Bear Stearns rescued; Fed's role stirs debate

WASHINGTON — The Federal Reserve's unprecedented intervention on behalf of investment bank Bear Stearns was intended to ease fallout from the credit crunch, but experts fear it augurs more government bailouts as the crisis worsens.

Friday's rescue came from JPMorgan Chase and the Fed, which rushed to pump new money into the venerable Wall Street firm after its financial state deteriorated so much in a 24-hour period that it threatened to fail. Bear Stearns stock lost nearly half its market value, about $5.7 billion, in a matter of minutes, and pulled the stock market down with it.

The rescue also reignited debate on Friday 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 at a time 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 University of Pennsylvania's Wharton School.

Word of the bailout reverberated through Wall Street, sending the Dow Jones industrial average careening more than 300 points before recovering to close down 194.65 to 11,951.09. The Standard & Poor's 500 index fell 2 percent on Friday, and the Nasdaq composite index fell 2.3. Bear Stearns shares fell $27, or 47 percent, to $30.

Comments from the Fed might have helped corral some of investors' nervousness Friday. The central bank said it voted unanimously to sign off on the arrangement between JPMorgan Chase and Bear Stearns and that it is ready to provide resources to stave off further credit troubles.

Fed Chairman Ben Bernanke also said Friday he would do what was possible to aid struggling homeowners. President Bush, seeking to calm investors, said Friday that policymakers will take "appropriate steps" to stabilize the financial system after the bailout was announced.

But investors remained pragmatic.

"This is another chapter in a book rather than a one-act play," said Phil Orlando, chief equity-market strategist at Federated Investors. He said the stock market is worried that further trouble in the credit markets will emerge and that the ramifications of the credit strains and a slowing economy could result in recession.

Friday's arrangement allows JPMorgan Chase to borrow from the Fed and provide that funding to Bear Stearns for 28 days. As a commercial bank, JPMorgan can do so, while Bear Stearns, an investment bank, cannot.

Fed officials said the procedure used dates back to the Great Depression of the 1930s but has rarely been used since that time, and experts said they believed the action was unprecedented for an investment bank.

"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 was allowed to fall into bankruptcy in 1990.

Before Friday'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. That action was widely viewed as an appropriate response to a failure that threatened to reverberate through the global financial system.

If the Fed bailout 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."

Fed officials likely were worried about a domino effect if Bear Stearns were to fall into bankruptcy, leaving other companies who 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.

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 former employer was exposed to two lines of business — mortgage-linked investments and hedge funds — that have been socked since last summer.

Compared to other investment banks, he said, "they're small and they don't have very great diversity in terms of their business."

Duncan Hennes, co-founder 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.

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.

Associated Press business reporter Tim Paradis contributed to this story.