this deal, what’s to prevent them from propping up, say, Wal-Mart or General Motors?

My real enjoyment from these stories is figuring out how it was put together and seeing if you can see who the unnamed sources are. In every story, there are many motives. Naturally, anyone involved in the deal will want to speak with the WSJ as soon as possible to get their version of the story out.

The article begins:

The past six days have shaken American capitalism.

Cute. That, of course, comes from John Reed’s famous book on the Russian Revolution, Ten Days that Shook the World. Reread that sentence again, but this time, take out the word “American.”

Now let’s start looking for clues:

The mood changed daily, as did the apparent scope of the problem. On Friday, Treasury Secretary Henry Paulson thought markets would be calmed by the announcement that the Federal Reserve had agreed to help bail out Bear Stearns. President Bush gave a reassuring speech that day about the fundamental soundness of the U.S. economy. By Saturday, however, Mr. Paulson had become convinced that a definitive agreement to sell Bear Stearns had to be inked before markets opened yesterday.

Bear Stearns's board of directors was whipsawed by the rapidly unfolding events, in particular by the pressure from Washington to clinch a deal, says one person familiar with their deliberations.

"We thought they gave us 28 days," this person says, in reference to the terms of the Fed's bailout financing. "Then they gave us 24 hours."

The “person” person is clearly a key source. Note that they're playing up the sense of urgency. We’re being told that a deal simply had to be done before markets opened. This is the key goal of the story—explaining why a month delay was unacceptable.

The terms of the Bear Stearns sale contained some highly unusual features. For one, J.P. Morgan retains the option to purchase Bear's valuable headquarters building in midtown Manhattan, even if Bear's board recommends a rival offer (That’s a nice trick.). Also, the Fed has taken responsibility for $30 billion in hard-to-trade securities on Bear Stearns's books, with potential for both profit and loss.

The question now looming over the transaction: Has the government set a precedent for propping up failing financial institutions at a time when its more traditional tools don't appear to be working?

Actually, there’s no question involved at all. Take that last sentence and delete the first word and the question mark.

Cutting interest rates -- which the Fed is expected to do again today, by between a half percentage point and a full point -- hasn't yet done much to loosen capital markets gummed up by piles of bad debt.

Even though the transaction ultimately could leave taxpayers on the hook for losses, the political response so far has been fairly positive. "When you're looking into the abyss, you don't quibble over details," said New York Democratic Senator Charles Schumer.

Sorry Chuck, but I do. This is the closest relationship between government and private enterprise since Eliot Spitzer, although the roles now seem reversed.

Last Tuesday, we’re told, Wall Street started to turn against Bear.

That same day, the market began turning on Bear Stearns. Phones were ringing off the hook at rival firms such as Goldman Sachs Group Inc., Morgan Stanley and Credit Suisse Group. Clients of those firms were growing worried about trades they had entered into with Bear Stearns -- about whether Bear Stearns would be able to make good on its obligations. The clients asked the other investment banks whether they would be willing to take the clients' places in the trades. But credit officers at Goldman, Morgan Stanley and others -- worried themselves about Bear Stearns's condition -- began to say no.

At Bear Stearns, Chief Financial Officer Samuel Molinaro, along with company lawyers and Treasurer Robert Upton, were trying to make sense of the situation. They felt comfortable with their capital base of roughly $17 billion and were looking forward to reporting Bear Stearns's first-quarter earnings, which had been respectable amid the market carnage.

One theory began developing internally: Hedge funds with short positions on Bear -- bets that the company's stock would fall -- were trying to speed the decline by spreading negative rumors.

Sounds like they were spreading the truth.

Bear Stearns's hope was that the Fed would make a loan from its discount window to provide several weeks of breathing room. That, the firm hoped, would perhaps halt a run on the bank by allowing it to swap bonds for the cash necessary to return to customers.

The Fed's standard preference in dealing with a troubled institution is to first seek a private-sector solution, such as a sale or financing agreement. But the possibility of a bankruptcy filing Friday morning created a hard deadline.

A trigger point was looming for Bear Stearns in the so-called repo market, where banks and securities firms extend and receive short-term loans, typically made overnight and backed by securities. At 7:30 a.m., Bear Stearns would have to begin paying back some of its billions of dollars in repo borrowings. If the firm didn't repay the money on time, its creditors could start selling the collateral Bear had pledged to them. The implications went well beyond Bear Stearns: If other investors questioned the safety of loans they made in the repo market, they could start to withhold funds from other investment banks and companies.

The $4.5 trillion repo market isn't a newfangled innovation like subprime-backed collateralized debt obligations. It is a decades-old, plain-vanilla market critical to the smooth functioning of capital markets. A default by a major counterparty would have been unprecedented, and could have had unpredictable consequences for the entire market.

But why is the unprecedented action that was taken better than the unprecedented of allowing a default in the repo market? Obviously, no one likes a default, but the risk of a default is priced in. Now the market has to price in the participant’s political influence as well.

Federal Reserve Bank of New York President Timothy Geithner worked into the night, grabbing just two hours of sleep near the bank's downtown Manhattan headquarters. His staff spent the night going over Bear's books and talking to potential suitors including J. P. Morgan. The hard reality was that even interested buyers said they needed more time to go over the company.

The pace and complexity of events left Bear's board of directors groping for answers. "It was a traumatic experience," says one person who participated. Sleep deprivation set in, with some of the hundreds of attorneys and bankers sleeping only a few hours during a 72-hour sprint. Dress was casual, with neckties quickly shorn.

A detail like “two hours of sleep” strongly suggests that Geithner was a source, as was “one person” from Bear’s board.

J.P. Morgan's effort to buy Bear kicked into high gear on Friday afternoon, just hours after the big bank and the Fed had provided Bear with the 28-day lifeline. Steve Black, co-head of J.P. Morgan's investment bank, returned early from vacation in the Caribbean, spearheading the bank's efforts with his J.P. Morgan counterpart in London, Bill Winters.

Mr. Black's role was pivotal. He was a longtime associate of J.P. Morgan Chief Executive James Dimon. And Mr. Black had a long relationship with Bear's CEO, Mr. Schwartz, dating back to the 1970s, when the two were fraternity brothers at Duke University.

There’s a nice little nugget. So the whole deal was started over a 30-year-old keg party. So I’m guessing Black was a source as well.

Wait a second, don’t Black and Schwartz really have the same name? Freaky....

On Saturday, the deal started to come together.

That evening, Mr. Black got on the phone to Mr. Schwartz, Bear Stearns's CEO. J.P. Morgan would be willing to buy Bear Stearns, subject to the conclusion of due diligence, he told Mr. Schwartz. The J.P. Morgan executives didn't set a specific price, instead providing a dollars-per-share range, according to people familiar with the matter. At the high end was a figure in the low double digits, these people say.

So how did it go from the low double digits to the low single digits? It's not really clear. JPMorgan started to get cold feet. Now for the climax:

Finally, they came to a conclusion. J.P. Morgan wouldn't buy Bear Stearns on its own. The bank needed help before it would do the deal.

Mr. Paulson was frequently on the phone with Bear and J. P. Morgan executives, negotiating the details of the deal, the senior Treasury official said. Initially, Morgan wanted to pick off select parts of Bear, but Mr. Paulson insisted that it take the entire Bear portfolio, the official said.

This was no normal negotiation, says one person involved in the matter. Instead of two parties, there were three, this person explains, the third being the government. It is unclear what explicit requests were made by the Fed or Treasury. But the deal now in place has a number of features that are highly unusual, according to people who worked on the transaction.

In addition to its option to purchase Bear's headquarters building, J.P. Morgan has the option to purchase just under 20% of Bear Stearns's shares at a price of $2 each. That feature gives J.P. Morgan an ability to largely block a rival offer, says a person with knowledge of the contract.

The deal also is highly "locked up," meaning that J.P. Morgan cannot walk, even if there is a heavy deterioration in Bear's business or future prospects. Bear Stearns holders can, of course, vote the deal down. But the effect that would have on J.P. Morgan's ongoing managerial oversight and the Fed's guarantees is largely unknown.

"We're in hyperspace," says one person who worked on the deal. All these matters are very likely to be litigated in court eventually, this person adds.

The Fed spent the weekend putting together a plan to be announced Sunday evening, regardless of the outcome of Bear's negotiations, that would enable all Wall Street banks to borrow from the central bank. Mr. Bernanke called the Fed's five governors together for a vote Sunday afternoon. All five voted in favor, using for the second time since Friday the Fed's authority to lend to nonbanks.

The steps were announced at the same time the Fed agreed to lend $30 billion to J.P. Morgan to complete its acquisition of Bear Stearns. The loans will be secured solely by difficult-to-value assets inherited from Bear Stearns. If the assets decline in value, the Fed -- and therefore the U.S. taxpayer -- will bear the cost.

Posted by edelfenbein at March 18, 2008 10:06 AM