Bailout or fire sale?

It can't be both!

The Fed is sure to take some heat over Friday's decision to extend an emergency loan to Bear Stearns (via JP Morgan), and last night's decision to open the discount window to primary dealers. Terms like "bailout" will inevitably be used to describe what the Fed is doing.

But in defense of the Fed, there are good reasons to think that the Fed acted appropriately in its capacity as lender of last resort. In that role, the Fed's job is to lend funds to solvent institutions, which, for whatever reasons, are experiencing a liquidity crisis -- i.e., a "run". And that's probably a reasonable description of the situation Bear Stearns found itself in on Friday. Why? How do we know Bear wasn't also insolvent? For the simple reason that somebody, namely JP Morgan, was willing to buy it. And, the fact that the $2/share price was viewed as a "fire sale" price suggests that the company was worth substantially more -- maybe not the $50-plus per share price of last Thursday, but something well above zero. Had Bear actually been insolvent, there would have been no buyer at any price.

And what about opening up the discount window to primary dealers? Yes, that sets a very interesting precedent, but it was probably a good idea. After all, "surprise" loans to financial institutions experiencing a liquidity squeeze do absolutely no good: it's the commitment of the central bank to step in and lend during a run that will avert the run. The loan to Bear Stearns obviously suggested an implicit commitment; the Fed has now simply made that explicit. If the policy succeeds, other dealers will never need to avail themselves of the facility.

For commercial banks, the price paid for access to the discount window has been regulatory oversight, the idea being that if the institution is regulated, the Fed will be in a good position to gauge its solvency. The open question now is whether, in opening the discount window for other institutions, the Fed will expect those institutions to a comparable degree of scrutiny. In light of recent events, that might not be such a bad idea...