The Fed Joins the Bailout Party

Today, Bear Stearns (BS) announced that its access to short-term liquidity was impaired. In Wall Street speak, that means they had no money. In the free market Bear Sterns would have been allowed to go bankrupt as a consequence of its risk-taking. In our market though the Fed has orchestrated a bail out of BS.

The Fed was tricky in how it structured this bailout so that the word "bailout" couldn't be used. Essentially, the Fed went to JP Morgan Chase (JPM) and asked, ever so nicely, if they would be willing to access the discount window in order to provide BS with the needed liquidity. Normally, JPM would have said "no way" but the Fed counter-guaranteed the loans using BS assets as collateral and JPM said "ok". Thus creating the bailout.

On Monday, BS will likely no longer exist (probably gobbled up by another major investment bank) and the Fed will have orchestrated the bailout of one of Wall Street's biggest investment banks. The arguments defending this that will emerge in the next week or so will involve what's called 'counter-party risk'. The counter-party risk argument will say that if the Fed had not acted BS obligations would have further crunched liquidity and possibly resulted in the failure of other financial institutions. Its interesting to note that the Fed has allowed other major banks to go out of business and this counter-party risk never caused the failure of our financial system (See Drexel Burnham Lambert).

The free market argument is simple. Risk-taker should be rewarded when they do well and punished when they don't. If the Federal Government intervenes in markets as a consequence of these excesses it encourages banks to repeat the process since it is recognized the government will likely intervene.

This bailout completes the triumvirate of intervention. First, Treasury twisted arms for banks to renegotiate mortgage loan terms for borrowers, second, the Fed pumped up liquidity to prevent bank failures and finally the Fed directly intervened to prevent a specific failure.

Unfortunately, the script is not finished yet. It is likely that Congress will also have its say and further distort the market for mortgage loans. The long term economic consequences of the response to this crisis will likely cause further pain down the road. Fortunately for the people running our government they likely will be long gone before these new effects will be felt. Unfortunately for you and me, will likely be the ones to feel the pain.