Confidence Game

Bear Stearns becomes the latest financial institution deemed by the government as too big to fail. It clearly won't be the last. From the Washington Post:

J.P. Morgan was unwilling to assume the risk of many of Bear Stearns's mortgage and other complicated assets, so the Federal Reserve agreed to take on the risk of about $30 billion worth of those investments. […]

Bear Stearns, in particular, was confronting a run on the bank as investors were too fearful of the future to make even overnight loans to the nation's fifth-largest investment firm. If it had been allowed to fail, senior officials believed, it would have created a cascading crisis of confidence that could well have brought down several other leading firms and dragged world markets with them.

Policymakers weighed that risk against the risk that their actions would create "moral hazard," or greater willingness of companies to take inappropriate chances.

Hard to believe that "moral hazard" is a serious concern, given that the Fed has now—for the first time in history—wrapped its security blanket around investment banks:

Since the central bank was created in 1913, it has served as a lender of last resort for ordinary banks, allowing them to post high-quality loans at a "discount window" in exchange for cash.

Last night, it announced a new provision that will in effect do the same for major investment firms. Starting today, and lasting for at least six months, this new operation will allow "primary dealers," which are 20 major Wall Street firms, access to cash in exchange for assets in which the market is not currently functioning.

Sure is a bad time to have your savings in dollars!

In November 2006, Brian Doherty asked a bunch of economist types: Can we bank on the Federal Reserve?