What happend to the Bear?

This latest worry for the Fed stems from the essential collapse of Bear Stearns, one of the largest U.S. investment banks.

Some of the trouble for Bear Stearns stemmed from the Global Legal Settlement of 2002 in which the 10 largest investment banks were barred from combining research and underwriting activities and required to pay substantial fines. Bear Stearns' original fines were approximately $80 million. The investment bank did have some insurance to help with the penalties except they management of Bear Stearns signed the Settlement agreement without talking to its insurers first as their contract stated. So there was $45 million of the penalty that Bear expected would come from insurers, but the insurers felt they hadn't been given sufficient notice. So, the two sides went to court.

Late last week, a NY appeals court ruled that the insurance companies were not responsible for that $45 million. So, Bear Stearns would now have to pay the $45 million penalty out of their own pockets. Worried that the investment bank would not be able to do so, shareholders got out fast. It was a fire sale on Bear Stearn shares dropping from a price of $68 per share on Tuesday, to under $30 per share on Friday to a buyout by JP Morgan on Sunday for $2 per share.

The problem for Bear Stearns is the same as all firms in today's securities markets - asymmetric information. Savers are having a hard time determining the risk of banks, investment banks, and publicly traded companies. With an increase in uncertainty comes an increase in the lemons problem. Without being able to tell stable investment banks from unstable, savers choose to pull back their lending.

The risk that this will spread is high. The increase in adverse selection problems after Bear Stearns has stopped most bank-to-bank lending. The interbank and federal funds markets are not functioning well. Those banks with reserves to lend are holding on to them for fear of getting a lemon.