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What Does Bear Stearns Mean for the Future?

Updated on April 8, 2008

What Does Bear Stearns Mean for the Future?

When the investment bank Bear Stearns was bailed out of a collapse by the Federal Reserve’s intervention, a number of observers took careful note of the action. First the background – as an investment bank, Bear Stearns was not in the same category as the high street banks, with which the Feds do have some proven connection. The FDIC, or Federal Deposit Insurance Corporation, is a government agency that insures the deposits of investors for a maximum $100,000 per depositor per institution. This means that if the bank fails, the depositor is covered up to this amount against loss of his savings. This leads to the typical advice that you should open an account at a different bank if you deposit more than $100,000. With a retirement account, the insurance may be up to $250,000.

The FDIC was founded in 1933 as a response to the thousands of bank failures that happened during the Great Depression, stripping innocent members of the public of their life savings. Since then, no depositor has lost any insured funds when their bank failed. The FDIC is funded by premiums that the banks pay, and not directly from the government. It is also responsible for identifying and monitoring risks to the funds, and thus to interact with the banks. The Glass-Steagall Act which established the FDIC also called for separation of commercial and investment banking, which is why an investment bank such as Bear Stearns, is not directly covered by the FDIC.

Some say unfortunately, this Act was repealed in 1999 by the Gramm-Leach-Bliley Act, which allowed banks to offer a range of services including insurance and investment. This blurring of the distinctions between the two types of financial institution means that the Fed is now intervening and providing value to nearly worthless securities.

Not that this was an easy or obvious step. A few years ago, Charles Kindleberger wrote a study about financial mania and crises, in which he asserted the Fed should “always leave it uncertain whether rescue will arrive in time or at all, so as to instil caution in other speculators, banks, cities and countries”. He did however feel that the government should be the ultimate saviour, with this proviso “A lender of last resort should exist, but its presence should be doubted.”

The sub-prime crisis has unfolded, brought on by reckless lending to less than perfect borrowers, who are now proving the validity of their lower ratings by defaulting on their mortgages. This availability of more borrowing power than previously unleashed has been instrumental in fuelling the housing bubble, and pushing house prices up so that houses were thought to be an ever growing equity source. With the inevitable collapse as realism came to the fore, and foreclosures climbed, the continued existence of the government sponsored housing companies Freddie Mac and Fannie Mae has been questioned, and the Feds responded on March 6th, saying that it was “absolutely not true” that the government would offer backing to them to help ensure liquidity through the sub-prime repercussions. In this way, the Feds wanted to make its intervention in doubt.

This was widely regarded as a drastic measure, and sure enough, already there has been an about turn in the Feds actions. Within two weeks from that announcement, the Feds felt that they had to supply up to $200 billion to these agencies, to maintain their liquidity. They also lent $30 billion to JPMorgan to supply the capital for a bailout of Bear Stearns at $2 per share – since increased to about $10, but still very far below the peak price last year of around $160.

So what, I hear you say? While, from one point of view, you may agree with the Fed action, in order to prevent a run on all companies that borrow heavily against securities, you need to understand the other side of the equation. With no legislative authority, the Feds have decided for the first time ever to lend to companies that are not banks, but securities dealers who do not even accept deposits. By accepting the collateral of securities, and underwriting it, the Fed is now committed to the past underwriting decisions of the investment banks. In effect, they, and, by extension, the American public, have taken away the risks of dealing in securities, but left the profits privatised. Employing leverage, which investment banks do at as high a ratio as 30:1, doesn’t now carry any risk, as in the end the Feds will guarantee liquidity.

If the intricacies of high finance and the stock market leave you thirsting for more knowledge, there’s a very good free primer in trading available at .


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