Feature

The Fed rushes in to avert a meltdown

The U.S. government this week took unprecedented action to prevent a meltdown of the global financial system, brokering an 11th-hour deal to sell the once-mighty investment bank Bear Stearns to a rival firm. After a tumultuous week in which Bear Stearns

What happenedThe U.S. government this week took unprecedented action to prevent a meltdown of the global financial system, brokering an 11th-hour deal to sell the once-mighty investment bank Bear Stearns to a rival firm. After a tumultuous week in which Bear Stearns’ share price fell more than 50 percent to $30, the Federal Reserve presided over frenzied negotiations that ended with Bear’s agreement to be acquired by JPMorgan Chase for $236 million, or just $2 a share. To complete the deal, the Fed agreed to take responsibility for $30 billion in hard-to-trade mortgage-related debt owned by Bear Stearns. The Fed acted after Bear clients began a run on the bank. With its capital dwindling to dangerously low levels, officials worried that Bear might default on its commitments to trading partners, setting off a cascade of defaults by other firms around the world.

To further reassure investors, the Fed cut the Fed funds rate, the interest that commercial banks charge one another for overnight loans, to 2.25 percent. Stock markets rallied on the news, with the Dow Jones Industrial Average soaring 420 points, its largest single-day gain in five years. The Fed also offered to lend directly to major investment banks, as well as to commercial banks, and to accept troubled mortgage securities as collateral.

What the editorials saidThe Fed’s emergency actions have averted a panic—for now, said The Washington Post. But much remains to be done. By putting up taxpayer money to push through the takeover of Bear Stearns, the Fed runs the risk of what experts call “moral hazard”—encouraging people to engage in risky behavior when they’re shielded from its consequences. If the U.S. wants to ensure that it doesn’t “simply encourage more of the same bad behavior” that doomed Bear Stearns, it’s clear that “financial regulation has to be tougher.”

Nobody is getting let off the hook here, said The Wall Street Journal. “Bear shareholders will essentially be wiped out in this closeout sale.” And that’s only fair, because Bear’s senior managers, who were major holders of the firm’s stock, “have mainly themselves to blame” for the firm’s demise. Much more worrisome is the Fed’s expansion of its lending authority. Commercial banks have traditionally been allowed to borrow from the Fed in exchange for submitting to the central bank’s regulations. Now that investment banks can borrow directly from the Fed, will they be subject to the same rules?

What the columnists saidMaybe the Fed should have allowed Bear to fail, said Nicole Gelinas in The Wall Street Journal. “That bankruptcy would have been painful, sending new waves of distrust through the financial system” and sticking firms that did business with Bear with big losses. But a bankruptcy filing would also have forced Bear—and its trading partners—to show exactly what sort of toxic investments it holds in its portfolio. “The whole credit crisis largely reflects a lack of good information.” By preventing the firm’s collapse, the Fed missed an opportunity to shine a light on the murky doings that led to Wall Street’s crisis of confidence.

The Fed had no choice, said Scot Lehigh in The Boston Globe. Letting Bear fail might have satisfied free-market fundamentalists, but it would have set off “a cascading series of financial institution failures.” But now the government must turn to other threats to our economy. Millions of homeowners are facing foreclosure. The U.S. should take steps to keep as many of them as possible in their homes, but “in a way that helps borrowers rather than simply bails out lenders or real estate speculators.”

How times have changed, said E.J. Dionne in The Washington Post. Not long ago, “Wall Street titans” were warning the government to “keep its hands off the private economy.” Now, they’re “desperate to be bailed out by government from their own incompetence.” You would hope that Wall Street’s high and mighty would be humbled by their transformation into “welfare clients.” But I’m not holding my breath.

What next?The stock market’s rally was short-lived, as rumors spread that other Wall Street firms could suffer the same fate as Bear Stearns. A Wachovia Corp. analyst said that Merrill Lynch, with $30.4 billion in subprime holdings, could be the next to fail. Other giants, including Lehman Brothers and Morgan Stanley, are also vulnerable. “Liquidity conditions,” said analyst Douglas Sipkin, “are more challenging than any time in recent history.”

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