Liquidity Trap
Nouriel Roubini on the Need to Regulate

Jared Bernstein on Bear Stearns

Jared Bernstein writes:

TPMCafe | Talking Points Memo | Total BS on Wall St.: The story of what%u2019s happening on Wall St. is really pretty straightforward. It%u2019s a classic bank run, this time on the investment bank formerly know as Bear Sterns, which we%u2019ll just call by the apt acronym BS.

Over the past few months, folks who%u2019d lent money to BS started to get worried that BS had made some bad bets with that money, and might not be able to pay them back. So they started calling in their IOUs.

When it started to look like those folks might be right%u2014BS might not be able to meet the %u201Cmargin calls%u201D%u2014the Feds got nervous that the firm could fail, and helped to orchestrate a bail out. Meanwhile, the firm went from being worth billions to being almost worthless in a matter of weeks.

There are many good articles out on this if you want to read up it. Go here, here, and in case you had a little residual love for BS in your heart, go here to get it expunged.

As for my contribution, I offer this primer.

Here%u2019s what happened:

First, some firms that lend money made some big, risky home loans. The loans were risky because they ended up with lots of people who would only be able to pay them if house prices kept rising.

But the lenders weren%u2019t that worried about the quality of loans because they didn%u2019t hold on to them. They securitized them, meaning they packaged them with other loans and sold them to other investors.

Then the bubble burst and prices started to tank.

Then the loans started to go bad, but because they were squirreled away who knows where, no one knew quite what to do. So the part of the economy that provides credit froze up, and without free-flowing credit, our economy can%u2019t expand.

As the losses piled up, well%u2026see the BS story above.

The Federal Reserve and the Treasury are trying to unfreeze the credit markets by injecting %u201Cliquidity%u201D%u2014making a lot more cash available. But it hasn%u2019t worked because investors are too spooked to lend and borrowers don%u2019t want to invest anyway right now, what with the economy heading south with a vengeance.

All of which raises some very big, very good questions: What%u2019s the risk engendered by these bailouts for the rest of us? There%u2019s a good argument to be made for the bailout (see Krugman today) but not if the fat cats get to skate on by unscathed. At the heart of the bailout is the Fed taking on the very smelliest part of the BS portfolio: the mortgatge debt. I%u2019d like to know what we%u2019re getting in return (and Mr. Paulson, the answer: %u201Csmoothly functioning markets%u201D is unacceptable).

And lest we forget, none of this had to happen. Market capitalism, once again, totally overshot, taking a fine idea%u2014providing credit so that folks who aren%u2019t rich can own homes%u2014and slicing and dicing it until no one understood the financial Frankenstein they%u2019d created. The government and the Fed turned a blind eye, which was fine with the %u201Cinnovators.%u201D Now that the monster has turned on them, they%u2019re running back to the gov%u2019t to bail them out.

My friends, we have a lot of cleaning up to do.