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Fed Intervention Changes the Rules

MICHELE NORRIS, host:

From NPR News, this is ALL THINGS CONSIDERED. I'm Michele Norris.

MELISSA BLOCK, host:

And I'm Melissa Block.

In the wake of Bear Stearns' near-death experience and the deal that allows it to be purchased by JPMorgan, U.S. financial markets took a hit today, but the damage wasn't nearly as bad as overseas where most markets fell between 3 and 5 percent. The NASDAQ and S&P were down 1.6 percent and 9/10th of a percent respectively, the Dow Jones Industrials plunged at the open but actually ended the day slightly higher.

NORRIS: The dramatic collapse of Bear Stearns over the weekend is a huge event, one of the largest financial panics since the Depression. But something else happened over the weekend that might have longer term implications. In order to respond to the crisis, the Federal Reserve had to change some of the fundamental rules of U.S. banking. Its goal was to stop a spread of panic that could've undermined the U.S. and world economies.

NPR's Adam Davidson joins us now.

And Adam, what is this rule that the Fed changed and why is it important?

ADAM DAVIDSON: I think it's important to remember what the Fed does. They are the psychological bulwarks, the core bedrock on which our entire economy is built; basically, through their job of being the lender of last resort. What that means is your bank or any bank in the U.S. that gets into serious trouble can always borrow money from the Fed. That is what gives us confidence in banks. The thing is, that lender of last resort did not extend to investment banks, to places like Bear Stearns or shares of Lehman or Morgan Stanley or Merrill Lynch, these massive institutions. When the Fed was created in 1913, they didn't play anywhere near the role in the economy that they do today. So what the Fed did over the weekend is basically move from 1913 to 2008 by extending that lender of last resort job to investment banks in general so that they won't collapse.

NORRIS: Now, as I understand this, the government basically allows banks to go to a proverbial discount window if they run into a little bit of trouble.

DAVIDSON: The discount window was created at a much simpler time. This is back when bankers were guys with big mustaches and top hats sitting over handwritten ledgers and they'd actually go down to a discount window - an actual window - where there would a teller, a Federal Reserve teller who would hand them paper worth $7 million that they bring back to their bank and keep themselves alive. Obviously, we live in a much different world today. We live in a world of computers and investment banks and sophisticated derivative financial instruments, a world that the Fed of 1913 would not recognize at all.

NORRIS: But Bear Stearns isn't the first investment bank to find itself on shaky ground. Why did the Fed act now and are there any concerns that they perhaps overstepped their boundaries?

DAVIDSON: First of all, the broad thing they did of extending the lender of last resort credit to investment banks, that's an idea that I think most people would say is long overdue. The problem is it's extremely political. When you talk about rewriting rules, the investment banks are going to have a say, the Democrats who think the investment banks are getting a sweetheart deal are going to have a say, it would get very tense. A lot of times, you have to wait until a big crisis. And so, over the course of a weekend, the Fed created a series of reforms that many wanted to have happen 20 years ago.

Now, the more narrow thing they did, they basically prevented Bear Stearns from going bankrupt, from becoming insolvent. That more narrow activity just regarding Bear Stearns is much more controversial. There are people who say the Fed should have just let Bear Stearns go under and sure it would've hurt a lot of people and sure it would have caused tremors throughout the financial system, but that's the whole point of capitalism. When you make mistakes, there is real price to pay, and so that that has gotten more mixed reviews.

NORRIS: Thank you, Adam.

DAVIDSON: Thank you, Michele.

NORRIS: That was NPR's Adam Davidson. Transcript provided by NPR, Copyright NPR.

NPR transcripts are created on a rush deadline by an NPR contractor. This text may not be in its final form and may be updated or revised in the future. Accuracy and availability may vary. The authoritative record of NPR’s programming is the audio record.

Adam Davidson
Adam Davidson is a contributor to Planet Money, a co-production of NPR and This American Life. He also writes the weekly "It's the Economy" column for the New York Times Magazine.