In 1984, Continental Illinois, then one of the country’s largest banks, found itself on the verge of collapse, after billions of dollars’ worth of its loans went bad. To avert a crisis, the government stepped in, purchasing $3.5 billion of the soured loans and effectively taking over the bank. Later that year, at a congressional subcommittee hearing, Representative Stewart McKinney summed up the lesson of the rescue effort: “Let us not bandy words. We have a new kind of bank. It is called too big to fail. T.B.T.F., and it is a wonderful bank.”

Illustration by Christoph Niemann

Since then, T.B.T.F. has become a generally accepted, if unwritten, rule in the financial world. Two weeks ago, though, it was given a new twist when the Federal Reserve acted to save the investment bank Bear Stearns, orchestrating the company’s sale to J. P. Morgan Chase by providing Morgan with up to thirty billion dollars in financing to cover Bear Stearns’s portfolio of risky assets. Previously, the government had intervened to protect only commercial banks—which take deposits and issue traditional loans, and which are heavily regulated. (Another first: the Fed is now allowing investment banks to borrow from it directly.) The Bear Stearns deal means that the T.B.T.F. rule now applies to investment banks as well. Suddenly, the federal government is committed to saving a whole lot more companies than it was a couple of weeks ago.

Rescuing failing companies obviously runs the risk of creating moral hazard—if we insulate people from the consequences of their irresponsibility, they’re more likely to be irresponsible in the future. But the Fed did a good job of lessening that risk, making sure that Bear suffered a heavy toll. The sale punished Bear shareholders severely, valuing Bear at just two dollars a share, down from sixty dollars a few days before, while thousands of Bear employees are likely to lose their jobs. That’s about as harsh as a bailout gets.

More to the point, the threat of moral hazard in this case was simply less dire than the threat of financial contagion. The Fed could have done what it did in February, 1933, when it stood quietly by while Detroit Bankers Corp. and the Guardian Detroit Union Group, Detroit’s two largest banks, foundered after a series of bad loans. But the failure of those two banks quickly led to bank runs in neighboring states—Cleveland’s two biggest banks failed soon after—and eventually to a national banking panic. Bear Stearns’s collapse, similarly, could easily have provoked market chaos. Bear wasn’t among the largest Wall Street banks, but it was a major clearinghouse for stock trades and played a central role in hundreds of billions of dollars of credit deals. If not too big, it was too important to fail.

The Bear deal does mark a major policy shift, since the Fed has now implicitly admitted that it will catch investment banks when they fall. But that shift really just ratifies the inevitable, given the nature of credit in today’s world. Most money that’s borrowed these days no longer comes from commercial banks, which are responsible for less than thirty per cent of all lending. Instead, in one form or another, the loans are packaged and sold as securities. And since investment banks do much of the selling and buying of those securities, they play an ever bigger role in financial markets. Two decades ago, the Fed could afford to let a firm like Drexel Burnham Lambert (which, admittedly, was dealing with criminal charges in addition to its economic woes) go under without worrying too much about the ripple effects. It would demand very steady nerves to do the same thing today.

You might, then, see the Fed’s willingness to help investment banks as evidence of their indispensability. But what it really underscores is how badly Wall Street has managed its business in recent years. Because investment banks’ trades and investments are typically very highly leveraged—Bear Stearns, for instance, had borrowed thirty dollars for every dollar of its own—the banks need to be exceptionally good at managing risk, and they need to insure that people trust them enough to lend them huge sums of money against very little collateral. You’d expect, then, that Wall Street firms would be especially rigorous about balancing risk against reward, and about earning and keeping the trust of customers, clients, and lenders. Instead, most of these firms have taken on spectacular amounts of risk without acknowledging the scale of their bets to the outside world, or even, it now seems, to themselves. That’s why, since the bursting of the housing bubble, we have seen tens of billions of dollars in surprise write-downs and complete paralysis in the credit markets. When you consider that the banks at the center of the subprime debacle were also at the center of the tech-stock bubble, the surprising thing about the Bear Stearns crisis isn’t that a major investment bank was abandoned by its customers and lenders but, rather, that it didn’t happen sooner.

Now that the Fed has stepped in, it’s possible that things will go back to normal. But let’s hope they don’t get too normal: one of the biggest problems in the market in the past decade has been that lenders, clients, and even ordinary small investors have put far too much faith in the magical abilities of Wall Street firms, and have failed to give their promises and performance proper scrutiny. Markets require trust to work well, but when trust is blind they are almost guaranteed to go haywire. We don’t want the paralytic level of skepticism that has reigned in the marketplace in recent months to continue, but we don’t want a return to the way things were, either. It’s a good thing that Bear Stearns was saved. But it’s also a good thing that it nearly died. ♦