07/17/2008 05:12 am ET Updated May 25, 2011

Ben Bernanke: Socialist

Yesterday, Ben Bernanke gave a speech about financial regulation. In the speech he discussed what happened with Bear Stearns. It is an interesting explanation.

As you are aware, one of the key events in financial markets in recent months was the near-bankruptcy in March of the investment bank Bear Stearns. The collapse of Bear Stearns was triggered by a run of its creditors and customers, analogous to the run of depositors on a commercial bank. This run was surprising, however, in that Bear Stearns's borrowings were largely secured--that is, its lenders held collateral to ensure repayment even if the company itself failed. However, the illiquidity of markets in mid-March was so severe that creditors lost confidence that they could recoup their loans by selling the collateral. Hence, they refused to renew their loans and demanded repayment.

This is a really interesting situation and it explains a great deal about the problems in the credit markets. Even though the lenders had collateral in their hands they were unsure they could actually sell the collateral. Bernanke makes no mention of what type of collateral the lenders had. However, I seriously doubt lenders took highly exotic paper to secure a loan. Assuming that to be a fair reading of the situation, we know the credit markets were literally frozen solid.

Bear Stearns's contingency planning had not envisioned a sudden loss of access to secured funding, so it did not have adequate liquidity to meet those demands for repayment. If a sale of the firm could not have been arranged, it would have filed for bankruptcy. Our analyses persuaded us and our colleagues at the Securities and Exchange Commission (SEC) and the Treasury that allowing Bear Stearns to fail so abruptly at a time when the financial markets were already under considerable stress would likely have had extremely adverse implications for the financial system and for the broader economy. In particular, Bear Stearns' failure under those circumstances would have seriously disrupted certain key secured funding markets and derivatives markets and possibly would have led to runs on other financial firms. To protect the financial system and the economy, the Federal Reserve facilitated the acquisition of Bear Stearns by the commercial bank JPMorgan Chase.

Short version: If Bear Stearns went under we were in deep shit. Fair enough -- and I think a fairly accurate statement about what would have happened if they had gone under. HOWEVER, we now get into a really interesting policy debate. Earlier in the speech, Bernanke made the following observation:

As you know, those poor lending practices have contributed to a sharp increase in mortgage delinquencies and foreclosures. The resulting costs have been felt not only by borrowers but also by entire communities, as foreclosure clusters have caused neighborhoods to deteriorate and reduced municipal tax bases. The decline in the national housing market, which has been a major cause of the broader slowdown in economic activity, was in turn greatly exacerbated by the collapse of subprime lending.

So -- poor lending standards have led to the collapse of communities and harder times for cities. Shouldn't they be getting some help too? Aren't they too big to fail as well? This is the problem with bailing out Bear Stearns and the accompanying moral hazard. You get into these kinds of debates about who is too important or too big to fail and there is never a clear answer. However, I can tell you what this situation looks like: Wall Street firm makes many bad loans and gets bailed out despite their stupidity.

The PDCF and the TSLF were created under the Federal Reserve's emergency lending powers, with the term of the PDCF set for a period of at least six months, through mid-September. The Federal Reserve is strongly committed to supporting the stability and improved functioning of the financial system. We are currently monitoring developments in financial markets closely and considering several options, including extending the duration of our facilities for primary dealers beyond year-end, should the current unusual and exigent circumstances continue to prevail in dealer funding markets. At the same time, we are taking measures that will serve over time to strengthen the primary dealers, other financial institutions, and the overall financial system. As I will discuss, these measures include working with the SEC and the primary dealers to increase the firms' capital and liquidity buffers and cooperating with other regulators and the private sector to help make the financial infrastructure more resilient.

So, Ben, what is the exact definition of "unusual and exigent circumstances"? When exactly are these over and who decides? Again -- we are now getting into a really gray area for which there is no answer. But, again, I can tell you what this looks like: Privatize the profits and socialize the losses.