Bear Stearns wipeout signals sea change

(Fortune) -- Bear Stearns is gone, but the brokerage firm's near collapse will live on as the moment it became impossible to ignore the mortgage mess.

Shareholders of the New York-based brokerage firm voted Thursday to approve JPMorgan Chase's $2.2 billion all-stock acquisition of Bear. The outcome was no surprise: JPMorgan (JPM, Fortune 500) already owned almost half of Bear Stearns' stock outright, and Bear execs and directors who owned a sizable bloc of shares had pledged their support as well. With the shareholder vote, Bear's 85-year run as an independent company has come to an end.

What won't go away are the outsize implications of JPMorgan's mid-March rescue of Bear Stearns (BSC, Fortune 500), for investors and taxpayers alike. The Federal Reserve Bank of New York brokered Bear's sale to JPMorgan, in large part because of worries that the failure of the nation's fifth-biggest investment bank could throw the financial system into a tailspin. Critics lashed out at the Fed, saying investors will use the rescue as a license to make risky bets in expectation of a bailout. Taxpayers already are on the hook for a bill as high as $29 billion, thanks to the Fed's agreement to backstop JPMorgan by buying some mortgage-backed securities out of Bear Stearns' troubled portfolio.

Still, some market players say that by reacting as it did, the Fed - which only last year was still claiming the subprime meltdown was contained - distinguished itself as the first official body to recognize the depth of the credit crisis, and to act accordingly. The tab for the nation's bubble-era mortgage-market excesses must be paid, according to this view, so the sooner all come to grips with reality the better.

"The Fed simply recognized the facts on the ground," says Don Brownstein, chief executive at Structured Portfolio Management, a Connecticut-based hedge fund that made a killing last year betting against subprime mortgage-related securities. By lending more freely to various financial institutions, Brownstein says, Fed chief Ben Bernanke saw "that the definition of a bank needed to be made compatible with actual practice."

JPMorgan agreed March 16 to buy Bear for the token price of $2 a share, after a weekend of emergency meetings involving Bear, JPMorgan and regulators headed off a possible bankruptcy filing. The talks came after Bear Stearns customers fled the firm amid rumors that it was running low on cash. A week later, the sides hammered out an amended deal that raised the per-share price to around $10, solidified JPMorgan's obligation to stand behind Bear's debt and gave JPMorgan the right to buy a big stake in Bear within two weeks, quelling what was shaping up as a rebellion by restive shareholders.

The decision to help rescue Bear wasn't a simple one. By brokering the Bear Stearns rescue and making emergency loans available to investment banks such as Lehman Brothers (LEH, Fortune 500) and Goldman Sachs (GS, Fortune 500), the Fed has put itself in the uncomfortable position of lending money to entities it doesn't regulate. That disconnect will be resolved only through political reform that may take years to negotiate.

That's not the only uncomfortable aspect of the rescue for some observers. Vincent Reinhart, resident scholar at the American Enterprise Institute in Washington, writes that federal action on behalf of Bear Stearns investors could clear a path toward a broader and more costly bailout of banks and individual borrowers.

He wrote this month that polls show most voters reject mortgage-relief efforts, because the great majority of them are current on their payments. But the Fed's decision to provide taxpayer support for the hasty takeover of an investment bank whose top officers make millions of dollars annually reframes the question, Reinhart says, in a way that makes federal aid more palatable.

"In effect, greater unfairness among households in offering debt relief to some now seems insignificant," he wrote last week in the Washington Post, "when compared with the unfairness wrought by the Fed between the financial sector and households."

The Fed isn't blind to the skeptics' concerns. Even back in March, in the weeks after the sudden flight of Bear's customer base left the firm on the brink of a bankruptcy filing, some officials were warning that Fed involvement would have far-reaching consequences.

"Recent events have likely reaffirmed and strengthened some creditors' expectations of support, or have created those expectations for the first time," Minneapolis Fed President Gary Stern said in a speech two months ago in London, just days after JPMorgan and Bear hammered out their revised merger agreement. "We simply cannot allow widespread perceptions of government support to pervade the financial system."

Since then, fears of another run on a bank have dissipated, as investors have concluded the Fed won't allow another major financial institution to collapse. But Brownstein stresses that "the worst for the real economy is yet to come," as job growth slows, home prices fall and consumer spending, the driver for most U.S. economic activity, drops.

Meanwhile, the Fed seems to have set itself up for an expanded regulatory role, as envisioned in the blueprint Treasury Secretary Henry Paulson outlined earlier this year. But that's a subject for Congress to take up at some point in the future. For now, Brownstein says, Bernanke deserves credit because, given the circumstances, "he had to push the envelope."