The Federal Reserve may have caused Bear Stearns to fail, said NJIT School of Management professor Michael Ehrlich. Based on Ehrlich’s academic research and experience working on Wall Street, he suggested that the Federal Reserve Board’s announcement of a $200 billion fund for financing securities from investment banks may have been perceived as a signal by market participants of a problem within the investment banking community.
The Federal Reserve’s announcement of an investment bank rescue fund surprised the market. Market participants began asking if the Fed knew something that they did not. If one of the investment banks was in trouble, which was it? The whispering campaign against Bear Stearns started because it was the smallest of the major investment banks and was the one most closely associated with the mortgage market.
"Once people started withdrawing funds from Bear Stearns, the concerns about a run-on-the-bank became self fulfilling," says Ehrlich. In the best case, Bear Stearns might have utilized the new funds to forestall a panic leading to liquidity crisis. Unfortunately, that was not possible and the unintended consequence was that Bear was forced into a sale to JPMorgan.
Ehrlich, whose specialty is market failure, is available to discuss domestic and emerging securities markets and institutions. For further information, email Ehrlich@adm.njit.edu or telephone (973-596-5305, office) or (516-330-5810, cell).
The Federal Reserve has established an important new standard. It is clear that the Fed wanted to stop any financial contagion. By allowing Bear Stearns clients and counterparts to continue with business as usual and forcing Bear Stearns equity holders (30% were employees) to bear the costs, the Fed has saved the markets but ruined the shareholders. A rescue of this type does not encourage moral hazard since the management of Bear bore the heaviest losses. Reportedly ex CEO Cayne lost over $1 billion over the last year.
“Like a firefighter battling a forest blaze, the Fed needed to establish a “fire break” to contain the damage to the financial system. In this case, Bear Stearns was probably just collateral damage,” notes Ehrlich.
Ehrlich was a government arbitrage trader at Salomon Brothers and senior managing director for fixed income emerging markets at Bear Stearns before joining NJIT. He received his bachelor's degree from Yale University and PhD from Princeton University.
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