Let's look at Bear Stearns to see why it failed. Then we need to see why the federal government is bailing the bankers out even though by law, they're not supposed to.
Bear Stearns is a bank. Banks borrow money and then lend it out, making their profit by paying lower interest rates on the borrowed money than they charge on the loans they make.
The borrowed money is of two kinds. Retail banks take deposits from savers. Those are the savings accounts we know that the government insured for up to $100,000. Financial banks, like Bear Stearns, get loans from investors. But as far as the bank is concerned in both cases they are borrowing money to lend.
The difference between what the bank pays for borrowed money is rarely more than one or two percent. The bank only has to keep enough money on hand to cover repayments to the depositors/lenders who supplied the funds in the first place. This is the reserve requirement. The greater the reserves the bank keeps, the less likely that bad loans will prevent it from repaying depositors/lenders who provided the money in the first place. Currently the Federal Reserve requires commercial banks to keep a 10% reserve behind all loans made for working capital and transactions loans for which there is no security other than the borrower's signature.
As long as the borrowers pay the bank its loans, borrowing money to lend at a higher interest rate is a money machine. What's the flaw? Well, loaning money to borrowers always runs the risk that the borrowers won't pay it back. Then the bank loses not only the interest they were expecting, but also some or all of the money they loaned out. Remember, this money was from depositors or lenders, who are also in danger of losing the money they deposited with or loaned to the bank.
Here is where the government steps in. If the bank can't repay its depositors, the government guaranteed repayment of up to $100,000. That makes lending to a commercial bank (depositing money savings accounts) a lot less risky than lending to a financial bank. (A side effect is that such deposits, being loans to the bank that have no risk, pay a low interest rate.) But the government is not in the business of handing bankers money to lend at a profit and then covering the bank's losses when it makes bad loans. So they demand that the bank have "reserves" - money kept on hand and not loaned out that will be the bank's first source of funds to cover bad loans. A 10% loans means that the bank borrows $100, but can only lend out $90. The bank loses the interest on the $10 kept in reserve, but those funds permit it to repay depositors/Lenders when they demand their money back. It is when those depositors/lenders demand their money back and the bank cannot provide it that a "Run on the Bank" occurs.
But reserve requirements only apply to banks that expect the government to repay its depositors if it can't. Bear Stearns was not a retail bank and had no insurance from the government. By giving up the insurance, Bear Stearns was given the privilege of not keeping reserves and not being subject to bank inspections. It was assumed that the lenders who provided the funds would be sufficiently knowledgeable and informed so that they could measure the risk Bear Stearns was bearing on its loans. For every dollar of capital the company had, it loaned out $32 which amounts to about a 3% reserve. They could make a lot more money than a regulated bank that had to keep a 10% reserve and was prohibited from making the most risky (and most profitable) loans. There was no expectation that the government would step in and save the bank when it underwent a Run.
Only - Bear Stearns was so large, and so deeply embedded in the entire financial system, that it was decided if they went under they could take a number of their lenders with them. The entire financial system was at risk when Bear Stearns failed. So the Federal Reserve provided guarantees of a lot of taxpayer money to Bear Stearns' lenders and then sold it off to J. P. Morgan.
So now the financial banks are on notice that they, too, are protected by government guarantees. Only they don't have to avoid the risky loans and the low capital ratios that made Bear Stearns so vulnerable.
That set the financial bankers up to be able to make the riskiest and most profitable loans, knowing that if the loans go bad the government will bail them out, and if the loans don't go bad, they get the profits.
Even the financial bankers are now saying that some regulation and reporting requirements need to be imposed on the riskiest high-flying financial banks.
Oh, and what caused the credit crisis? These high-flying financial banks were supposedly very knowledgeable about the risks they were taking when they loaned money. Residential mortgages were supposed to be the safest of loans with a very low rate of default. So they were bundled together in great securities with thousands of individual mortgages. The rating agency looked at them, assumed that the good mortgages would cover the risky sub-prime mortgages, and sold the whole package as very safe AAA securities.
When it was learned that the number of bad loans were much higher than previously known, suddenly the lenders providing funds to Bear Stearns and other did not know if they could get back money they loaned those banks. So they quit loaning to anyone depending on such massive mortgage-backed securities. And that turned out to be almost everyone.
Worse, when the mortgage-backed securities were first created and sold, the original documentation did not go with the security. Just a computerized summary of each mortgage. The cost of finding that original paper documentation and having someone review it was impossible to imagine. So no one knows just how risky any mortgage-backed security is.
Since Bear Stearns had only about $3 reserve behind every $100 of loans they had made, no one who loaned money to them had any reason to believe they would get their money back. So all lending to Bear Stearns stopped and all lenders with loans already made wanted their money back - all at once. That $3 reserve was smoke in a high wind.
Bear Stearns was bankrupt and the offer of $2 a share was a gift to the stockholders. There was nothing of any value to back even that $2 per share price. That's what a run does to a bank. But it was too big to fail, so the government had to provide taxpayer money to bail out the bankers who made the bad loans.
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