Bear Stearns Should Have Been Allowed To Go Bankrupt


The notion that the government did the right thing by bailing out Bear Stearns but went wrong when it let Lehman Brothers go is absolutely wrong. It would have been far preferable if the crisis management of Bear Stearns failure had been restricted to ameliorating the secondary effects of the bailout while letting Bear go into the bankruptcy it was hurtling toward in March of 2008. The markets would have been far better prepared for the eventual collapse of Lehman Brothers if that had occured.

We’ve argued this point in this space before. Now David Skeel, a bankruptcy professor at the University of Pennsylvania Law School makes a very similar point in The Weekly Standard.

The conventional wisdom about the bailouts of 2008 goes something like this. Federal regulators started off on the right foot by bailing out Bear Stearns and midwifing its sale to JPMorgan Chase. They were right to bail out AIG six months later, but botched the execution. And Lehman Brothers, the only exception to the bailout rule, showed once and for all that bankruptcy is not an adequate way to handle the collapse of a large financial institution.

But what if regulators hadn’t bailed out Bear Stearns? If we conduct this simple thought experiment, it raises serious questions about both the conventional wisdom and the Obama administration’s new proposals for regulating investment banks and bank and insurance holding companies. Bankruptcy starts to look much better, although it could use several market-correcting tweaks.

You should read the whole thing, where he describes exactly what this thought experiment looks like. He concludes by arguing that allowing bankrupcty for failed financial institutions, rather than bailouts and resolution authority, would allow the markets to work once more. Creditors would have to figure out the creditworthiness of banking firms, rather than attempt to game the system through regulatory arbitrage bets on what regulators will do.

(Hat tip: Professor Bainbridge.)

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