Why Bear Stearns needed to be saved

If the government had not intervened, the fallout from Bear Stearns would have been irreversible. ‘Laissez faire’ simply doesn't work any more, explains Karim Rahemtulla.

It hasn't taken long for some rogue to capitalize on the Bear Stearns (NYSE:BSC) collapse - but I have to admit, it's pretty clever. I found a new dictionary definition today: To be 'Bear Stearned.' Meaning: To mess up, fail miserably, or collapse. As in: 'Wow, I really bear stearned that test.' But don't get the Oxford's English Dictionary folks on the line just yet. This obviously isn't official.

Joking aside, the Bear fallout reminds us of a critical driving force within the stock market the fear factor. In Bear Stearn's case, the fear was absolutely warranted, as investors piled out of the stock en masse on news that JP Morgan (NYSE:JPM) had swooped in to gobble up the company for a mere $2 per share. At that point, it didn't matter whether they thought Bear Stearns should be left to fail. They just wanted out. And fast.

While some saved money, the ripple effect led many others to bail out of their other positions in fear. Make no mistake - financial catastrophe was truly on the doorstep. Thankfully, it's been averted for now - and hopefully forever. But let's examine what would have happened had the government not stepped in.

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These days, laissez-faire' just doesn't cut it

When it comes to the free markets, many people are laissez-faire thinkers. That is, they let the market solve its own problems, rather than external sources interfering with it.

In theory, this is an admirable philosophy. In practice, however, it can be a one-way ticket to catastrophe - particularly today. You see, those economists of yesteryear weren't confronted with 30-to-1 leverage, derivatives on derivatives, crooked bankers, lax rating agencies and malicious investors. So while the theory might make for good reading, it's often harder to put into practice. But what if there hadn't been a Bear Stearns bailout?

What if the Bear wasn't saved?

If Bear Stearns had just been left to fail outright, with no Fed-fueled rescue plan (as some think it should have), the stock market would have been absolutely battered this past Monday.

Imagine the scene at other investment banks, which would have collapsed under debt obligations that were not met and other agreements made with other banks were not met either.

Here's how this scenario would have played out:

The financial markets would have seized.

Your bank would have closed its doors.

The FDIC would not have the capital to cover all the assets in a nationwide bank run.

The government would have instituted capital controls.

Gold would have raced to $2,000 per ouncebut you would not be able to buy or sell it, since market trading would have been suspended.

The government would have no choice but to turn on the printing presses to unprecedented levels causing a massive devaluation in the U.S. dollar. In turn, this would have led to a total collapse of emerging markets and the currencies of those countries.

Even developed markets like the G7 would have also seen a collapse in their markets and currencies.

Your house would be worthless, your business would be worthless, and your assets would be frozen and devalued every hour.

Think I'm exaggerating? This is not some sensational fantasy. It actually happened 10 years ago when the Asian markets collapsed. I was there at the time and saw the carnage at first-hand. The only difference was that those markets weren't worth much to begin with. But the U.S. market, its assets and the financial system is worth in excess of $50 trillion.

The Bear needed to be bailed

So while we might not like the fact that the government bailed Bear Stearns out of the mess (to a certain extent), when that would never be the case with 99% of other businesses, it was an absolutely necessary step. After all, do you really think that the impact of a financial collapse like the one I laid out above would be limited to one country or one market? Not a chance.

This is one case when 'laissez-faire' economics would have caused Armageddon. Without a backstop, we'd be left to the devices of people. And I don't know about you, but there are certain people whose devices I wouldn't want impacting my financial well-being!

An irreversible crisis

The folks who think that it's okay for a financial system to collapse are the people who should scare you. They 'think' that they know the outcome for every crisis and it's that hubris that allows them to celebrate each time the markets or the dollar takes a tumble.

But here's the problem: some crises are irreversible and all the profits they intended to make will evaporate just as quickly as the underlying markets that they enjoyed undermining. Investing is usually a zero-sum game, but financial Armageddon is not.

When is fear justified?

There are hedge funds, investment banks, investors and plain old regular folks who crow victory every time the markets decline. That crowing gets even louder as we head toward catastrophe. Rumor mongering, financial trash-talking and outright selling and buying of targeted securities are all meant to produce one result: fear in the marketplace.

In Bear Stearns's case, that fear was totally warranted. But on many other occasions, it's not - and it's a smarter move to take the contrarian approach. Don't get me wrong. It's not always easy to do the opposite of what everyone else is doing. It takes real courage in your convictions.

But a mass sell off can also present some great opportunities to buy quality stocks at bargain prices. See what you can gain from the small cap sector that's been in trouble over the past few months.

By Karim Rahemtulla, Invesment Director, Mt. Vernon Research for the Smart Profits e-Report, www.smartprofitsreport.com