Federal Reserve's Actions: Moral Hazard Or Greater Good?

Federal Reserve backing of Monday's higher bid from JPMorgan Chase & Co to buy investment bank Bear Stearns Cos stirred new talk of moral hazard, even as it was cast as part of an ongoing effort to calm financial markets.

Critics argued that the U.S. government is prepared to rescue a failing Wall Street bank while dragging its heels on help for home-owners facing the possibility of foreclosure.

Still, investors pushed U.S. shares to a second straight session of big gains on hopes that the credit crisis, which has pushed the economy to the brink of, or possibly already into, a recession, might have turned a corner.

Recent moves by the Fed, culminating in Monday's revised JPMorgan-Bear Stearns terms, may have prevented other Wall Street firms from heading into a downward spiral, which would only add to the economy's woes. JPMorgan agreed to raise its bid for Bear Stearns to $10 a share from the $2 per share terms in the initial agreement announced on March 16. Still, Bear Stearns shares are down from $80 as recently as the end of February and from over $170 in early 2007, massive losses which to some made the concept of "moral hazard" -- the idea that investors take greater risks believing the government will protect them from losses -- seem spurious.

The Fed may have attempted to inoculate itself from charges of fostering moral hazard by making clear that JPMorgan would be the first to face losses if Bear Stearns' assets went sour, and that the Fed stood to gain if they did not. The central bank said it will assume control of a portfolio of Bear Stearns assets valued at $30 billion, pledged as security to facilitate the deal. Any profit from those assets will accrue to the Fed, while JPMorgan would bear the first $1 billion of any losses.

The Fed will finance the remaining $29 billion on a non-recourse basis to JPMorgan Chase at the discount rate, currently 2.5 percent. "This action is being taken by the Federal Reserve, with the support of the Treasury Department, to bolster market liquidity and promote orderly market functioning," the New York Fed said in a statement.

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JP Morgan Raises Bear Stearns Offer

JPMorgan Chase & Co raised its takeover offer for Bear Stearns Cos on Monday to about five times its original bid and struck a deal to buy nearly 40 percent of the bank, all but locking up the controversial acquisition.

Under the revised deal, JPMorgan will buy 95 million newly issued Bear Stearns shares and Bear's board agreed to vote in favor of the offer. With those shares, JPMorgan would own 39.5 percent of Bear Stearns and have secured the backing of Bear Chairman James Cayne, owner of a 3 percent stake in Bear.

The new offer valued Bear Stearns at about $2.1 billion, compared with $236 million under the original deal. The new deal, which has financial backing from the Federal Reserve, is likely to raise concerns that the U.S. government is prepared to help rescue Wall Street bankers even as millions of home owners face the possibility of foreclosure.

The Federal Reserve Bank of New York is providing $29 billion in special financing for the deal and will take control of a $30 billion portfolio of Bear's less liquid assets. "This action is being taken by the Federal Reserve, with the support of the Treasury Department, to bolster market liquidity and promote orderly market functioning," the New York Fed said in a statement.

JPMorgan, facing pressure from disgruntled Bear shareholders such as British billionaire Joe Lewis, raised its offer to about $10 a share in stock from its original bid on March 16 of $2 per share for the 85-year-old Wall Street investment bank, representing a boon to short-term traders who jumped in last week when the shares plunged.

While the new offer represents a less onerous fire-sale price, it is still 68 percent below the March 14 closing price of Bear shares of $30.85, and more than 90 percent below Bear's all time peak level of over $170.

Bear, recently ranked as the fifth-largest U.S. investment bank, collapsed as large subprime mortgage losses and falling confidence in the company prompted a run on the bank. Bear shares surged 76 percent to close at $11.25, as some investors speculated on an even higher offer. JPMorgan shares, which have climbed more than 25 percent since the deal was announced, rose 1.3 percent to close at $46.55.

The perception of a done deal is important for JPMorgan to encourage banks and other customers that it's safe to do business again with Bear. To that end, JPMorgan tightened its guaranty of Bear's liabilities. It agreed to back all of Bear's prime brokerage contracts and all of its short- and long-term loans.

If shareholders vote down the deal, the guaranty will run another 120 days unless extended. The guaranty expires if Bear's board recommends another deal. The stronger guaranty and the increased probability of a deal prompted credit rating agency Standard & Poor's to raise its rating on Bear Stearns. JPMorgan expects to complete the purchase of the new Bear shares by April 8. A date for Bear's shareholders to vote on the deal has not been set.

BlackRock Inc will manage the $30 billion portfolio of Bear's less liquid assets under guidelines established by the New York Fed. Those guidelines are "designed to minimize disruption to financial markets and maximize recovery value," the New York Fed said.

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Just How Bad Is The US Economy?

For months, Americans have been subjected to a sort of economic water torture -- a maddening drip of bad news about jobs, gas prices, sagging home values, creeping inflation, the slouching dollar and a stock market in bumpy descent.

Then came Bear Stearns. One of the five largest U.S. investment banks nearly collapsed in a single day before the government propped it up by backing emergency loans and a rival stepped in to buy it for a paltry $2 per share.

As economists and Wall Street types grope for historical perspective, which is another way of saying a road map out of this mess, Americans are nervously wondering about retirement savings, interest rates, jobs that had seemed safe.

They are surveying the economic landscape and asking: Just how bad is it? They are peering over the edge and asking: How far down? And the scariest part of all? No one can say for sure.

Businesses are feeling the pinch. Clients are cutting back and sales are going down. People are treating themselves less often. Restaurants are reporting declining traffic and eating at home has increased for the first time since 2001.

Parents are calling Financial Planners for advice on how to deal with grown children who have moved back in with Mom and Dad after losing a job or just to save money.

Less trash is being set on the curbs of Mesa, Ariz., where surging home foreclosures are leaving more houses empty. That means fewer homeowners paying the city $22.60 a month for pickup. People are sticking with what they have.

On top of an economy that was already groaning under the weight of a downturn, Bear Stearns came down like an anvil. Understanding how things got so bad means rewinding to the start of the housing boom. Wall Street and the banks made it far easier for people with shaky credit to get a mortgage -- known as a subprime loan. Investors wanted a piece of the fast-growing mortgage pie, so there was plenty of money sloshing around the market to pay for the loans. Financial firms sliced up the mortgages and sold them as complex investments, finding eager buyers among pension funds, hedge funds and more who were chasing higher returns and willing to overlook risks.

As long as housing prices went up, the strategy worked. When they began to crumble, so did financial stability. The housing problem set off the dominoes: Surging defaults meant the mortgage-backed securities plunged in value. That dried up the money to fund new home loans, and lenders everywhere became tighter with credit.

Bear Stearns found itself in the cross hairs. Market rumors began to swirl about the size of its exposure to mortgage securities, whether it had ample reserves to cover potential losses. Clients and investors began to demand their money back.

The last time the U.S. economy tilted into recession was 2001. And it was an entirely different animal. Investors bore the brunt of that downturn as the stock market shook off the excesses of the late-'90s technology boom. Encouraged by their government -- and fortified with tax rebates in their pockets -- Americans kept spending. Perhaps most importantly, there was no reason for anyone to doubt the stability of the financial system. There was no credit crisis to speak of, and the housing boom had yet to begin.

This time around, no one has declared a recession just yet: By the generally accepted rule, that takes two consecutive quarters of shrinking economic activity. The economy came close to stalling late last year but eked out small growth. The Fed dusted off other Depression-era tools, too. It allowed securities dealers to borrow directly from the Fed, a privilege once restricted to commercial banks. And it announced it would lend up to $200 billion to investment banks in exchange for the banks' beaten-up mortgage-backed securities. The idea is to maintain confidence in the American banking system. If that fails -- if more Bear Stearns episodes emerge -- it could gum up the entire economy, historians note.

So what's the way out?

Already, the Fed has slashed interest rates. It has cut the closely watched federal funds rate, the overnight lending rate for banks, six times since September, from 5.25 percent to 2.25 percent -- two-thirds of the cut coming in the last two months alone. But the Fed can't work alone. Upcoming tax rebates for millions of people and tax breaks for businesses may give a little relief, but economists think that something will have to be done soon to slow down the number of foreclosures, a cornerstone of the economy's woes.

Economists and market historians seem to agree that this is more than a typical, cyclical slump. And the X-factor that sets it apart -- determining how deep the wounds from the mortgage mess really are -- also makes it impossible to map the path of the downturn.

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Treasury Department Should Play More Active Role, Buy Troubled Mortgage Bonds

The Treasury Department should take a more active role to deal with the meltdown in financial markets that threatens to deepen the U.S. economic slowdown.

President George W. Bush and Treasury Secretary Henry Paulson have resisted calls to use public funds to stem the surge in home foreclosures which are at the root of the financial crisis. The Federal Reserve has spearheaded efforts to ease the credit crunch by reducing interest rates and by becoming the lender of last resort for the biggest Wall Street dealers.

President George H.W. Bush, the current president's father, signed the 1989 law which created the Resolution Trust Corp to dispose of the assets of insolvent savings and loans banks. From 1986 through 1995, 1,043 savings banks with over $500 billion in assets failed, costing taxpayers $75.6 billion, according to a Federal Deposit Insurance Corp. analysis.

The Fed last week extended credit to non-banks for the first time since the Great Depression, lending $28.8 billion as of March 19 to the biggest securities firms to try to stabilize capital markets.

For the Federal Reserve to keep the financial markets from imploding it needs to buy troubled mortgage bonds from banks and securities firms. Even after cutting rates by 3 percentage points since September, expanding the range of securities it accepts as collateral for loans and giving dealers access to its discount window, the Fed has been unable to promote confidence.

The only tool left may be for the Fed to help facilitate a RTC-type agency that would buy bonds backed by home loans, said Bill Gross, manager of the world's biggest bond fund at Pacific Investment Management Co. While purchasing the some of the $6 trillion mortgage securities outstanding would take problem debt off the balance sheets of banks and alleviate the cause of the credit crunch, it would put taxpayers at risk.

The Fed, the Bank of England and the European Central Bank are exploring the feasibility of using taxpayers' money to shore up the mortgage-backed securities market, the Financial Times reported on March 22, without saying where it obtained the information.

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Why Bear Stearns Is Valued More Than $2 Per Share?

The building alone, they say, is worth $8 a share. Maybe all the copiers, BlackBerrys, and laptops could command a few bucks. Rip out the pipes, faucets, and elevator doors, and surely you could fetch top coin in this metals-crazed market.

Those are just some of the reasons, legit and otherwise, that shares of Bear Stearns (BSC) never did hit their now notorious $2-a-share, Fed-supervised "take under" price. Bear shares bottomed at just under $3 on Mar. 17 before they surged to as much as $8.50 on Mar. 18. Of course, this is all so much cold comfort to anyone who got in at $170 last year (or even $70 last week). Still, the fact that the stock is trading at triple its agreed-on buyout figure means

1) something is being lost in translation,
2) something else is afoot, or
3) the Wall Street arbitrageurs, who play spreads of a few nickels and dimes, must be having a collective aneurysm.

Maybe all of the above.

If you are a Bear shareholder, was it ever remotely conceivable just days ago that the firm had so much toxic waste on its books that its liabilities would come to represent almost the entirety of its enterprise value? Until recently, the 85-year-old brokerage had never posted an unprofitable quarter. Did any Wall Street analyst or short-seller dare to posit a Bear target price in the single digits—anticipating outright collapse? Wasn't Jim Cramer defending the stock at $63 just last week?

Some Street wags were mumbling Mar. 18 that Bear shareholders conceivably could pocket more than $2 a share if Bear were allowed to enter into an orderly bankruptcy.

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Federal Reserve Bypassed Its Emergency Lending Policies

The Federal Reserve bypassed its own emergency-lending policies to let securities firms borrow at the same interest rate as commercial banks as the central bank sought last weekend to stave off a financial-market meltdown.

Guidelines revised in 2002 say the Fed should charge non-banks more than the highest rate that commercial banks pay. Instead, Chairman Ben S. Bernanke and his colleagues, in emergency votes on March 16, invoked broader authority in the Federal Reserve Act to give Wall Street dealers the same rate as banks.

Bernanke raced to unveil the steps before trading on the Tokyo Stock Exchange began on March 17. The weekend action, timed to complement JPMorgan's rescue of Bear Stearns, included a cut in the so-called discount rate and the opening of borrowing to the primary dealers in Treasury securities, not all of which are banks.

The changes were the Fed's most aggressive response to the 8-month-old credit squeeze that's worsening the housing recession and the economic slowdown. Bear sought the Fed's help after a run on the firm, the second-largest underwriter of US mortgage-backed securities.

The 2002 guidelines say that non-banks may only receive emergency cash "at a rate above the highest rate in effect for advances to depository institutions." That means securities firms may normally have to pay more than the current 3 percent rate reserved for banks that are less financially sound.

In deciding to charge securities firms such as Goldman Sachs Group Inc., Morgan Stanley and Lehman Brothers Holdings Inc. the same rate as commercial banks, the Fed used 1920s-era authority provided by Congress to set interest rates that the law says "shall be fixed with a view of accommodating commerce and business," the Fed staff official said.

The Fed reduced the primary discount rate March 18 by 0.75 percentage point to 2.5 percent. The secondary rate, offered to more-distressed banks, is a half-point higher, at 3 percent.

The federal funds rate, the more closely-watched US short-term benchmark, was cut by the same margin to 2.25 percent.

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California Leads US In Defaults, Home Price Decline

California, the birthplace of the subprime mortgage industry, is paying the highest price of any state as the housing meltdown persists. Its gross domestic product will drop 1.5 percent in the first half of 2008, the most in the US, analysts at Lexington, Massachusetts-based Global Insight Inc. estimate.

The state had the most foreclosure filings in the US last year and the biggest fourth-quarter decline in prices, according to RealtyTrac Inc., an Irvine, California-based seller of data on defaults, and the Office of Federal Housing Enterprise Oversight in Washington.

California, the most populous US state and accounting for almost one-seventh of gross domestic product, will lose $25 billion in personal income by the end of 2008 and property values will fall by $630.7 billion, according to forecasts from economist Jerry Nickelsburg at the University of California, Los Angeles, and the US Conference of Mayors.

"The housing slump is the real drag on the economy," Nickelsburg said.

Almost half of the 25 biggest U.S. subprime lenders were based in the state, according to industry newsletter Inside Mortgage Finance, and almost a quarter of the country's outstanding subprime loans were issued there, more than in any state, data from San Francisco-based research firm LoanPerformance show. Such loans are made to borrowers with limited or tainted credit histories.

Prices that more than doubled in California from 2000 to 2005 fueled demand for nontraditional mortgages that allowed people to purchase homes, said Peter Navarro, a professor at the University of California, Irvine.

The number of houses and condominiums sold in California plummeted 30 percent in January from a year earlier to 313,580, and the median price for an existing home dropped 22 percent to $430,370, according to the California Association of Realtors.

California had 481,392 foreclosure filings on properties last year, the most of any state, said Daren Blomquist, a spokesman for RealtyTrac. Stockton's metropolitan area had the second-highest US foreclosure rate and Riverside-San Bernardino, Sacramento and Bakersfield ranked fourth, fifth and seventh, respectively.

In Sacramento, half of the city's current home sales involve bank-owned property, helping explain why the increase in property tax revenue will slow to 2 percent in fiscal 2008-2009 and may fall in 2010 and 2011, said Fehr, the finance director.

The area has been one of the hardest hit by the housing- market slump in Northern California. Home prices in Solano County dropped 21 percent in February from a year earlier, according to La Jolla, California-based DataQuick, which tracks the property market. Almost half of the estimated 334,500 home sales in 2008 will be trustee sales, according to the Norris Group, a Riverside-based firm that buys and sells foreclosed properties.

With no end in sight to the slump, homeowners are racing to get their property revalued to reflect current prices and lower their tax bills. In San Diego County, 11,456 applications seeking reassessments were received last year, more than triple the 2006 number and the most in 10 years.

Los Angeles County Assessor Rick Auerbach announced today his office is reviewing about 310,000 houses and condominiums purchased since July 1, 2004, for reassessment. Already, 41,000 properties have had their values cut by an average of $66,000 each, Auerbach said.

Harry Subers, a 59-year-old unemployed engineer, said he and his wife ``paid way too much'' for their house in Ben Lomond. They did it because they love living among the redwood trees of the Santa Cruz mountains, he said.

After their adjustable-mortgage rate rose last year, their payments climbed 20 percent to $1,900 a month, or more than two- thirds their monthly income of $3,000. The couple put the home up for sale because they could no longer afford it, Subers said.

Selling turned out to be tougher than they thought since three other nearby homes have languished on the market and one hasn't sold for three years, he said. They paid $412,000 in 2004.

The real estate slump has taken its toll, with more than 31,000 jobs eliminated last year in the subprime mortgage industry by California-based companies, including 12,000 positions at Countrywide Financial Corp. in Los Angeles, 3,200 at New Century Financial Corp. in Irvine, and 2,600 at ACC Capital Holdings in Orange, according to Chicago-based outplacement firm Challenger Gray & Christmas.

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Difference Between Key Interest Rate & Discount Rate

For all the readers who have seen a hordes of news about slashing of key interest rates (also known as federal funds rate) and discount rate by Federal Reserve Board, here is a brief difference explained on both of these rates in layman's language.

The federal funds rate or key interest rate is what banks charge each other for overnight loans and is the basis for everything from business loans to credit card charges.

The discount rate is what the Fed charges member institutions directly for short-term loans.

JPMorgan Chase Acquires Bear Stearns for $240 Million

JPMorgan Chase & Co. agreed to buy Bear Stearns Cos. for about $240 million, less than a 10th of its value last week, after a run on the company ended 85 years of independence for Wall Street's fifth-largest securities firm.

Shareholders of New York-based Bear Stearns will get stock in JPMorgan equivalent to about $2 a share, compared with $30 at the close on March 14, the two companies said in a statement today. The U.S. Federal Reserve will provide financing for the transaction, including support for as much as $30 billion of Bear Stearns's "less-liquid assets.''

JPMorgan Chief Executive Officer Jamie Dimon had the upper hand in negotiations after coming to the smaller firm's rescue last week with a cash infusion engineered by the Fed. Bear Stearns's CEO, Alan Schwartz, faced the prospect of bankruptcy as clients pulled $17 billion in two days last week and creditors stopped renewing loans.

"JPMorgan Chase stands behind Bear Stearns,'' Dimon, 52, said in the statement. "Bear Stearns's clients and counterparties should feel secure that JPMorgan is guaranteeing Bear Stearns's counterparty risk. We welcome their clients, counterparties and employees to our firm, and we are glad to be their partner.''

Bear Stearns's sale to JPMorgan caps an eight-month slide in the company's fortunes that began last July with the collapse of two of its hedge funds. Those failures sparked a wider market concern that called into doubt the value of any asset linked to the mortgage market, the biggest business at Bear Stearns, which has 14,000 employees.

The Fed's rescue attempt last week failed to avert a crisis of confidence among Bear Stearns's customers and shareholders, who drove the stock down a record 47 percent after the cash infusion was announced.

"The past week has been an incredibly difficult time,'' Schwartz, 58, said in the statement. "This transaction represents the best outcome for all of our constituencies based upon the current circumstances.''

Bear Stearns's profit exceeded $2 billion in 2006, yet the price JPMorgan is paying is about one quarter the value of the securities firm's headquarters building in midtown Manhattan. The 1.2 million-square-foot, 45-story structure built in 2001 is worth about $1.2 billion, based on the average $1,000 per- square-foot that comparable office space in the city is currently fetching.

Minutes after the deal was announced, the Fed, in an emergency move, cut the rate on direct loans to commercial banks by a quarter percentage point.

The prime brokerage was the third-largest behind Goldman Sachs Group Inc. and Morgan Stanley as of April 2007, according to Sanford C. Bernstein & Co. About a sixth of the firm's income came from packaging and trading mortgage bonds, a market that has been almost completely frozen since July.

JPMorgan, the third-largest U.S. bank by assets, has posted $3.7 billion in writedowns, a fraction of the $22.4 billion reported by New York-based Citigroup Inc., the biggest U.S. bank.

Treasury Secretary Henry Paulson defended the Fed's bailout today, saying policy makers will do whatever is needed to prevent disruptions in financial markets from hurting the economy. Paulson said he was involved with the discussions on Bear Stearns's future this weekend, without elaborating.

Bear Stearns, founded in 1923, survived the Great Depression and first sold shares to the public in 1985. Schwartz, an executive with more than 30 years of experience at Bear Stearns, was the hand-picked choice of his predecessor, James "Jimmy'' Cayne, 74, who remains non-executive chairman of the firm.

Cayne stepped down after reporting an $854 million fourth- quarter loss, the first in the company's history. He was at a bridge tournament in Detroit last week as the firm faced speculation about its cash position. Cayne came under fire last July for playing golf and bridge while the hedge funds collapsed.

When Bear Stearns invited potential buyers for detailed presentations by department chiefs yesterday, only JPMorgan and private equity firm J.C. Flowers & Co. showed up, according to people familiar with the talks.

Other potential buyers, such as Royal Bank of Scotland Group Plc and HSBC Holdings Plc, which had expressed interest in the past, didn't send representatives. Hundreds of Bear Stearns employees went to work yesterday to help with the sale process and the presentations.

Bear Stearns has offices in cities including London, Tokyo, Hong Kong, Beijing, Shanghai, Singapore, Milan and Sao Paulo, according to its Web site.

JPMorgan's participation in the bailout follows a long tradition at the bank of stepping in to rescue financial markets from crisis, according to Charles Geisst, the author of "100 Years on Wall Street.''

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Market Turns To Federal Reserve: Another 75 Basis Points Cut Expected

U.S. stocks next week will turn to the Federal Reserve, hoping it will deliver hefty cuts in interest rates after concerns about the possible collapse of investment firm Bear Stearns on Friday dashed investors' hopes that the end of the credit crisis gripping global markets was in sight.

"After Bear Stearns, they'll likely cut by more than was previously thought to show the market that they stand ready to provide as much liquidity as needed," said Paul Nolte, director of investments at Hinsdale Associates.

Bear Stearns Cos. Inc. jolted markets Friday, saying that liquidity, or the company's ability to fund its businesses, had "deteriorated significantly" in 24 hours. The 85-year-old investment firm, deserted by its clients and counterparties, was forced to accept an extraordinary bailout package from the Federal Reserve and banking giant J.P. Morgan Chase. The move failed to reassure investors, who saw it as yet another sign of how serious the credit crisis that started with bad home loans last summer has become.

"The problem is, it's moved from a credit crisis to a crisis of confidence," Nolte said. "As difficult as it is to correct a credit crisis, it's even tougher to address a crisis of confidence."

Shares of Bear Stearns plunged 47% on Friday, taking its financial peers down along with it, as well as the broader market.

Investors can expect more news from the ailing financial sector next week, with Bear Stearns posting quarterly results Monday after the close, followed by fellow investment firms Goldman Sachs.

After the Bear Stearns news, market bets that the central bank will cut interest rates by 75 basis points next Tuesday jumped, pricing in a 100% chance of such as move, compared with 88% previously. The market also sees over 50% odds of an additional 25 basis points -- which would bring short-term interest rates to 2% from the current 3%.

All the worries about financial institutions and credit markets, meanwhile, are being compounded by the belief of many investors, analysts and economists that the U.S. economy is headed toward, or has already entered into, a recession.

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Bear Stearns Faces Market Heat & Big Bailout

Bear Stearns is clawing to stay alive, with many on Wall Street now betting the storied investment bank may not survive the weekend as an independent shop.

Bear's stock was in a free fall on Mar. 14—hitting an 11-year low—following the news that JPMorgan Chase and the New York Federal Reserve had stepped in with an emergency cash bailout for the New York-based investment firm. The bailout was engineered after days of denials by Bear executives that the firm was facing a liquidity crisis and lacked sufficient funds to continue operating. Bear's stock finished down 47% at 30, on volume that was more than 18 times normal trading. JPMorgan dipped 4% to 36.54.

Bear Stearns CEO Alan Schwartz says the situation at Bear took a turn for the worse during the past 24 hours and the firm's liquidity situation had "significantly deteriorated." In a conference call Friday afternoon, Schwartz says "nervousness in the market" prompted clients and lenders to "get cash out" of the firm.

Schwartz and other top executives at Bear are trying to put on a brave face, saying the firm will be able to weather the current storm. But many on Wall Street, and even some within Bear, aren’t sure.

It's not clear what had changed so dramatically at Bear to necessitate the emergency bailout, in which JPMorgan is providing a secured line of credit to the beleaguered investment firm. But events appear to have moved quickly on Mar. 13. People familiar with the situation say Bear officials called the Fed late in the day, saying the firm had a funding problem. Officials from the Fed were at Bear's spacious offices on Madison Avenue all night, scouring its books and trying to devise a rescue plan. The Fed and Bear then reached out to JPMorgan, seeing if the big bank led by CEO Jamie Dimon could help out. JPMorgan, which has multiple business relationships with Bear, was inclined to do so. But only with some guarantee from the Fed that it would make JPMorgan whole if Bear were to fail and couldn't make good on its obligations. So if Bear fails, everyone in the U.S. will indirectly own a little piece of the company.

It would have been highly risky for other Wall Street firms if Bear Stearns had been allowed to go under because Bear is tightly interconnected with them as both a borrower and a lender. Any firms that are owed a lot of money by Bear would have fallen under suspicion, on grounds that they might not be able to pay their own debts if Bear failed to pay them. That could have triggered a dangerous wave of defaults. The rescue by JPMorgan Chase gives the financial system breathing room to pay off Bear's debts gradually.

Rumors about a funding crisis at Bear had spread like wildfire all week on Wall Street—plummeting the stock in the process. With shares of Bear trading around $30, the stock has lost more than half its value in the past week. It was only a year ago that shares of Bear were trading around $150—just a few dollars below its all-time high.

The Fed apparently contacted JPMorgan because it was in a much better position to come to Bear's aid than other big banks, such as Citigroup, Bank of America, and UBS, all of which are dealing with their own subprime-related woes. Under the terms of the deal, JPMorgan is providing a secured loan to Bear for an initial 28 days. The Fed has agreed to stand behind the loan and to make JPMorgan whole if Bear fails and the collateral it has put up cannot cover the outstanding debt.

The move by JPMorgan to come to Bear's rescue has raised speculation that the big bank may ultimately buy the struggling investment firm. Indeed, a sale of Bear may be the only way it can survive. A source familiar with the situation tells BusinessWeek that Bear executives are now talking to JPMorgan about "exploring strategic initiatives."

Even with the emergency funding, there's little confidence in Bear on Wall Street, especially after the firm's management was out all week denying financial trouble. Once Wall Street loses confidence in a brokerage, it can be a death sentence because other firms are reluctant to lend it money or trade with it. All week there have been rumors about some investment firms being reluctant to trade or lend money to Bear because they were uncertain about its ability to make good on its commitments. In recent days, a number of hedge funds that are prime brokerage clients of Bear have taken steps to move their lucrative business to other Wall Street banks.

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American Recession 2007-2008

Wall Street got its hopes up on Mar. 11. Elated by a Federal Reserve move to stop the credit crunch, the U.S. stock market posted its biggest one-day gain in five years. Look out, though. Fed officials are the first to acknowledge that their initiative attacks only one problem, the liquidity squeeze at big banks. It does nothing about the central risk to the U.S. economy: an unprecedented crash in home values that is sapping households' wealth and confidence while putting an enormous strain on the banking system.

How bad will this downturn get? No one can know because we've never experienced such a headlong slide in the housing market—and this comes at a time when its current value of $20 trillion accounts for the vast majority of most families' wealth. Right now most economists expect the U.S. to experience a mild, short recession in 2008. But there is at least a possibility of a steeper decline that the traditional recession remedies—interest-rate cuts here, deficit spending there—won't be able to handle.

What should be done? Policymakers have three options for putting a safety net under the economy. Each has its pros and cons, and the cons become most apparent when the measures are taken to an extreme. That's why a three-pronged approach that uses each option in moderation may be the best way to go.

The first option is to depend mainly on aggressive measures by the Fed to flood the economy with liquidity. That's already under way. On Mar. 11, the central bank announced an innovative program to lend $200 billion in high-grade Treasury securities to big commercial and investment banks. It will allow them to use, as collateral for the loans, valuable but harder-to-trade assets such as AAA-rated mortgage-backed securities. The measure could enable them to start lending and borrowing again. The cons: no direct help for distressed homeowners who don't qualify for refinancing.

A second option would be some sort of a government-led bailout of homeowners, which reduces the burden of looming debt and high interest rates, and limits foreclosures. The third option would be assistance to the lenders and holders of mortgage-backed securities in an effort to thaw the credit markets. The trouble is, both of these options are seen as unfair by those who don't require bailouts. And it's up in the air who would have to bear the biggest share of the housing-related losses: homeowners, investors, or taxpayers.

The airwaves and blogosphere are alive with people who say nothing should be done. They argue that intervening now would only delay the inevitable liquidation of credit-fueled excesses. "Under proposed bailouts, responsible people lose and have to give their money to gamblers, liars, and sleazy lenders," says the widely followed Patrick.net housing blog.

But the "don't just do something, stand there!" philosophy is overly pessimistic. Policymakers have an obligation to make sure the downturn doesn't gather speed and turn into something along the lines of the long and deep 1973-75 recession. It is extremely dangerous for there to be millions of homeowners who have a clear financial incentive to abandon their homes because they are worth less than the mortgages on them. Already there are signs that the stigma of abandoning a home is fading, as desperate homeowners flock to Web sites with names like walkawayplan.com and youwalkaway.com. The entire capital of the U.S. banking system would be wiped out many times over if everyone who was underwater on a mortgage turned the keys over to their lenders.

There's a social aspect, too. Concentrated foreclosures, voluntary and otherwise, can destroy neighborhoods because abandonment increases decay and crime. And the housing crash undermines the social compact.

The Federal Reserve is already on the case with a double-barreled approach. Since last summer it has cut the federal funds rate from 5.25% to 3%, and markets are forecasting the central bank will cut to around 2% before it finishes. The Fed may need to go even lower, though, perhaps to 1.5% or even back to its 2003-04 level of 1%. Lower short-term interest rates allow banks to rebuild their damaged balance sheets by paying less for the debt they carry, and they should also pull down market interest rates, stimulating the economy with cheaper loans for homeowners and businesses.

The Fed's second tactic is to ease the credit crunch by convincing market players that suspect assets really are worth something. It's doing that by giving commercial and investment banks new options for backing up their loans. The Fed's Mar. 11 move is designed to help its primary dealers—20 huge firms at the core of the financial system. They will be able to pledge a wider variety of collateral—including AAA-rated private label mortgage-backed securities—in exchange for top-quality Treasuries. And the loans will be for 28 days instead of just overnight. One immediate beneficiary will be Bear Stearns, which will have an easier time getting its hands on Treasuries it can then use as collateral for loans from other financial institutions that have been increasingly concerned about its ability to repay.

But the Fed can't do it alone. Many analysts say the federal government will need to intervene directly in the housing market. When the government steps in, that's when the battle starts about who wins and who loses. Home mortgages account for 44% of private nonfinancial debt, making them one of the main pillars of the debt market. If the value of household real estate falls by 25%—an amount many economists consider plausible—it would be a $5 trillion loss of wealth. Any type of government bailout plan will alter the eventual distribution of losses between homeowners and investors. One person's "necessary intervention" is another's "outrageous bailout."

The purest form of bailing out homeowners would be forcing lenders to reduce the amounts borrowers owe. Such a "cramdown" could be accomplished by legislative fiat or, more likely, by changing the federal bankruptcy law to allow judges to reduce mortgage debt in a Chapter 13 reorganization the same way they're allowed to reduce other debts. Bills to change the bankruptcy law have stalled in Congress but could gain traction if foreclosures keep rising. The downside: In the short run, lenders might face even bigger losses. In the long run, they would charge higher interest rates for fear of future cramdowns.

In the Presidential race, Republican Senator John McCain doesn't want to bail out either side, favoring private workouts between borrowers and lenders. Here's how he summed up his feelings on Mar.11: "It is not the government's role to bail out investors...or lending institutions who didn't do their job." Democratic Senators Barack Obama and Hillary Clinton both tilt toward homeowners, but Clinton is more aggressive, calling for a voluntary 5-year freeze on subprime mortgage rates and a 90-day moratorium on foreclosures.

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