Bear isn't too big to fail, too important to fail

The Federal Reserve is bailing out Bear Stearns. But it isn't because the firm is too big to fail. It is a fraction the size of its competitors. And regulators usually leave stumbling brokers to fend for themselves -- as they did when Drexel Burnham and First Boston stood on the brink. But the financial system has become more tightly bound in recent years by webs of counterparty exposure. If one important player failed, the fallout would be keenly felt by all. Giving Bear access, with the help of J.P. Morgan Chase, to loans from its discount window, represents a huge increase in the Fed's willingness to support a broker -- an institution it doesn't directly regulate. Of course, the Fed has sponsored bailouts of entities outside its purview before, as when it herded banks to unwind Long-Term Capital Management a decade ago. Then, too, it was concerned about banks' counterparty exposure to the hedge fund. That kind of exposure has increased a lot since then through the ballooning derivatives markets. Credit derivatives, which barely existed when LTCM ran aground, now constitute a $50 trillion market, though much of that consists of offsetting contracts. Other derivatives markets have also grown. These have seen only one episode where a big counterparty defaulted -- when Enron went toes up in 2001. Its trading partners worked out their net exposures and negotiated settlements through the bankruptcy process. But that took time. If a big counterparty like Bear went bust today, it is unclear whether the result would be so orderly. Banks are racing to grab as much liquidity as possible, whether via margin calls from borrowers or at Fed loan auctions. And prices of many illiquid instruments are difficult to come by. It would be hard to quickly define each institution's net exposure to Bear. Until they knew where they stood, banks would be even less likely to lend, and more likely to try to grab collateral from counterparties -- accelerating the crisis. Bear may not be too big to fail, but its market role -- like that of its rivals -- may be too complicated. The Fed is right to try to keep it afloat. Sparkling History For much of its history, Bear thrived on its ability to handle risk. Founded in 1923 as a stock-trading partnership, Bear was transformed a decade later by the arrival of Salim "Cy" Lewis, a former Salomon Brothers trader, into a bond-trading powerhouse. In 1940, he jumped into takeover speculation, buying New York subway stocks and city bonds after correctly anticipating that the city would take over the subway lines. Under Mr. Lewis's successor Alan "Ace" Greenberg and then James Cayne, Bear expanded into other areas of fixed income, most notably the booming market for mortgage securities. It was one of the first on Wall Street to go public in 1985, and three years later also became one of the first to depart the Wall Street area and move to midtown Manhattan. --- Like Drexel Burnham Lambert Inc., which collapsed in 1990 after its main market, junk bonds, suffered a steep downturn, Bear's main market of mortgages has been the center of bond-market woes that hit Wall Street starting in June. But the Federal Reserve didn't intervene to stop Drexel's collapse, partly because the firm had been the subject of a bruising series of regulatory investigations that took hold in 1986.