This is pretty basic, but I still haven't seen an answer. I keep seeing phrases like "total meltdown" and "massive instability", but I don't know what people really mean.
So Bear Stearns files bankruptcy. A court freezes their assets and liabilities while they come up with a work-out plan. Probably all the creditors eventually get close to 100 cents on the dollar, they just have to wait until Bear’s assets turn into cash.
Of course, Bear Stearns' creditors (A) have creditors of their own (B). A has trouble paying B because A can’t get cash from BSC. However, A should have some capital and liquidity. Unless A’s position with BSC was awfully big, A should be able to pay off B. Maybe we can find one or two other brokers that end up with bankruptcy “protection”, but not everybody.
What does this have to do with the rest of the economy? The rest of us are still making stuff and selling stuff and getting paid.
I can see some psychological impacts. Consumers and businesses are a little more cautious, and that leads to a recession. But, so what? We had a bunch of supposedly smart people make some really dumb decisions, it’s no surprise that would have some fallout. Maybe next time we’ll be a little more careful.
I guess I’m saying that I have trouble seeing an inevitable path from “Bear Stearns declares bankruptcy” to “massive depression”, and I’m having trouble justifying the Fed diving into this just to avoid a recession.