Analyzing Bear Stearns Bailout

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Last summer, after Bear got into trouble, the company failed to raise more capital for an essentially selfish reason: An influx of capital would have diluted the shares of existing stockholders, including those of senior management, and reduced the firm’s return on equity. Companies in such straits shouldn’t be given a choice. If bonuses and rentals in the Hamptons are a bit more humble than they otherwise would have been, so be it.

Other options worth pursuing include varying capital requirements throughout the economic cycle—making sure that firms build up reserves during good times—and forcing investment banks to keep a bigger percentage of their holdings in liquid assets. (It was a liquidity crisis that did Bear in.)

While the regulators are at it, they should also impose minimum capital requirements on big hedge funds, such as D.E. Shaw, Renaissance Technologies, and Citadel (which, incidentally, was mentioned as a possible purchaser of Bear Stearns). Such unregulated and opaque firms are now among the biggest players in the market, and the collapse of one of them would cause almost as much grief as the demise of Bear or Lehman Brothers.

More transparency is needed. Until Merrill Lynch set out the details of its mortgage investments in October, there was no way for financial analysts, let alone ordinary investors, to tell how much of its trillion-dollar balance sheet was devoted to complex collateralized debt obligations. (More than $30 billion is the answer.) And how many Citigroup stockholders knew the firm had been on the hook for $83 billion worth of investments made by off-balance-sheet vehicles affiliated with the company?

The regulatory agencies also need to be modernized. At the moment, the Fed oversees financial supermarkets like Citi, the Comptroller of the Currency looks after other big commercial banks, the S.E.C. oversees Wall Street firms, and a variety of federal and state regulators handle local banks, thrifts, insurance companies, mortgage lenders, and other financial institutions. Since financial firms of all kinds have been merging at a dizzying rate, it only makes sense to consolidate the regulators too.

Barney Frank, the chairman of the House Financial Services Committee, has proposed setting up a new “superregulator” to monitor economy-wide risk, a plan seconded by Barack Obama in his recent speech at New York’s Cooper Union. Britain, among other countries, has already moved toward establishing a single financial regulator, though disputes between the Financial Services Authority, the Bank of England, and the Treasury are still a problem. Ending the turf wars isn’t a practical option, but that shouldn’t be an excuse for sticking with the status quo.

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