Bear Stearns: The Fed's Original 'Systemic Risk' Sin

One year ago today, the Federal Reserve saved Bear Stearns from bankruptcy. The central bank's agreement to invest $30 billion (later reduced to $29 billion) in Bear's opaque securities greased a sale of the firm to J.P. Morgan Chase. For the first time since the 1930s, the federal government was putting taxpayers at risk to rescue a Wall Street investment bank. To this day, the government has not explained precisely why.

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Until 2008, diversification of risk was considered a good thing. If pain was to be shared among a thousand broker-dealers and hedge funds that chose to do business with Bear, that sounds like a system working as it should, not one at risk. Hedge funds are particularly well suited to suffer the consequences of their decisions. Under SEC rules, such funds are only available to institutions and affluent individuals, who are better able to bear losses than the average taxpayer. Moreover, sophisticated hedge-fund investors understand that they may not enjoy the state and federal legal protections available to those who stay in mutual funds. Yet those who invested in Bear counterparties received a protection they might not have imagined before the events of last March.

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One could argue that the Bear bailout not only didn't prevent the failure of Lehman and AIG six months later, but it may have contributed to the autumn meltdown. If nature had been allowed to take its course, Bear's directors and executives would have faced the liability tsunami of bankruptcy, and creditors would likely have suffered as well. Watching this horror show, would the leadership at AIG and Lehman have spent more of the next six months seeking to avoid this fate?

Bear stockholders ended up receiving $10 for each of their shares. Responding rationally to this government intervention, and knowing that their firms were each significantly larger than Bear, executives at AIG and Lehman might have believed that the feds had just built a floor under them.

Come the reckoning in September, Lehman CEO Richard Fuld was stunned to discover that Washington was willing to see his firm go bankrupt...

As for AIG, when the New York Fed was preparing to rescue the firm, CEO Robert Willumstad was reportedly surprised to learn that he wouldn't be running the company anymore.