Bear Stampede Outdoes Even `Mary Poppins' Panic: Kevin Hassett

Commentary by Kevin Hassett

April 7 (Bloomberg) -- With congressional hearings filling the airwaves, Federal Reserve officials defending unprecedented moves, and a hail of new acronyms battering our heads, something important is clearly going on in the U.S. financial system. Trouble is, most people have no idea what it is.

All one really needs to understand the Bear Stearns Cos. mess is two words: ``Mary Poppins.''

Last September, historian Niall Ferguson wrote a prescient piece in the Telegraph of London that alluded to the movie classic and suggested that it wouldn't take much to cause a liquidity disaster today.

In the film, recall, young Michael starts a run on a bank when he demands that the bank president, Mr. Dawes Sr., return his tuppence. Screaming ``Give it back, Gimme back my money!'' Michael incites a panic, and depositors rush to get their money out, as a banker yells, ``stop all payments.''

Almost nothing at all happens, but a bank run occurs, nonetheless.

As Ferguson foresaw, Bear Stearns Chief Executive Officer Alan Schwartz last week made the case that something similar happened to his company, with the exception being that the problem was started by individuals with malicious intent.

``It looked like more than just fear -- it looked like people wanted to induce a panic,'' he said.

Christopher Cox, chairman of the Securities and Exchange Commission, lent some credence to the accusation, when he told Congress the SEC is investigating the matter.

Plausible Scenario

Is such a scenario plausible? A review of the business model of the New York-based investment bank suggests it might have been. Here is a sketch of how things might have gone:

Bear Stearns participated in many bank-like activities. Fund ``A'' might have an account with Bear Stearns and decide it wants to hold General Motors stock for a while. Bear Stearns would hold the stock for its client, and then might decide to lend it to a firm -- Fund ``B'' -- that wanted to short the shares, or bet that they will decline in value.

Suppose Fund A hears a rumor that some people have started having trouble getting access to their assets at Bear. Fund A might decide to cut and run, in which case it would order Bear to sell the General Motors Corp. stock and hand over the cash. But Bear has already loaned the shares to Fund B, and can't buy them back right away. So it would need to borrow money from somebody else.

Bear in a Bind

If nobody else stands willing to lend, then Bear's in a real bind. Once the bind is visible, then every other client might panic, which would create the kind of stampede that shut the teller windows in Mary Poppins.

It's easy to see how such a scenario could spin out of control. Even if Bear had enough assets sitting around to clean up the mess, it couldn't liquidate them fast enough, given that a run had already begun.

It might be that shrewd short sellers with big accounts told Bear to give them their money back at the same time they shorted Bear Stearns stock because they suspected, given Bear's other financial troubles, that such a move may ignite a panic.

Word spreads fast when such things occur on Wall Street, and once the stampede began, every short seller worth his salt might well have jumped on the bandwagon. Clever traders are good at hiding their strategies from others when they need to. They do so by spreading their trades out among many different firms, for example.

Neither Illegal, Immoral

In this case, however, a clever trader might have wanted others to know what he was up to and could have done so simply by loading all of his short trades in one place.

Such actions need not have been illegal, or even immoral. Bear proved to be susceptible to a run. Guessing that ahead of time and warning others might have just been good business. Only time will tell whether the investigations will turn up any true villains.

The scariest thought is that if such a strategy could bring down Bear, it might take out others as well. The good news is that this now seems very unlikely.

The main lesson of the Bear Stearns debacle is simple: The U.S. has allowed a number of institutions such as Bear to emerge that really are in the business of doing what banks do but haven't been folded into the banking system in a way that affords them the same kind of protection from runs that banks have.

Fed Stands Ready

The Fed clearly now understands this, which is why it created the Primary Dealer Credit Facility, which stands ready to lend to Wall Street Banks. Much work needs to be done to construct a regulatory structure that recognizes the new realities, but a run such as that against Bear should no longer work.

The Fed move came too late for Bear investors, but it's a sign the March crisis, like Mary Poppins, will have a happy ending. We entered March with policies that invited disaster. Financial disaster was averted, and we enter April with a regulatory system in place that should allow investment banks to flourish once again, without worrying that another run is around the corner.

(Kevin Hassett, director of economic-policy studies at the American Enterprise Institute, is a Bloomberg News columnist. He is an adviser to Republican Senator John McCain of Arizona in his bid for the 2008 presidential nomination. The opinions expressed are his own.)