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Bear on the Run
Investment Banks Could Become More Appealing
A classic bank run caused Bear Stearns’ mid-March fall. Here’s how a run works: Imagine that a small-town bank collects $30 million in deposits, then lends $25 million of it to homeowners.
Each depositor has the right to withdraw his or her funds immediately. But if everybody were to simultaneously demand their money, the bank wouldn’t be able to pay them because it has only $5 million in cash. The bank calculates that this scenario is highly unlikely — but that even if this were to happen, it could use the loans it made to homeowners as collateral to borrow $25 million from other banks and thus have enough cash to cover all withdrawals.
But now imagine that the bank’s homeowner-loan portfolio starts to look financially shaky, and depositors suspect that many of these loans will never be repaid. Afraid that they might lose their money, some quickly line up at the tellers’ windows. Others begin to fear for the bank’s solvency after seeing the queues.
So our troubled bank must now raise an extra $25 million to pay back all depositors. But other banks are highly unlikely to lend it money, since they won’t take the questionable $25 million portfolio as collateral for an interbank loan.
Fortunately, this scenario could never happen in the United States because the federal government effectively insures all bank deposits. So depositors know their money is safe even in insolvent banks, and the banks themselves avoid becoming victims of panicky bank runs.
But the government doesn’t normally insure investment banks such as Bear Stearns, so in March this once-esteemed bank was at risk of a bank run. Hedge funds had billions deposited at Bear Stearns. When Bear’s subprime-mortgage portfolio fell too much in value, these hedge funds quickly sought to withdraw their money, but no other bank would lend Bear the money it needed to cover all withdrawals. Consequently, Bear experienced a run that pushed the company to the brink of bankruptcy.
Then the Federal Reserve Board stepped in. It got JPMorgan Chase to agree to buy Bear Stearns in return for the Fed guaranteeing $30 billion of Bear’s assets.
Why did the Fed take such a risk to save a mere investment bank? Bear had its paws in trillions of dollars of trades and transactions, so if the firm went down, the liquidity of these assets would have been compromised, as there would have been confusion over who owned what and how much they’d be entitled to reclaim. The entire financial system would have been damaged, because formerly liquid assets would no longer have been easily tradable.
The Fed’s actions in preventing Bear from going under will likely cause other investment banks to take on more risk. To visualize, imagine that you’re in Las Vegas and discover that the government will bail you out if you lose everything while gambling. You might rationally take much greater risks. And casinos will eagerly lend you large sums because they know the government will cover any losses you can’t. The Fed’s Bear bailout, analogously, will make hedge funds less cautious about letting large investment banks hold their money. All of this will help investment banks and make them more attractive investments for shareholders.
A final note: Many Bear employees invested heavily in their firm’s stock. When the bank tanked, many lost both their job and savings. Only the financially reckless risk their nest egg by putting it in their employer’s stock.
James D. Miller is an associate professor of economics at Smith College in Northampton, Mass. His latest book is Singularity Rising: Surviving and Thriving in a Smarter, Richer and More Dangerous World (BenBella Books), on sale in October.