Bernanke: Bear Stearns collapse threatened economy

At a congressional hearing Thursday, the Fed chairman defended the rescue of the investment bank.

posted April 3, 2008 at 5:10 p.m. EST

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The financial markets have hardly been rolling in good times recently, Bernanke pointed out. Short-term bank funding has been curtailed, particularly for highly leveraged investors. Write-downs and losses at some big financial institutions have reduced the overall pool of available capital.

The Federal Reserve in March had cut the federal funds rate to 2-¼ percent in an attempt to jump-start financial markets.

"Normally, the market sorts out which companies survive and which fail.... However, the issues raised here extended well beyond the fate of one company," Bernanke told the Senate banking panel.

The parties involved in the financial transactions brokered in the Bear Stearns case could have seen their investments at risk. A Bear Stearns bankruptcy would have involved the unwinding of tens of millions of dollars of transactions and investments at a time when the markets were already volatile.

"When our financial system is under stress all Americans bear the consequences," said Robert K. Steel, under secretary of the treasury for domestic finance.

The fateful day was Thursday, March 13, in the account offered by the officials. That day, Bear Stearns' available liquid funds fell from $12.4 billion to $2 billion, as customers pulled out money, and other financial institutions refused to provide short-term loans.

"No financial institution can withstand the abrupt cliff of people unwilling to fund it," said Mr. Geithner of the New York Fed.

It was then that the government stepped in. JPMorgan said that the government needed to absorb $30 billion of risky assets or the deal would not go through, said US officials. The Fed and the Treasury did not set the terms of the deal – initially $2 a share and later increased to $10. But they made clear the price had to be low, so that it would be less easy to characterize it as a bailout.

"Bear Stearns did not fare very well in this operation. Its shareholders took very severe losses," said Bernanke.

Going forward, Congress and US regulators need to figure out how to make the system less vulnerable in the future, said officials.

Among other things, Washington needs to ensure that there is a "stronger set of shock absorbers" in terms of capital and liquidity for private financial institutions whose operations are critical to US economic health, said Geithner.

In turn, these institutions should be subject to stronger and more consolidated supervision, according to the New York Fed chief.

Senator Dodd said that the Senate Banking panel is planning a series of hearings on the issue but that reform won't come quickly.

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