The Bear Stearns Bailout Didn't Avert the Financial Crisis, It Caused the Crisis

By Peter Wallison.

"Almost exactly ten years ago, the federal government rescued Bear Stearns, a large Wall Street investment bank that was sinking under the weight of its subprime mortgage holdings. A recent article in the Wall Street Journal suggested that the Bear rescue turned out to be only a temporary measure and did not prevent the financial crisis that occurred six months later. But rather than an unsuccessful effort to avert a crisis, the Bear Stearns bailout was actually a principal cause of the disastrous panic that hit the markets six months later.

To many on Wall Street and elsewhere in 2008, the rescue of Bear established a policy that the government was going to rescue all the large financial institutions.  Otherwise, the bailout made no logical sense.

Bear was the smallest of the five large Wall Street investment banks, a group that also included Goldman Sachs, Morgan Stanley, Merrill Lynch, and Lehman Brothers. Lehman, the next smallest, was 50% larger than Bear. It was reasonable to believe that if the government was going to rescue the smallest of these firms, it would certainly rescue those that were larger.

So the immediate result of the Bear rescue was moral hazard—a change in the psychology and actions in the market based on an assumption about government policies. This had several effects that ultimately led to the financial crisis.

Normally, during financially troubled times, the managements of financial companies would seek to reassure creditors by shoring up the firm’s equity position. This, however, did not seem necessary after the Bear rescue. If the government was going to bail out all creditors—as it did in the case of Bear—the creditors of even larger firms would now see no reason to run. If the worst happened, they too would be bailed out.

This analysis fit well with management’s interests. The stock market had fallen by almost 50% as the number of mortgage failures multiplied in 2007 and 2008, so managements had little appetite for diluting their shareholders by selling additional equity. The smart course seemed to be riding out the storm by becoming as liquid as possible, without issuing large numbers of new shares.

Accordingly, after the rescue of Bear, the financial market settled down, even as conditions in the mortgage market grew worse.

On September 7, the Treasury Department declared that the two massive government-backed mortgage companies—Fannie Mae and Freddie Mac—were insolvent, and placed them in a government conservatorship in which they remain today.

This shocked investors. Fannie and Freddie had always been known for buying only prime mortgages. If they were insolvent, investors reasoned, the mortgage crisis was not solely a problem of subprime loans.  Very few understood at the time that both companies—in complying with a regulatory system known as the affordable housing goals—had acquired more than $1.5 trillion in subprime and other risky mortgages.

The insolvency of Fannie and Freddie re-ignited fear in the financial markets. During the succeeding week, Lehman Brothers, the other investment bank—in addition to Bear Stearns—most heavily invested in mortgages, could not raise new financing to replace short term funds that were not being rolled over.

The moral hazard created by the Bear rescue now had its disastrous effect. As Lehman slid toward bankruptcy during the following week, the Treasury and Fed did nothing. In later accounts, both Fed chair Bernanke and New York Fed President Tim Geithner, said that Treasury Secretary Paulson had told them he was being called “Mr. Bailout” and would not rescue Lehman.

When the Treasury and the Fed—seemingly for no reason—failed to rescue Lehman, requiring it to file for bankruptcy on September 15, investors panicked. Not expecting a major failure, and now uncertain whether any investment was safe, they wanted cash or government securities. Liquidity for private firms—even those previously thought to be financially strong—dried up, putting many of them in jeopardy of failing. It was now clear that once the government had rescued Bear Stearns, it was a massive mistake not to rescue Lehman. The question, then, was whether the Treasury and Fed should have rescued Bear in the first place.

Some might contend that if Bear had been allowed to fail, the same panic would have occurred in March instead of the following September. Although we’ll never know for sure, this seems unlikely. Bear was a much smaller firm than Lehman, and had been on its way to failure for several months; no one would have been shocked when it went under. In addition, no large nonbank firm had ever before been rescued with a government bailout, so the market had no expectation that Bear would be rescued. Finally, even though Lehman’s collapse was a complete surprise, and fell on an unprepared market, no other large firms failed because of interconnections with Lehman. So the fear that the failure of one large firm would drag down others—the reason that Bear had been rescued—was wrong.

In other words, if Bear had been allowed to fail, there would have been losses, but not the panic that followed Lehman’s unexpected collapse; other firms, even Lehman, would at that point have rushed to shore up their equity positions. Under these circumstances, it is likely that the 2008 financial crisis would never have occurred."