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Deposit Insurance For Sophisticated Investors?

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Has the bailout of Bear Stearn’s creditors created a precedent that implies a government guarantee for sophisticated investors doing business with investment banks? That’s what Nicole Gelinas argues in the editorial pages of the Wall Street Journal today.

[C]ounterparties on Bear's derivatives and other creditors like Bear's short-term financiers… should have known that they were taking on credit risk. Well, creditors are creditors; in a bankruptcy, they line up. What the Fed has done instead for these sophisticated investors is to offer them a rough approximation of FDIC insurance, even though they are not depositors and knew going in to the deals they had no such insurance.

For all the vague talk of “moral hazard” it’s nice to see Gelinas nail down one of the precise mechanisms. The Federal Reserve, with the help of JP Morgan, are rewarding lenders who extended financing to Bear Stearns and counter-parties who entered into complex derivative trades with the company despite—or perhaps out of ignorance of—the company’s shaky financial position. When you reward behavior, you get more of it. When you guarantee risk-taking, you get more risk. If Gelinas is right, the Fed’s intervention in the collapse of Bear Stearns may end up creating more risk rather than less in the financial markets.
The Bear Precedent [Wall Street Journal]