Bernanke: Bear Stearns collapse threatened economy

The US government saved Bear Stearns from bankruptcy because a collapse of the investment bank would have reverberated throughout the economy – increasing the risk of lower incomes, lower home values, and unemployment for ordinary Americans.

That was the explanation offered by Federal Reserve Board chairman Ben S. Bernanke and a range of US officials at an April 3 Senate hearing on the decision to help broker the sale of Bear Stearns to JPMorgan Chase in March.

Washington's task now is to strengthen its oversight of the nation's financial system so that the weaknesses of a single firm does not again threaten the whole economy, officials said.

"We need to begin to design a comprehensive set of reforms for the financial system," said Timothy F. Geithner, president of the Federal Reserve Bank of New York.

Bear Stearns' brush with bankruptcy remains one of the most dramatic events in the recent turmoil in financial markets. The nation's fifth-largest investment bank was done in by the credit crunch that has also caused mortgage foreclosures and tight money for businesses throughout the US – indeed, throughout the world.

On Capitol Hill, some legislators have questioned the propriety of the actions of the Federal Reserve and Treasury Department in facilitating the deal between Bear Stearns and JPMorgan. In particular, some Democrats want to know why the Fed agreed to take $30 billion of risky Bear assets off Morgan's hands – and whether a big investment bank was getting the kind of bailout that so far has been denied homeowners facing default on their mortgages.

"Was this a justified rescue to prevent a systemic collapse of financial markets or a $30 billion taxpayer bailout for a Wall Street firm while people on Main Street struggle to pay their mortgages?" asked Sen. Christopher Dodd (D) of Connecticut, chairman of the Senate Committee on Banking, Housing, and Urban Affairs, in his opening statement at the hearing.

Mr. Bernanke and other officials defended their actions as necessary to protect the economy as a whole, not specifically Bear Stearns.

The financial markets have hardly been rolling in good times recently, Bernanke pointed out. Short-term bank funding has been curtailed, particularly for highly leveraged investors. Write-downs and losses at some big financial institutions have reduced the overall pool of available capital.

The Federal Reserve in March had cut the federal funds rate to 2-¼ percent in an attempt to jump-start financial markets.

"Normally, the market sorts out which companies survive and which fail.... However, the issues raised here extended well beyond the fate of one company," Bernanke told the Senate banking panel.

The parties involved in the financial transactions brokered in the Bear Stearns case could have seen their investments at risk. A Bear Stearns bankruptcy would have involved the unwinding of tens of millions of dollars of transactions and investments at a time when the markets were already volatile.

"When our financial system is under stress all Americans bear the consequences," said Robert K. Steel, under secretary of the treasury for domestic finance.

The fateful day was Thursday, March 13, in the account offered by the officials. That day, Bear Stearns' available liquid funds fell from $12.4 billion to $2 billion, as customers pulled out money, and other financial institutions refused to provide short-term loans.

"No financial institution can withstand the abrupt cliff of people unwilling to fund it," said Mr. Geithner of the New York Fed.

It was then that the government stepped in. JPMorgan said that the government needed to absorb $30 billion of risky assets or the deal would not go through, said US officials. The Fed and the Treasury did not set the terms of the deal – initially $2 a share and later increased to $10. But they made clear the price had to be low, so that it would be less easy to characterize it as a bailout.

"Bear Stearns did not fare very well in this operation. Its shareholders took very severe losses," said Bernanke.

Going forward, Congress and US regulators need to figure out how to make the system less vulnerable in the future, said officials.

Among other things, Washington needs to ensure that there is a "stronger set of shock absorbers" in terms of capital and liquidity for private financial institutions whose operations are critical to US economic health, said Geithner.

In turn, these institutions should be subject to stronger and more consolidated supervision, according to the New York Fed chief.

Senator Dodd said that the Senate Banking panel is planning a series of hearings on the issue but that reform won't come quickly.