One More Healthy Debate About the Bear Stearns Bailout

The Bear Stearns (BSC) bailout has spurred a lot of healthy debates. One side believes that the Fed’s intervention is to bail out the Wall Street and is causing more troubles down the road , or, worse, is because of a century old conspiracy, while the other side believes that the Fed is not bailing out Bear Stearns , or is doing the right thing to prevent further issues, such as deflationary risk . Of course, there are people sitting on the sideline, pointing out that, in the long run, if the Fed is betting on the right direction, the Bear Stearn move actually brings in money for the government and it might start a new era, putting security firms’ regulation in Fed’s hands .

The reason for government’s intervention, as Treasury Secretary Hank Paulson put it:

Bear Stearns found itself facing bankruptcy. The Federal Reserve acted promptly to resolve the Bear Stearns situation and avoid a disorderly wind-down. It is the job of regulators to come together to address times such as this; and we did so. Our focus was the stability and orderliness of our financial markets.

The current situation is like that a skyscraper was set on fire by some stupid person in the same building. We have to save all the people inside before the building burnt out. Only after that, we start think about the punishment. The current priority is to save the system and the consequence of failing that task will be miserable to the US economy. Notice that the collapse of Bear Stearns is largely due to a lack of confidence not lack of capital as Cox, the Chairman of SEC, stated:

Notwithstanding that Bear Stearns continued to have high quality collateral to provide as security for borrowings, market counterparties became less willing to enter into collateralized funding arrangements with Bear Stearns. Bear Stearns’ liquidity pool started at $18.1 billion on March 10 and then plummeted to $2 billion on March 13. Ultimately market rumors about Bear Stearns’ difficulties became self-fulfilling.

The same self-fulfilling issue could easily drag the whole US financial system down if the government sits idle. Consider the situation when people lose confidence and all the investors, both domestic and overseas, pull money out of the system. When that happens, we will see the Great Depression again. The fact for the Fed to become the first resort simply explains the severity of this real estate crisis.

It is a bailout. It is mainly to bail out both Bear Stearns investors and the confidence of the market. It sends a strong signal that the government will take care of the mess, which is very important to stabilize the market. For Bear Stearn employees who have helped create the mess, they have got a huge hit already. For example, the chairman of the company, James Cayne, has sold his entire stake in the company for $61 million, which was worth close to $1 billion at one time. Is it fair? Definitely not! Moral hazard and adverse-selection incentives make the bailout even more costly. On the other hand, unless we have a better solution, most likely, we have to live with the imperfect world.

Finally, I will end this post with a statement from L. William Seidman, former chairman of both the FDIC and the Resolution Trust Corporation, regarding the previous real estate crisis:

The banking problems of the ’80s and ’90s came primarily, but not exclusively, from unsound real estate lending.

History does not repeat itself, but it does rhyme.

Disclosure: none