I’ve been trying to make sense of what the Federal Reserve has been doing with Bear Stearns. My usual source for smart thinking about financial issues, Kip Esquire, is so far silent, so I’m trying to figure this out myself. It’s not going well.
The argument against government bailouts of private businesses is that it’s a bad idea for the government (even in the form of the Federal Reserve) to rescue a corporation that’s in trouble. It sets a bad precedent, creating what economists refer to as a moral hazard.
A lot of big financial institutions are thought to be “too big to fail,” meaning that their failure would have such severe repercussions that the federal government would have to step in to save them. This insulates the institution’s investors from the inherent risk of investing, encouraging them to invest more money in riskier ventures than would normally be wise. This leads to more failures and more government help.
My usual prescription for this problem is some tough love: The government and the Fed should let Bear Stearns bleed to death as a lesson for others. If this sets off the expected chain reaction of bank failures, it will be bad for the economy, but it might be worth it to discourage future risky behavior by investment banks.
As I learn more about the Bear Stearns bailout, however, I’m beginning to doubt my gut reaction because Bear Stearns isn’t really being bailed out in the usual sense. Instead, it’s being sold to J.P. Morgan Chase at a huge discount. It had a market value on Friday of $3.5 billion, but J.P. Morgan is only paying about $240 million. In other words, the owners of Bear Stearns lost 93% of their investment. (That’s just the loss over the weekend. If you look back a couple of weeks, the loss rises to 99%.) That ought to be enough to discourage future investment in absurdly risky assets.
On the other hand, it looks like the Fed will be securing their loan to J.P. Morgan by essentially taking over some of Bear Stearns’ portfolio. Since that porfolio consists of mortgage-backed securities, does this mean that the Fed will be holding the mortgages on people’s homes? Does this mean that the Fed will be in a position to foreclose on people’s homes? Do you think those people will be screaming to their congressmen about this?
I guess what it comes down to is that I’m suspicious of the Fed’s involvement, but I don’t quite know how to think about it.