If you have been following this crisis at all you can see that there is a huge amount of debate going on as to whether or not the Federal Reserve should have intervened to try and save Bear Stearns or whether they should have stayed out of it. In order to have a full understanding of both sides of this debate one must first understand the role Bear Stearns played in the global financial markets.
In addition to being a major player in the mortgage backed securities markets as we covered in part 1 of this series, Bear Stearns was also the second largest prime broker in the country. The fact that they had such a large share of the prime brokerage business was a key factor here, so the first thing we are going to look at is exactly how prime brokerage works.

Institutions unlike most individuals trade via credit lines. In order to obtain a credit line a financial institution must prove their credit worthiness by providing financial statements and then must put up collateral in the form of cash or liquid securities to secure the credit line. This process is very similar to what an individual goes through when they apply for a mortgage to buy a house but just on the institutional level instead of the individual level.

The second thing that it is important to understand is here is where an individual will normally have their trading account with one firm and trade with that firm only, institutions normally trade with multiple firms. They do this because they want to receive the best price possible for their trades and at the institutional level certain banks and broker dealers give better prices for say foreign exchange trades than they do bond trades as an example. With this in mind, it would be a real hassle if they had to go through the credit approval process at every institution they wanted to trade with and then to have to figure out how to report for all the different trades they have at the different institutions.

So just like visa allows you to use one card for most if not all the places you shop, a prime broker allows you to have one account which has one credit line that you can use with any of the banks or broker dealers that the prime broker allows you to trade with. The prime broker also provides you with back office reporting capabilities that allow you to see all your trades that you have made with different banks and broker dealers in one place.

Once this is done the prime broker then acts as the counterparty to all trades. What this means is that when one of these financial institutions that uses Bear Stearns as their prime broker makes a trade, the bank or other financial institution that they are making that trade with sees Bear Stearns as the institution making the trade, not the institution that originally made the trade. So because Bear Stearns is the Second largest prime broker in the country, they have many billions of dollars of outstanding trades on behalf of their clients with financial institutions all over the world at any one time.

So you can see here the problem that if the second largest prime broker in the country went bankrupt, this would be the equivalent from a trading standpoint of every financial institution that used Bear Stearns as their prime broker going bankrupt, all at the same time.

So now that we understand this we can look at the differing sides of the debate as to whether or not the firm should have been rescued which will be the topic of our next lesson.

For more great information about the subprime crisis please visit the subprime crisis learning center at InformedTrades.com, and have a great day!