Too Dumb To Fail.(The Talk of the Town)(Bear Stearns)

In 1984, Continental Illinois, then one of the country's largest banks, found itself on the verge of collapse, after billions of dollars' worth of its loans went bad. To avert a crisis, the government stepped in, purchasing $3.5 billion of the soured loans and effectively taking over the bank. Later that year, at a congressional subcommittee hearing, Representative Stewart McKinney summed up the lesson of the rescue effort: "Let us not bandy words. We have a new kind of bank. It is called too big to fail. T.B.T.F., and it is a wonderful bank."

Since then, T.B.T.F. has become a generally accepted, if unwritten, rule in the financial world. Two weeks ago, though, it was given a new twist when the Federal Reserve acted to save the investment bank Bear Stearns, orchestrating the company's sale to J. P. Morgan Chase by providing Morgan with up to thirty billion dollars in financing to cover Bear Stearns's portfolio of risky assets. Previously, the government had intervened to protect only commercial banks--which take deposits and issue traditional loans, and which are heavily regulated. (Another first: the Fed is now allowing investment banks to borrow from it directly.) The Bear Stearns deal means that the T.B.T.F. rule now applies to investment banks as well. Suddenly, the federal government is committed to saving a whole lot more companies than it was a couple of weeks ago.

Rescuing failing companies obviously runs the risk of creating moral hazard--if we insulate people from the consequences of their irresponsibility, they're more likely to be irresponsible in the future. But the Fed did a good job of lessening that risk, making sure that Bear suffered a heavy toll. The sale punished Bear shareholders severely, valuing Bear at just two dollars a share, down from sixty dollars a few days before, while thousands of Bear employees are likely to lose their jobs. That's about as harsh as a bailout gets.

More to the point, the threat of moral hazard in this case was simply less dire than the threat of financial contagion. The Fed could have done what it did in February, 1933, when it stood quietly by while Detroit Bankers Corp. and the Guardian Detroit Union Group, Detroit's two largest banks, foundered after a series of bad loans. But the failure of those two banks quickly led to bank runs in neighboring states--Cleveland's two biggest banks failed soon after--and eventually to a national banking panic. Bear Stearns's collapse, similarly, could easily have provoked market chaos. Bear wasn't among the largest Wall Street banks, but it was a major clearinghouse for stock trades and played a central role in hundreds of billions of dollars of credit deals. If not too big, it was too important to fail.

The Bear deal does mark a major policy shift, since the Fed has now implicitly admitted that it will catch investment banks when they fall. But that ...