WASHINGTON - Banking experts said they feared that yesterday's unprecedented Federal Reserve intervention to rescue Bear Stearns Cos. augurs more government bailouts as the crisis worsens.
The Fed's action was intended to ease fallout from the severe credit crunch that has gripped the country since last summer. But the step quickly reignited debate about how big a role the central bank should play.
Several banking experts were dubious about the Fed's plan to save Bear Stearns, saying it sets a bad precedent when other investment banks could wind up in similar trouble due to bad mortgage-linked investments.
"There's a limit to how many of these entities they can bail out," said Franklin Allen, a finance professor at the Wharton School.
The arrangement announced yesterday allows JPMorgan Chase & Co. to borrow from the Fed and provide that funding to Bear Stearns for 28 days. As a commercial bank, JPMorgan can borrow from the Fed, while Bear Stearns, an investment bank, cannot.
Fed officials said the procedure dates to the Great Depression of the 1930s but has rarely been used since that time.
"It is the first bailout of an investment bank by the Fed," said Charles Geisst, a Wall Street historian and finance professor at Manhattan College. By contrast, investment bank Drexel Burnham Lambert Inc. was allowed to fall into bankruptcy in 1990.
Before yesterday's action, the most significant similar move in recent history was the Fed's orchestration of a $3.6 billion bailout by Wall Street banks of collapsed hedge fund Long-Term Capital Management amid the Asian financial crisis in 1998. The step then was widely viewed as an appropriate response to a failure that threatened to reverberate through the global financial system.
If the Fed bailout of Bear Stearns fails, taxpayers would wind up being on the hook, said Lawrence White, an economics professor at New York University's Stern School of Business.
"I know things are a little dicey out there, but we can't have the Fed going around protecting everybody in sight," White said. "You take risks and you lose, you're supposed to be shown the door, and these guys are not being shown the door."
Federal Reserve officials likely were worried about a domino effect if Bear Stearns were to fall into bankruptcy, leaving other companies that have lent money to the investment bank in the lurch. That could cause a chain reaction, potentially threatening the financial system.
Indeed, fears have grown that other financial firms could be at risk. "It's the cockroach theory: There's never [just] one," said Joan McCullough, an analyst with East Shore Partners Inc. in New York.
The Securities and Exchange Commission has been monitoring Bear Stearns since last year, when two of the firm's hedge funds collapsed as a result of bad bets on the mortgage market.
R. Christopher Whalen, managing director of consulting firm Institutional Risk Analytics and a former Bear Stearns banker, said his ex-employer was exposed to two lines of business - mortgage-linked investments and hedge funds - that have been socked since last summer.
Compared with other investment banks, he said, "they're small and they don't have very great diversity in terms of their business."
Duncan Hennes, cofounder of investment firm Atrevida Partners, who chaired the group of banks that bailed out Long-Term Capital Management, said the Bear Stearns episode had elements of a "run on the bank."
"It's liquidity that takes a firm down," he said. Liquidity refers to a company's available cash.
Joseph Mason, a finance professor at Drexel University, had little sympathy for Bear Stearns' problems.
"Once an institution is insolvent, the only responsible thing to do is to unwind it in an orderly fashion," Mason said. "It's not a business enterprise worth saving."
As the mortgage and credit crises have deepened, murmurs of government intervention to back up distressed financial companies have been in the air in recent days. On March 6, shares of mortgage-finance titans Fannie Mae and Freddie Mac fell after the Treasury Department denied rumors that the government would formally back the embattled companies.
While the Treasury isn't obligated to assist Fannie or Freddie in a financial emergency, many on Wall Street believe the government would bail them out if there is a collapse. The idea that they are "too big to fail" enables the two companies to borrow relatively cheaply by issuing top-rated securities backed by mortgages.