Bear Run

Why the Fed had to bail out Bear Stearns.

Bear Stearns offices in New York City

It took only a week. Last Monday, when rumors began to circulate that Bear Stearns was having liquidity problems, Bear Executive Committee Chairman Ace Greenberg and CEO Alan Schwartz assured investors that the rumors were, in Greenberg’s words, “ridiculous,” that the storied brokerage house had a strong balance sheet, and that its liquidity situation was fine. Schwartz maintained as much through Wednesday, despite mounting concerns and downgrades by analysts, pointing out that Bear had $17 billion on its balance sheet. Between Wednesday and Friday morning, full-fledged panic ensued, and Bear’s counterparties—its clients and lenders—began withdrawing their cash from the firm, a textbook run on the bank, creating a liquidity crisis where there had arguably been none.

Now Bear is being bailed out by the Fed via JPMorgan Chase, which is buying the troubled firm for $2 a share. And as one might expect, the finger-pointing and recriminations have already begun. Bear Chairman Jimmy Cayne was at a bridge tournament in Detroit while the Fed was arranging the bailout package, which didn’t help the perception that management wasn’t paying enough attention to looming catastrophes. The Fed itself is dodging criticism from people who worry that its willingness to play lender of last resort to the embattled brokerage will cause similar institutions to expect that their worst mistakes can be fixed with a Fed bailout.

These are not irrelevant concerns, but regardless of whether Jimmy was playing bridge while Bear burned or whether the Fed is going to find itself perpetually crowbarring financial institutions out of the corners into which they’ve wedged themselves, this week’s bailout was the least disastrous possible outcome. If Bear had been left alone to collapse under the weight of its own problems, the broader effects would have been devastating (or, considering today’s carnage, more devastating).

The alternative would have been to let Bear slide into a Chapter 11 bankruptcy, which would have happened quickly. Among other things, Moody’s, S&P, and Fitch all downgraded Bear on Friday, potentially forcing the firm to put up additional collateral to meet the requirements of a credit-default swap triggered by the downgrades—collateral it didn’t have. Bear notionally holds $13 trillion in derivatives contracts, and even if credit-default swaps were only a small fraction of that, any sort of credit event would have been catastrophic for both Bear and its buyers, the latter of whom would find themselves holding guarantees from a firm that was not in a position to guarantee anything.

Bear’s client assets would also have been frozen in the event of a bankruptcy, crippling not just the brokerage but many of the hedge funds that have collateral at the firm. (Fear of this happening is part of reason that the run on the bank—or run on the brokerage, rather—happened in the first place.) Taxpayers would have ended up footing the bill for assets that were federally insured, effectively a different kind of bailout.

And the psychological repercussions of a Bear bankruptcy would have been even more devastating than the financial ones. Bear Stearns may not technically be a bank, but it’s a market leader in prime brokerage and clearing, which means that it’s providing trading and back-end services to many other Wall Street financial institutions. Over time, the smaller players in these areas would pick up Bear’s business, but the firm occupies enough of the market that the vacuum it left wouldn’t be filled quickly or easily. In what has been an era of mega-mergers in the financial-services sector, it’s inconceivable that any single large player could disappear overnight without sending ripples—or, more accurately, small tsunamis—through the entire industry, particularly when confidence levels are so shaky.

Even with the bailout, we’re seeing a shadow of the disaster that might have been. Asian markets were down this morning, despite the calming of last week’s worst-case fears that a Bear collapse would wreak havoc on the yen trading. And perhaps most tellingly, Lehman Brothers, which has a somewhat similar profile to that of Bear, was down about 20 percent in trading Monday on fears that its clients may do the same thing Bear’s did, leaving it in a similar position. Lehman Brothers’ pre-emptive acquisition of a $2 billion break-glass-in-case-of-emergency credit line does not seem to have reduced the market’s fearful comparisons.

Panic spreads quickly, and it’s not hard to imagine a scenario in which clients get uncomfortable with minor exposure to credit markets and run for their lives simply because their brokerage house looks vaguely like Bear. Unfortunately, it’s not clear that the Fed can handle many more bailouts of this size.