The Bear Precedent

If the Federal Reserve hadn't arranged the sale of Bear Stearns and taken over responsibility for its most questionable securities, the company likely would have had only one avenue as it ran out of operating cash late last week: bankruptcy.

That bankruptcy would have been painful, sending new waves of distrust through the financial system and likely forcing Bear's counterparties to book reserves for losses. But even in a world of bad choices, there's always a worst choice. And the Fed, by being so quick to jettison the bankruptcy process, cut off a valuable source of new information to financial markets and blurred the critical distinction between sophisticated and unsophisticated investors.

True, a Bear bankruptcy would be a mess. To get an idea, pull up one of the Enron bankruptcy spreadsheets from six years ago: creditor after creditor listed on page after page, with amounts owed from a few hundred dollars to hundreds of millions each.

A Bear bankruptcy would also have caused shocks through the financial system. Institutional investors would have to rethink whether or not they trust the party on the other side of each of their trades, particularly in the opaque derivatives market. ("Is the company good for the money?") Hedge funds, and other personal and institutional clients, would have to worry about who has actual custody of their accounts.

And so, to avoid those shocks, the Fed has done something unprecedented. It has provided $30 billion in guarantees behind Bear's most complex, illiquid securities, so that the much larger and more secure J.P. Morgan Chase & Co. would be willing to buy the company for $2 a share.

J.P. Morgan's role, from the Fed's perspective, is to soothe Bear's trading counterparties as well as its clients. The Fed hopes the sale will mollify institutional investors and traders—not just with regards to their perceived risk at Bear, but with regards to similar risks at other institutions.

Those are the expected benefits; what are the costs?

For the markets, a bankruptcy would have generated something more valuable than a short-term, soon-to-wear-off boost in confidence. That something is knowledge.

Consider: The whole credit crisis largely reflects a lack of good information. Mortgage originators and underwriters shoved their underlying securities into structures so complicated that investors pretty much took it on faith that they were AAA-rated. These same investors now have to take someone else's word that the securities are worthless. Ratings agencies still don't seem to know what's going on.

A spectacular bankruptcy would shine a bright light on this mess. To start, Bear's trading counterparties and other creditors would have to show themselves and explain their positions to a public examiner. And then bankruptcy lawyers would have to pore through each and every one of Bear's assets and liabilities, making the full autopsy public.

Of course, such a full accounting would take at least a year and likely longer. But we've already endured almost a year of an opaque credit crisis. What if, in another year, we're still in the middle of the crisis with no new real, third-party information to guide us out? The information provided by Bear's bankruptcy would then be invaluable.

But what about actual clients (not trading counterparties or other creditors) with accounts at Bear, including hedge funds that house their own securities there? If the Fed wanted to do something extraordinary to soothe confidence in a bankruptcy, it could have worked to ensure that Bear received, within hours of filing, carefully supervised financing allowing it to do transactions for such clients as they moved their holdings elsewhere in an orderly fashion.

That leaves counterparties on Bear's derivatives and other creditors like Bear's short-term financiers who, unlike account holders, should have known that they were taking on credit risk. Well, creditors are creditors; in a bankruptcy, they line up. What the Fed has done instead for these sophisticated investors is to offer them a rough approximation of FDIC insurance, even though they are not depositors and knew going in to the deals they had no such insurance.

As rumors of Bear's troubles started early last week, counterparties stopped trading with Bear seemingly as quickly and carelessly as they had traded with it before. Now, they've been rewarded for this herd panic: the Fed has stepped in.

If the herd behavior of these supposedly savvy investors had forced Bear into bankruptcy, thus imperiling their own funds, maybe the counterparties of other institutions would learn a lesson: Don't run.

Perhaps we would then see these sophisticated investors pressuring each other not to flee other institutions, like Bear, on the other side of these complex derivatives trades. And perhaps we would see counterparties demand that their trading partners provide better information about their assets and liabilities.

Instead, the message from the Fed is, wittingly or not: it's OK to panic. We'll save you when you do.

In our service-based economy, one of the biggest wealth generators is supposed to be a highly sophisticated, innovative elite of bankers, traders and investors. The Fed's sudden determination that these folks need the same kind of protection from their own behavior as Grandma does is a watershed.

No doubt these newly protected traders and other creditors are happy, at least for now. But they should realize that, along with government protection, could come all kinds of unwelcome new regulations so that the Fed can protect itself.