Today the Treasury Department will ask Congress for new Fed powers to protect the financial markets from the specter of "systemic risk" posed by investment banks as well as commercial banks. The Fed should not have the unilateral authority to bail out investment banks like Bear Stearns.
The flawed process employed by the Fed in that unprecedented move violated the spirit of an important law -- the Federal Deposit Insurance Improvement Act. The FDICIA was passed specifically to establish procedures to be used by regulators when dealing with failed financial institutions. But FDICIA applies only to federally insured depository institutions, like banks and savings and loan associations. When the statute was passed nobody in their wildest dreams thought that government bailouts would extend beyond federally insured deposit institutions to include investment banks -- which unlike commercial banks have no small creditors and no federally insured deposits to protect.
The event that led to the FDICIA's rules on bailouts occurred in 1984, when federal regulators determined that Continental Illinois Bank & Trust Co., then the seventh largest bank in the U.S. was too big to fail. Continental was teetering on the edge of insolvency as a result of bad loans acquired from the financially troubled Penn Square Bank. Large uninsured depositors, particularly foreign governments and non-U.S. corporations, began a run on the bank. Fearing that closing Continental would destabilize the entire banking system, the government organized a complex rescue package that provided $4.5 billion in permanent financial assistance in exchange for the transfer of $4.5 billion in non-performing loans to the Federal Reserve Bank of Chicago.
The FDIC also contributed $1 billion in new capital to the bank in exchange for non-voting preferred stock and other assets. The Fed chipped in, promising to provide the funding necessary to satisfy Continental's short-term cash requirements. After the Continental Illinois bailout, bank bailouts became routine until Congress put a stop to the practice when it passed FDICIA in 1991.
The Bear Stearns bailout has two important things in common with the Continental Illinois bailout. First, and unlike the 1998 bailout of the hedge fund Long Term Capital Management, the Bear Stearns bailout puts government funds at risk.
In fact far more government funds are being put at risk in the Bear Stearns bailout then were put at risk in the Continental Illinois bailout. The Fed had to promise to lend $30 billion to J.P. Morgan Chase at a substantially below-market rate -- currently 2.5% -- in order to persuade it to assume Bear Stearns's liabilities. J.P. Morgan is using the collateralized debt obligations and other deeply troubled assets on Bear Stearns's books as collateral for the loan. The government is bearing all of the risk beyond the first billion in losses, which amounts to a total of $29 billion in contingent liability for taxpayers.
Second, like the Continental Illinois bailout and other discredited bailouts of the 1980s, the Bear Stearns bailout protects all of Bear Stearns's creditors, not just the small vulnerable ones, from losses. These public policy problems -- risking public funds and bailing out fat-cat creditors -- were precisely the public policy problems that Congress sought to avoid when it enacted FDICIA.
The only significant difference between the Continental Illinois bailout and the Bear Stearns bailout is that Continental struggled along for a decade before being acquired, while Bear Stearns is being absorbed immediately into J.P. Morgan. As at Bear Stearns the Continental board of directors and top management were removed and the company's shareholders lost most of the value of their investments. Oddly, the Bear Stearns shareholders are emerging from this bailout far better than the Continental Illinois shareholders emerged from theirs.
FDICIA was designed to minimize use of the discredited "too-big-to-fail" doctrine for a number of reasons. Principal among these was that it unfairly benefits large banks at the expense of smaller rivals since only big banks are too big to fail. The too-big-to-fail strategy also creates significant moral hazard, as creditors have no incentive to monitor and control the flow of credit to large borrowers that are considered too big to fail.
Key provisions of FDICIA were designed to curtail drastically the ability of regulators to utilize the too-big-to-fail doctrine to bail out distressed financial institutions. In particular, FDICIA required that the bailout strategy that imposes the least cost on the government deposit insurance funds should be employed. To employ an alternative strategy requires a vote of two-thirds of the directors of both the FDIC and the Federal Reserve, who must then recommend in writing to the Treasury secretary that a bailout be employed. Then the Treasury secretary must consult with the president of the United States to determine that employing the usual resolution procedures "would have serious adverse effects on economic conditions or financial stability" and that the planned action would "avoid or mitigate such adverse effects."
Moreover, FDICIA requires that losses to the FDIC insurance fund from a too-big-to-fail rescue effort must be expeditiously recovered from a special assessment on the banks that contribute to the FDIC insurance fund. And any too-big-to-fail rescue must be investigated by the General Accounting Office.
There is no reason to apply this statutory framework to banks but not to investment banks. The purpose of FDICIA was to make sure that the only bank creditors protected by government bailouts should be those who enjoy the benefits of the FDIC's federally sponsored deposit insurance protection. None of Bear Stearns's creditors enjoyed such protections. Indeed, unlike commercial banks, Bear Stearns never contributed a dime in insurance premiums in exchange for the protections it got from the government.
The bailout of Bear Stearns creates an unfair competitive environment in U.S. financial markets that is worse than the unfairness that led to FDICIA. Not only are large firms being favored over small firms, but investment banks are getting for free a better government bailout than commercial banks receive only after paying insurance premiums to the FDIC. The result will further weaken the U.S. banking industry and lead to a wave of mergers among investment banks seeking to become "too big to fail."
Mr. Macey is a professor of law at Yale.