Every one got scared today because it came out that Bear Stearns was in danger of going under. But the fed rode to the rescue. Felix Salmon tries to justify the bail out….

While I have a certain amount of sympathy for this tough-love approach to the banking system, in the end I’m quite glad that Ben Bernanke and Tim Geither, softies that they are, went down the route that they did. Not because I think Bear’s shareholders deserve their $30 per share or whatever they’re going to end up receiving, but rather because of the sheer amount of wealth that could have been wiped off the stock and bond markets as a result.

It turns out, you see, that every mom-and-pop stock-market investor is actually, and rather unwittingly, taking investment-bank default risk, then. Which is why it’s nice to have a Fed on the lookout for them. So far, retail stock-market investors haven’t panicked; let’s try and keep it that way, shall we?

But for my money, I think the Naked Capitalism has the right take….

Bear is a large prime broker, which means it lends to hedge funds. It is also a significant counterparty in enough different credit markets that its collapse would have at a minimum caused panic as to who might have been hurt. You’d have a further scramble for liquidity and reluctance to lend, which is precisely the condition the Fed has been trying to alleviate.

In particular, according to Bloomberg, Bear was the second largest underwriter of mortgage bonds, The lead manager (I’m assuming Bear was also a significant lead manager) is the only one who knows where the bonds went and is thus in the best position to trade them. So Bear’s role as an important market-maker may have played into the calculus.

But the answer to the question of whether Bear should have been allowed to tank depends on how long it would take the crisis to pass. Swap spreads were elevated a full year after the LTCM rescue, but here the relevant metric would be how long the acute phase might take. If it was two weeks or a month, and no one save maybe some middling sized hedge funds (or a lot of teeny ones) would fail, that would have been acceptable. But the Fed couldn’t assess this in a 24 hour period. (However, some parties believe that the Fed’s $200 million TLSF was in part to assist Bear; if so, they’ve had at least a week to evaluate this risk. But in that case, I’m not certain they asked the right questions).

I still think Bear should have been permitted to fail. Now every the same size or larger knows the Fed will ride into the rescue. This is a terrible precedent. It also increases the odds of the Fed running out of firepower long before the crisis is over.

Even with the rescue, markets still dropped today.