Moments of Truth

The Fed-orchestrated bailout of Bear Stearns was finalized on March 16, 2008, exactly five years after George W. Bush declared a "moment of truth" for the world with respect to the disarmament of Iraq. Interestingly, the Bear episode has also been cast as a sort of "moment of truth" for the global economy.

For instance, the Chicago Tribune reports:

David Jones, chairman of Investors Security Trust in Ft. Myers, Fla., and a former Wall Street economist, said the Fed's interest rate cuts will take a while to work, but added that "we have turned the corner on the potential for a financial meltdown."

Jones said that before the Fed rescue of Bear Stearns Sunday night, he had feared the stock market would plunge as it did at the start of the Great Depression. The Fed's intervention came at the right time, he said, and "it was the moment of truth".

I'm not sure if David Jones ever goes by Davy Jones, but it is ironic, and perhaps somewhat frightening, that the Tribune is going to someone with that name for a sunny view of the future.

A number of economists and market commentators have also pointed to the bailout as a sign that the Fed is willing to do just about anything to save the market, and that investors need not worry: losses will be socialized! Others, like Larry Summers, have pointed to signs of a turnaround in the credit markets following the bailout.

Upon closer inspection, the Bear Stearns moment of truth has a lot in common with the Iraq moment of truth and its aftermath. Let me count the ways:

1. Weapons of mass destruction figure prominently. In this case, they are the credit derivative contracts that Warren Buffet has called financial weapons of mass destruction (in March 2003, no less) because they entail "mega-catastrophic risk." Of course, Bear Stearns definitely had these WMDs, unlike Iraq, though it is impossible to say what damage they would have caused if Bear had gone bankrupt. But now, as then, perhaps the more significant concern is the fact that WMDs are not restricted to one place -- every major investment bank is dangerously exposed to credit risk through these contracts. It is unclear to me how the Fed hopes to contain this problem.

2. Concern for the law does not figure prominently. The Fed is not supposed to act as lender of last resort to investment banks, which take much larger risks than commercial banks, are less regulated, and pay their employees way too much money for being Ivy League-educated and greedy. In other words, this $30 billion loan was an illegal use of taxpayers' money.

3. Just trust us, they say. Transparency is not the Fed's strong point, and this was no exception. Who was whispering in the ears of Ben Bernanke and Henry Paulson in the days prior to the bailout? Which lawyers figured out that this was ok? How do they know that this will avert a catastrophe for the next two years?

4. We don't have many good reasons to trust them. Ben Bernanke and Henry Paulson are probably a bit puzzled right now, because what's happening runs so contrary to the view they've been paid to propagate for so many years (no housing bubble, hedge funds are great, fundamentals are strong, etc.). They probably have no clue what's going on, and they definitely have no clue what's going to happen. Trusting them to do the right thing for our economy seems sort of silly, considering how wrong and self-interested their combined record is when it comes to judging what's best for the future of the economy.

5. It is a giant waste of taxpayer money. Since the $30 billion loan is non-recourse, the Fed is essentially throwing money after mortgage assets that are judged to have gone very bad. The only money the Fed will be re-paid is by money from those mortgage assets. Hmmm...and this is supposed to be a sign that the Fed is acting wisely, and that the economy will soon return to health?

6. Retired generals are voicing opposition. Paul Volcker, the former Fed chief, said that the Fed's actions "extend to the very edge of its lawful and implied powers." (see #2)

7. The press is showing signs of waking up after a period of repose. Dana Milbank's excellent piece on Bear Stearns' millionaire welfare recipients in the Washington Post is one sign of this. The video is also worth watching:

8. "Big Lie" comes to mind.

If I think of any more similarities, I'll add them. Of course, while the Iraq war has been a catastrophe, the final toll of the Bear moment of truth is still unknown. There are, of course, reasons to believe that providing this kind of safety net to debt-laden, risk-taking investment banks could make for a harsher economic reckoning down the road, but if that happens it will be hard to trace those problems back to the Bear bailout.