It was not what we wanted to post for essay of the week, but sometimes you have to give way to current events. As everyone who has not been living under a rock knows, the major story of the week is the dramatic collapse of Bear Stearns. Since it is likely to heavily influence the news next week, we have decided to make this essay from Naked Capitalism essay of the week.

We do this with reluctance. Naked Capitalism has the best overview of the types of problems that are bound up in the Bear Stearns collapse, but we really think this issue has been overhyped. This problem will not end the world as we know it no matter what the traders on Wall Street think. As long as China, Japan, and Brazil are willing to buy treasuries at almost any price, then the US government will have plenty of money to throw at any problem. When you see a sharp rise in the interest rates on treasury bonds, then you can start screaming if you are so inclined. Until then save your breath.

Don’t get us wrong. The Bear Stearns collapse is not good news. But the thing that has kept this crazy house of cards afloat has been the fact that the US Federal Government has been able to pay historically low real interest rates on its debt even as it was running a record current account deficit and spending money on guns and butter like there was no tomorrow. Until that stops, things will still be reasonably all right in the US.

For that reason, a case could be made that it would be better to select this piece from Econbrowser on the TSLF, this piece from Brad Setser on central bank intervention, or this piece from Demography Matters on China’s inflation and labor shortages. All three of those essays talk about issues that will still be important next year when everyone will have already forgotten about Bear Stearns and are freaking out about other issues.

But since we live in the now, and not in the future, and since most people don’t have the time to read more than one essay in their spare time, it seems best to encourage people read Naked Capitalisms take on the issues raised by Bear Stearns collapse so that people know what the issues are.

From Reuters….

“You can safely assume that Bear is not alone here,” said an interest rate strategist at one European investment bank in London, who declined to be identified.

“We have been setting prices in swaps markets in recent days that were designed to say ‘no deal’ and at least one other U.S. investment bank — not Bear — dealt. That is very worrying if they needed the cash that badly. We have been forced to review our counterparty limits ever since.”

From the Independent……

A Goldman Sachs trader in New York said: “Everyone is in a total state of shock, aghast at what is happening. No one wants to talk, let alone deal; we’re just standing by waiting. Everyone is nervous about what is going to emerge when trading starts tomorrow.”

In the UK, Michael Taylor, a senior market strategist at Lombard, the economics consultancy, said on Friday night: “We have all been talking about a 1970s-style crisis but as each day goes by this looks more like the 1930s. No one has any clue as to where this is going to end; it’s a self-feeding disaster.” Mr Taylor, who had been relatively optimistic, has turned bearish: “It really does look as though the UK is now heading for a recession. The credit-crunch means that even if the Bank of England cuts rates again, the banks are in such a bad way they are unlikely to pass cuts on.”

Mr Taylor added that he expects a sharp downturn in the real UK economy as the public and companies stop borrowing. “We have never seen anything like this before. This is new territory for us. Liquidity is being pumped into the system but the banks are not taking any notice. This is all about confidence. The more the central banks do, the more the banks seem to ignore what’s going on.”

Mr Taylor added that the problems unravelling at Bear Stearns are just the beginning: “There will be more banks and hedge funds heading for collapse.”

The A-Team departed our factory, having established a system–several systems, really, all different–to reduce inventory by hiring more people to handle it. I am not sure they even managed to reduce the total inventory, or just where it was stored. Little matter either way; the next day, P.B. was told to start trimming his manpower. Click Here to continue reading.

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.