The Federal Reserve and the Treasury Department have orchestrated the survival of Bear Stearns. The defenders of that maneuver argue that if Bear Stearns had failed it would have created a lot of collateral damage, so much collateral damage, that you and I, normal folk who don't invest in hedge funds, normal everyday people who know nothing about high-falutin' financial instruments like "collateralized debt obligations" would have been engulfed as well...
...by subsidizing the marriage of Bear Stearns and JP Morgan, the government has removed some of the loss from the profit and loss system...
...government bails out Bear Stearns and its creditors rather than letting those who have been reckless learn a lesson for the next time.
I disagree. Bear Stearns was liquidated in a hurry. The market was in the process of liquidating it and forcing it to sell its assets for less than what I believe they were worth. I believe that both J.P. Morgan and the taxpayers are going to make a profit at Bear Stearns' expense. I don't see this as creating moral hazard.
I believe that something different is going on with homeowners. The problem for homeowners is not that they are being forced to sell valuable homes at fire-sale prices. In general, the problem is that they overpaid for their homes to begin with. If the Fed wanted to supply funds to keep homeowners in their homes, the Fed would end up losing money.
My claim is that if Bear Stearns had access to capital or to large loans at reasonable rates for sufficient time, it would eventually turn out to have positive net worth. No amount of capital or loans will enable a borrower with a $400,000 mortgage on a $350,000 home to have positive home equity.
When the "shadow banking system" does not have capital requirements, normal financial activities, as regulated by the Fed, are inefficiently taxed and too much of an economy's leverage ends up in the unregulated shadow banking sector.
I agree that regulatory arbitrage is a big deal. Regulatory arbitrage exists when one institution can invest in a given asset more profitably than another institution solely because of its lower capital requirements. Fannie Mae and Freddie Mac took most of the risk in mortgage markets away from banks and savings and loans in a remarkably short span of time, thanks to regulatory arbitrage. The subprime mortgage market was largely the creation of an even less-regulated set of institutions. Many of them are now defunct and will not be missed.
What keeps less-regulated institutions from taking all risky assets away from banks? Government safety mechanisms, including regulation, allow banks to borrow more cheaply than other firms. To the extent that government safety mechanisms are being extend to investment banks, their cost of funds will be artificially low, because they do not face bank capital regulations.
However, I am not convinced that the government has effectively guaranteed investment banks. Again, I do not think that the government prevented the demise of Bear Stearns. Instead, it took a speculative position in Bear Stearns' assets.
I am also not convinced that government can get capital regulations right for investment banks. The capital regulations for commercial banks seem to be working well. The capital regulations for Freddie and Fannie were working well ten years ago, but that may not be the case today. Capital regulations for investment banks will be no better than the state of the art of risk measurement. And state-of-the-art risk measurement is what failed to prevent the current problems.