Too Big To Fail

The New York Fed and JP Morgan have teamed up to keep Bear Stearns from failing.  This is the same Bear Stearns that made Billions repacking subprime mortages.

To understand the subprime mess click here< /a>.

The Fed believed that Bear Stearns (BS) was too big to fail. What does that mean exactly?  Does it mean the equity investors in BS will lose too much money?  Does it mean management at BS took too many risks but did not understand those risks?  Does it mean once companies get to a certain size the government will always give them a free insurance policy at tax payer expense?

If the Fed believed that BS was too big to fail, then they should have let BS go bankrupt and then stepped in to stabilize the business and sell it.  Bailing out the shareholders of the company is just encouraging managers to take too much risk.  I really doubt many of these managers will have to sell their Hamptons home.  If the government is going to create a moral hazard with banks, what is to keep this entire process from repeating itself.  Oh wait, it has repeated.  The same type of thing happened with the S&L crisis over a decade ago.

The current situation is a little different than the S&L crisis.  In fact, it is much bigger and less controllable.  No matter what the government does, it cannot prop up the value of homes.  This is a function of the market.  The government would have to buy all of these homes, at inflated prices, at a tremendous cost to the tax payer.  Again, all this would do is encourage banks and home owners to take more risk than they should and prolong the market correction that homes need to endure.

It is critical that the government allow banks to fail.  Depositors are protected with the FDIC so they will not be hurt.  Instead, investors in the banks will be the ones that take the financial hit.  This is exactly as it should be.  When you buy an equity you take a risk.  You risk losing all of your money should the company fail to create value.  BS has certainly failed to create value and must be allowed to fail.  

It is not like subprime mortgage homes disappear when BS goes under.  They are still sitting exactly where the were before this mess.  The difference now is more people can afford these homes with traditional mortgages with 10-20% down payments and fixed interest rates.

Harry Reid (D-NV) says government needs to act now to head off a melt down.  He could not be more wrong.  The melt down will occur when government gets involved.  It is just a matter of how long it will be.  I prefer my cough medicine in quick doses.  Not drip by drip.