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Extra3/17/2008 3:21 PM ET

Banks brace for deepening financial crisis

The rapid demise of Bear Stearns threatens to sap dwindling confidence in the banking system, which has lost liquidity after the collapse of the subprime mortgage market.

By The Wall Street Journal

Many bankers are steeling themselves for the global financial crisis to both last longer and grow deeper, a shift in mood that could magnify the potential for upheaval in markets and economies worldwide.

Just a month ago, financiers in the United States and Europe held out hope that the turmoil might end this year. Now, a new view is emerging: As the malaise spreads beyond risky mortgage securities and into the high-octane world of derivative investments, the pain is likely to extend well into 2009.

Sunday's deal to sell Bear Stearns (BSC, news, msgs) to JPMorgan Chase (JPM, news, msgs) -- along with the Federal Reserve's surprise Sunday-evening cut in its emergency lending rate -- signals that regulators and the banking industry alike are prepared to take unusual steps to reassure financial markets. The Fed also made the rare move of saying it will lend directly to securities dealers, the first time it has done so since the 1930s.

However, the fact that the Bear Stearns deal puts a paltry $2-a-share value on the storied investment bank, which as recently as a week ago was trading around $70, is unlikely to assuage fears that the worst is yet to come.

The next four weeks will be critical in determining whether bankers' gloomy mood is justified. On Tuesday, the world's biggest banks and brokers will start reporting precisely how much money they lost in the first quarter on bad investments, on top of previous losses. These reports will also hold vital clues to what they feel the future holds.

As last week's meltdown at Bear Stearns shows, bankers' mood swings can sometimes bring about the very scenarios they fear. The 85-year-old firm suffered a de facto run on the bank when nervous lenders and clients stopped doing business with it, sparking others to follow suit.

The global economy relies heavily on banks' willingness to lend money not only to companies and individuals, but also to one another -- providing "liquidity," or an ample flow of cash coursing through the world's economies. The current period of turmoil has its roots in a stark disappearance of this liquidity. Lending that would otherwise fund everything from basic corporate operations, to sophisticated investment strategies used by hedge funds, has dried up.

The darkening outlook among bankers can help to explain why previous efforts by the Fed and other central banks haven't yet had the desired effect of reviving the flow of money.

"Why do I have to provide liquidity to one of my competitors, when I don't know if the liquidity in the market will continue to be there or not?" asks Alessandro Profumo, the chief executive of one of Europe's largest banks, UniCredit Group. "I have to take care of my company."

Signs of malaise are abundant. Last week, banks' own cost of borrowing reached the highest level in two months. Meantime, the highly specialized markets that let banks securitize, or package and sell loans, remain all but frozen.

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Ben Bernanke © Larry Downing / Reuters
Confidence on the ropes
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A week ago broker-dealer Lehman Bros. (LEH, news, msgs) announced a fresh round of layoffs totaling 5% of its work force. That followed reductions by Bear Stearns, Morgan Stanley (MS, news, msgs) and Merrill Lynch (MER, news, msgs). At Société Générale in London, traders who sell bank debt have given up on finding customers some days. "The market is not open every day," says Demetrio Salorio, deputy head of debt capital markets for Société Générale there.

As banks try to reduce their own holdings of unwanted investments, their selling further pushes down values. Swiss banking giant UBS AG (UBS, news, msgs), among the hardest hit by the financial crisis, is reducing its balance sheet -- the amount of loans, securities and other assets it holds -- by about $520 billion from its level at the end of last year. That amounts to a 20% reduction.

People familiar with the situation say UBS has weighed moves such as selling billions of dollars in mortgage securities and a U.S. brokerage unit. A spokesman for UBS declined to comment on the mortgage securities and said the brokerage unit isn't for sale.

Continued: How far beyond subprime?

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