Willem Buiter explains today why he thinks the Bear bailout was unwarranted. I apologise for quoting at some length, but believe me, it’s a lot shorter than the 2,150-word blog entry:
While the Fed, like any public institution, should support institutions and arrangements with public goods properties, like markets, it should not as a rule support private businesses, even when these private businesses are misleadingly called financial institutions. The Fed should support individual businesses only if failing to do so threatens serious negative externalities. In the financial field these externalities often are through contagion effects, as in the case of the classical bank run by depositors…
Deposit-taking institutions are deemed to fall into this category because they are an important part of the retail payment mechanism. Other institutions are deemed too systemically important to fail because they play a key role in the wholesale payments, clearing and settlement system.
Finally, some institutions are provided with liquidity on non-market terms or bailed out when they are insolvent because it is feared that their failure would trigger a chain-reaction of contagion effects. Fear and panic would spread through the markets and first illiquidity and then insolvency would threaten institutions that would have remained both solvent and liquid but for the failure of this ‘focal institution’.
How does Bear Stearns line up according to these three criteria for special Fed attention? Bear is not a deposit-taking institution. It plays no role in the retail payment mechanism and is of no significance to the proper functioning of the wholesale payments, clearing and settlement system…
Since Bear Stearns is not a deposit-taking institution, and appears to be of no other systemic significance, there is no need for a special resolution regime of the kind managed by the FDIC for troubled deposit-taking institutions. The firm could have been left to go into receivership.
If the Fed fears the risk of contagion effects and financial panic, it could have requested the nationalisation of the investment bank. This should have been done at a zero price. The existing shareholders could, if the US government were feeling generous, be granted the privilige of claim on whatever value is left after all other creditors have been paid off.
While I have a certain amount of sympathy for this tough-love approach to the banking system, in the end I’m quite glad that Ben Bernanke and Tim Geither, softies that they are, went down the route that they did. Not because I think Bear’s shareholders deserve their $30 per share or whatever they’re going to end up receiving, but rather because of the sheer amount of wealth that could have been wiped off the stock and bond markets as a result.
It turns out, you see, that every mom-and-pop stock-market investor is actually, and rather unwittingly, taking investment-bank default risk. Which is why it’s nice to have a Fed on the lookout for them. So far, retail stock-market investors haven’t panicked; let’s try and keep it that way, shall we?