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Why the Feds Stepped in to Save Bear Stearns

To find out what has caused the crisis with Bear Stearns, double click on the above 'South Bank' video. It is very, very funny.

Amidst all the gallows humor, I have to admit this was one of the best explanations that I have heard for our current crisis, and why sharp and sophisticated parties like the insurers, the bond raters, and the large institutional investors failed to properly assess risk, underlying securities, such as the "Bear Stearns High Grade Structured Credit Enhanced Leverage Fund".

The video also illustrates the Fed's bandaid solution is symptomatic of the way they are addressing the crisis as a short-term liquidity crisis, rather than an underlying credit and insolvency crisis.

Alan Greenspan, the dry, sometimes acerbic, former chairman of the Board of Governors of the Federal Reserve from 1987 to 2006, who must share much of the blame for encouraging the easy credit, housing bubble, nevertheless echoed much of the video with his recent remarks:

The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities....(2010?)

Discontinuities are, of necessity, a surprise. Anticipated events are arbitraged away. But if, as I strongly suspect, periods of euphoria are very difficult to suppress as they build, they will not collapse until the speculative fever breaks on its own. Paradoxically, to the extent risk management succeeds in identifying such episodes, it can prolong and enlarge the period of euphoria. But risk management can never reach perfection. It will eventually fail and a disturbing reality will be laid bare, prompting an unexpected and sharp discontinuous response. (a "shall I jump out the window" moment?)

This gloomy appraisal was taken from his article in the London 'Financial Times' 'We will never have a perfect model of risk'... especially, as Kevin Drum underlines, that "all those risk management systems created by 'the rocket scientists' weren't designed to take into account the possibility that there was any actual risk in the system".

Note: Wizbang Blue is now closed and our authors have moved on. Paul Hooson can now be found at Wizbang Pop!. Please come see him there!

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Editors: Lee Ward, Larkin, Paul S Hooson, and Steve Crickmore

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