Vol. 72/No. 13      March 31, 2008

Days later the Federal Reserve bank, the U.S. government’s central bank, worked closely with top officials in the Bush administration to engineer a buyout of Bear Stearns by the banking monopoly JP Morgan Chase. They also announced a government bailout for other Wall Street securities dealers that made billions over the last decade speculating on securities based on mortgages and other debt, which today is largely worthless.

“Banks and brokerages are a house of cards built on the confidence of clients, creditors, and counterparties,” David Trone, a Wall Street broker told the New York Times. “If you take chunks out of that confidence, things can go awry pretty quickly.”

In Bear Stearns’s case it took a couple of days from when the run began until its managers announced the bank had collapsed. Like most Wall Street firms it was massively leveraged, with loans that amounted to over 30 times its assets.

To keep the panic from spreading, the Federal Reserve stepped in. Under a deal announced March 16, JP Morgan Chase agreed to buy Bear Stearns for pennies on the dollar of its book value. As part of the deal the Federal Reserve agreed to guarantee $30 billion of shaky investments on Bear Stearns’s books.

The central bank announced the same day that it would begin lending directly to the top 20 Wall Street investment banks and securities dealers. As collateral for these loans, it would accept “a broad range of investment-grade debt securities.” This includes paper based on mortgage and other debt that securities dealers can no longer find a buyer for.

The Federal Reserve has not extended credit to such entities directly since the Great Depression. Normally only commercial banks, which hold customer deposits, can borrow directly from the Federal Reserve.

In 1999, the Clinton administration repealed the depression-era Glass Steagall Act. The act had mandated that commercial banks and investment banks, which deal in insurance, stocks, bonds, and other forms of speculative capital, are distinct and must remain separate.

As a result, commercial banks like JP Morgan Chase, Citigroup, and FleetBoston began pouring massive capital into these speculative financial instruments. This helped propel the inflation of the speculative bubble that has now burst.  
 
 
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