Fed’s Innovative – Or Hazardous – Strategy

Frontier Centre, Role of Government, Uncategorized, Worth A Look

The Federal Reserve dusted off a tool it hasn’t used since the Great Depression Friday, then tweaked it to rush financial aid to one of the nation’s biggest investment banks.

In an unprecedented move, the Fed pumped credit into JPMorgan Chase & Co., one of Wall Street’s bedrock institutions. JPMorgan then funneled the money to Bear Stearns Cos., an investment bank with Silicon Valley ties, to help it avoid defaulting on over-leveraged investments.

Supporters of the Fed considered the emergency loan a gutsy move that could help stop the mortgage crisis from sinking the economy. Opponents say the Fed should stay out of it and let Wall Street swallow its bitter pill.

Lyle Gramley, an ex-member of the Fed’s governing board and former economist for the Mortgage Bankers Association, painted Friday’s action as a shrewd gambit to prevent the subprime mortgage crisis from pushing the nation into a long and deep recession.

“I’ve been watching the economy for 50 years and I’ve never seen anything like this before,” Gramley said in a telephone interview from his home office in Maryland. “The Fed is very, very worried.”

David Henderson, a research fellow with Stanford’s Hoover Institution, said the Fed should let Bear Stearns fail because all the investments involved are complex financial paper being swapped back and forth among high-rollers who are capable of working out deals themselves.

“This is not Jimmy Stewart’s ‘It’s a Wonderful Life,’ ” said Henderson, referring to the movie hero who used his honeymoon cash to prevent a run on the town savings and loan during the Great Depression. “This is not a run on Bear Stearns that will lead to a run on someone else.”

Just what has the Fed as concerned as any time since the Dust Bowl?

Economist Jane D’Arista with the Financial Markets Center, a Fed watchdog and critic, used data from the central bank to paint the following picture. For 30 years, Americans have moved their money out of the safe but low-yielding banking industry and into new, high-risk, high-return opportunities, including investment banks and mortgage lenders.

Now, said D’Arista, these financial newcomers are in trouble because they have invested on margin. That means putting only so much down now, with a promise to put more into their trading account if the asset – say a bundle of mortgage contracts – should fall.

That is exactly what started happening with subprime mortgage contracts and that started to hit Bear Stearns with margin calls to ante up more money into its trading accounts – money that it didn’t have and now the Fed has rushed in to supply.

“The joke in the market right now is, ‘Who is this Mr. Margin and why is he calling me?’ ” D’Arista said in a telephone interview.

The Federal Reserve had to do some fancy footwork Friday to rush its margin support to Bear Stearns, judging by a sketch of the operation provided by a senior Fed staffer. Because the Fed did not have an immediate way to loan money directly to Bear Stearns – which is not a bank in the traditional sense – it routed the emergency loan through JPMorgan, which is. The staffer would not say how much was loaned or at what interest rate.

The irony for those who recall their financial history is that John Pierpont Morgan was the banker who held Wall Street together during the so-called Panic of 1907 that predated the creation of the Federal Reserve in 1913.

Gramley, the former Fed governor, said this novel effort signaled both the seriousness with which the Fed views this potential breach in the financial dike and its determination to keep its finger in the hole. “They are being aggressive and innovative to restore market stability,” he said.

What Gramley said the Fed fears is that if other big investment houses start defaulting on their obligations and dump mortgage paper on the market, it will further depress the housing and mortgage sector and plunge the nation into recession – worsen it.

But Henderson, the Hoover scholar, said these are all big deals among big boys who can work out deals between themselves and take their losses, and that the Fed intervention only delays this day of reckoning and encourages future bad investments, a policy some economists would call a “moral hazard.”

“They would work it out more quickly,” he said. “Right now everyone’s waiting to see who gets bailed out.”

The Associated Press contributed to this report.