Whoa-oh, Domino?

Story Highlights:

• After a wild weekend of rumors and spreading fear in the capital markets, JP Morgan announced Sunday it will buy Bear Stearns for a song.
• The Fed, in a unique move, helped ink the deal which should help steady Bear's clients and vendors alike. At this point, the Fed has made it abundantly clear it will not allow systemic failure in financial markets.

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(Editor's Note: MarketMinder does NOT recommend individual securities; the below is simply an example of a broader theme we wish to highlight.)

Choose your idiom. Is yesterday's Bear Stearns sale to JP Morgan a "fire sale" or the first "domino" to fall? The "tip of the iceberg"? Or "are the flood gates now open"? Whatever you want to call it, make no mistake, this is a serious capital markets issue.

But the problems revealed by yesterday's sale of Bear Stearns stem more from a lack of confidence among lenders rather than a serious lack of liquidity.

(See our recent Cover Story "A Confidence Game" for more.)

That's not to say a confidence crisis can't be serious. It can even lead to self-fulfilling prophecies of demise. Because investment banks are able, but simply not willing, to lend to borrowers with significant mortgage-backed securities (MBS) exposure, firms like Bear Stearns can starve in the presence of abundance. For Bear, among the biggest originators and owners of MBS, the combination of a lack of fresh credit and a run on cash from nervous lenders spelled trouble. But the self-fulfilling prophecy was avoided when the Fed, proving it is willing to innovate where necessary, stepped in over the weekend to grease the skids for the sale to JP Morgan.

In addition to financing the sale, the Fed agreed to fund up to $30 billion of Bear Stearns's less liquid assets (like MBS). Analysts estimate most of Bear's $33 billion mortgage-backed exposure (between prime, alt-a and subprime) could be pledged against this facility, with the remaining exposure apparently acceptable to JP Morgan.

The Fed also lowered interest rates again, but more importantly created a lending facility to provide financing directly to securities dealers like Bear Stearns—a truly unique feature. The move (along with the creation of the Fed's Term Securities Lending Facility) could serve as an important source of backup liquidity for securities firms going forward.

Despite all of this, it wouldn't be surprising, or unusual, to see more broker dealers in trouble in the coming weeks. But note that Bear hasn't collapsed. Rather, its assets were absorbed in a fire sale. This has positive consequences for both customers and vendors—not to mention JP Morgan (though Bear stockholders may be miserable). It's also a reminder of how capital markets work. By stepping in to buy what will likely turn out to be an oversold Bear Stearns, JP Morgan probably got a fantastic bargain.

This is not a trivial issue, but again, it is an issue of sentiment and confidence in the financial system more than weakness in the fundamentals. The Fed has made it abundantly clear they will not allow a systemic failure in capital markets. Such turbulence is painful and difficult to endure for investors, but it would be a mistake to give up the ghost now. Psychology can only rule for so long before fundamentals regain primacy.