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April 14, 2008

What did the Fed do?

There was an earthquake of sorts in the financial markets recently when the Federal Reserve organized a rescue of the investment bank Bear-Stearns. This is all high and confusing finance. Was this just about saving some investors, or was there something bigger at stake? Listen

Dr. Mike Walden, North Carolina Cooperative Extension economist in the College of Agriculture and Life Sciences at N.C. State University, responds:

"I think there was something much bigger at stake. Now Bears Stearns did have a lot of direct and indirect investments in the mortgage market, particularly in higher risk mortgages, so they have been hurt clearly by the fallout from the decline in housing. But the issue here was not just that Bears Stearns and its employees and investors would have been hurt, the issue here was whether this could have pulled down the entire financial system. And the reason it could is because investment banks as well as commercial banks are all intertwined. They lend each other money; there is a lot of loanable money in back of them. And so it's a domino effect. The fed was concerned that if Bears Stearns were to fall, that would be the first domino in perhaps a whole line of banks - commercial banks - that would either fail or have major losses. And really the first goal of the Federal Reserve, the reason - the major reason - it was set up in the early 1900s is to preserve the financial system, to make sure the financial system is working well. And so the Federal Reserve I think saw this as a major threat to the entire financial system, not just to one company, to really everyone. And of course we are all part of the financial system. That's why they moved in. They really serve as a backstop for the financial system, a lender's last resort. And I think the Federal Reserve was exercising that function in this Bears Stearns bailout."

Posted by Dave at April 14, 2008 08:00 AM