Analyzing Bear Stearns Bailout

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Bernanke and many other economists believe the Fed’s failure to bail out stricken banks between 1929 and 1932 was one of the main reasons the Depression lasted so long. In 1932, Herbert Hoover established the Reconstruction Finance Corp., which lent to banks, railroads, and other troubled businesses but failed to reverse the string of bank failures. By the start of 1933, when Franklin Delano Roosevelt entered the White House, thousands of banks had gone under and many more were facing potential runs on their deposits. F.D.R. declared a bank holiday. When the banks reopened, the Fed had broader power to bail out those that were struggling. A few months later, the Glass-Steagall Act established a system of federal deposit insurance, removing the threat to depositors of seeing their savings wiped out. Stability returned to the banking system.

Roosevelt saved capitalism from itself; as a quid pro quo, he insisted on much tighter regulation. Under another Glass-Steagall provision, investment banks and commercial banks were split apart, with the latter being prohibited from underwriting many types of risky securities. Tighter capital requirements were also introduced for commercial banks, along with limits on how much credit they could extend to consumers and real estate developers. To police Wall Street and prevent a repeat of the chicanery that marred the 1920s, Roosevelt founded the Securities and Exchange Commission.

The current situation is crying out for another Roosevelt, or at the very least, another Hoover. (The 31st president is often misread as a conservative ideologue, but in addition to founding the R.F.C., he raised the tax rate on high earners from 25 to 63 percent.) Great care will need to be taken in crafting a 21st century New Deal for Wall Street, but the broad outlines are clear.

If Wall Street executives are going to call on the Fed every time they trash a firm, the government needs to impose some speed bumps in the form of mandatory capital requirements. During the past couple of decades, investment banks like Goldman Sachs, Morgan Stanley, and Bear Stearns have turned themselves into neo-hedge funds, with vast proprietary trading desks that employ enormous leverage. Bear’s top managers, who saw themselves as riverboat gamblers, loaded the firm with a debt-to-capital ratio of 30 to 1. When a financial institution has this much debt, even a three or four percentage-point fall in the value of its assets can prove fatal.

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