Fears that the bankruptcy of Bear Stearns would cause widespread uncertainty about the financial conditions of other global investment banks and further deepen the credit crunch prompted Federal Reserve officials to engineer the company's rescue plan, New York Fed Bank President Timothy Geithner said.

Geithner outlined the events leading up to the Fed's rescue plan for the troubled New York investment company in Thursday's testimony before the Senate Banking Committee.

"The news that Bear's liquidity position was so dire that a bankruptcy filing was imminent presented us with a very difficult set of policy judgments," Geithner said.

"In our financial system, the market sorts out which companies survive and which fail. However, under the circumstances prevailing in the markets, the issues raised in this specific instance extended well beyond the fate of one company," he told the Senate panel.

In the days leading up to the March 13 intervention, fixed income traders began hearing rumours that European financial institutions had stopped doing fixed income trades with Bear Stearns, according to Geithner.

Fearing that their funds might be frozen if the company ended up in bankruptcy, a number of U.S.-based fixed-income and stock traders that had been actively involved with Bear Sterns reportedly decided to stop doing business with the company.

Many firms started pulling back from doing business with Bear Stearns and some hedge funds that used it to borrow money and clear trades were withdrawing cash from their accounts, he said. Some large investment banks stopped accepting trades that would expose them to Bear Stearns, and some money market funds reduced their holdings of short-term company-issued debt, Geithner said.

The rumours of Bear Stearns' failing financial health caused its balance of unencumbered liquidity on March 13 to decline sharply to levels that were not adequate to cover maturing obligations and funds that could be withdrawn freely.

"It became clear that Bear's involvement in the complex and intricate web of relationships that characterize our financial system, at a point in time when markets were especially vulnerable, was such that a sudden failure would likely lead to a chaotic unwinding of positions in already damaged markets," Geithner said.

He said Bear Stearns' failure to meet its obligations would have cast a cloud of doubt on the financial position of other institutions whose business models bore some superficial similarity to Bear's, without due regard for the fundamental soundness of those firms.

"The sudden discovery by Bear's derivatives counterparties that important financial positions they had put in place to protect themselves from financial risk were no longer operative would have triggered substantial further dislocation in markets," the New York Fed president said.

There was a potential for the company's counterparties to liquidate the collateral they held against those positions and to attempt to replicate those positions in already very fragile markets, he said.

"We judged that a sudden, disorderly failure of Bear would have brought with it unpredictable but severe consequences for the functioning of the broader financial system and the broader economy, with lower equity prices, further downward pressure on home values and less access to credit for companies and households," Geithner said.

Geither outlined some principles that should guide changes to the regulatory framework in order to avoid another similar financial meltdown.

"We need to ensure there is a stronger set of shock absorbers, in terms of credit and liquidity, in those institutions, banks and a limited number of the largest investment banks, that are critical to market functioning and economic health, with as stronger form of consolidated supervision over those institutions," he said.

Regulatory arbitrage should be reduced by consolidating and simplifying the regulatory framework, he said. "We need to make the financial infrastructure more robust, particularly in the derivatives and repo markets, so the system can better withstand the effects of default by a major participant."

In the Q&A after his testimony, Geither told the committee that the Fed would have been very uncomfortable lending to Bear Stearns from the discount window because it was in desperate financial straits.

Geithner expressed his personal view that Bear Stearns was not a sound institution. "In all these (Fed lending) facilities we need to be very confident that we're lending to a sound institution," he said. "Looking back, it is not obvious that the dealer discount window lending facility would have been powerful enough" to save Bear Stearns.

"These are very exceptional conditions we're facing in markets," Geithner said. "We're thinking through what is adequate liquidity for firms. We've seen a substantial withdrawal in the markets to finance collateral."

By Steve Campbell, edited by Stephen Huebl and Cristina Markham