Informed Speculation

It’s hard to take a consistent stand on principle when things are going badly…and this economy of ours faces some real big-time challenges of a sort that could quickly tip into ‘major disaster’ area. So while I oppose government intervention in private markets in principle, what is one to make of the Fed’s unprecedented intervention in the matter of Bear Sterns? In the ominously titled article “Ten Days That Changed Capitalism“, the Wall Street Journal‘s David Wessel must be quoted at length:

The past 10 days will be remembered as the time the U.S. government discarded a half-century of rules to save American financial capitalism from collapse.

On the Richter scale of government activism, the government’s recent actions don’t (yet) register at FDR levels. They are shrouded in technicalities and buried in a pile of new acronyms.

But something big just happened. It happened without an explicit vote by Congress. And, though the Treasury hasn’t cut any checks for housing or Wall Street rescues, billions of dollars of taxpayer money were put at risk. A Republican administration, not eager to be viewed as the second coming of the Hoover administration, showed it no longer believes the market can sort out the mess.

“The Government of Last Resort is working with the Lender of Last Resort to shore up the housing and credit markets to avoid Great Depression II,” economist Ed Yardeni wrote to clients.

First, over St. Patrick’s Day weekend, the Fed (aka the Lender of Last Resort) and the Treasury forced the sale of Bear Stearns, the fifth-largest U.S. investment bank, to J.P. Morgan Chase at a price so low that a shareholder rebellion prompted J.P. Morgan to raise the price. To induce J.P. Morgan to do the deal, the Fed agreed to take losses or gains, if any, on up to $29 billion of securities in Bear Stearns’s portfolio. The outcome will influence the sum the Fed turns over to the Treasury, so this is taxpayer money; that’s why the Fed sought Treasury Secretary Henry Paulson’s OK.

Then the Fed lent directly to Wall Street securities firms for the first time. Until now, the Fed has lent directly only to Main Street banks, those that take deposits from ordinary folks. That’s because banks were viewed as playing a unique economic role and, supposedly, were more closely regulated than other types of lenders. In the first three days of this new era, securities firms borrowed an average of $31.3 billion a day from the Fed. That’s not small change, and it’s why Mr. Paulson, after the fact, is endorsing changes to give the Fed more access to these firms’ books.

Wessel then ties it all back to the mortgage crisis:

[T]he clear and present danger that the virus in the housing, mortgage and credit markets is infecting the overall economy is too great to ignore. The Great Depression was worsened because the initial government reaction was wrong-headed. Federal Reserve Chairman Ben Bernanke spent an academic career learning how to avoid repeating those mistakes.

Is it working? It is helping. One key measure is the gap between interest rates on mortgages and safe Treasury securities. A wide gap means high mortgage rates, which hurt an already sickly housing market. A lot of recent activity, including Wednesday’s previously planned auction in which the Fed is trading Treasurys for mortgage-backed securities, is aimed at increasing demand for those securities to drive down mortgage rates.

The gap remains enormous by historical standards, but has narrowed. On March 6, according to FTN Financial, 30-year fixed-rate mortgages were trading at 2.92 percentage points above the relevant Treasury rates; Wednesday the gap was down to 2.22. Normal is about 1.5 percentage points. Money markets are still under stress, as banks and others hoard cash and super-safe short-term Treasurys.

Is it enough? Probably not. Although it’s hard to know, the downward tug on the overall economy from falling house prices persists. The next step, if one proves necessary, is almost sure to require the explicit use of taxpayer money.

(Score one for Peter)…

What makes the Bear Sterns intervention probably a good thing on balance, despite my distaste for it on a theoretical level, is the incredible explosion of credit default swaps, cbo’s, reverse cbo’s, mortgage-backed securities, and other arcane financial instruments that, supposedly, allow big financial players to hedge almost any possible risk. But when the truly global players are essentially shuffling risk back and forth among themselves, with, in many cases, the amount of exposure for each player essentially impossible to determine, we are in very dangerous waters indeed. A meltdown of Bear Sterns would possible have triggered a panic that would have ground global financial markets to an effective halt.

Predictably, the Democratic presidential candidates are calling for a tighter regulatory environment – and I’ll concede there are corners of today’s financial markets that could stand a little more light shone on them. At the very least, more disclosure and better accounting rules regarding valuations of the newer derivatives seems to be in order.

I’m going to have to concede, reluctantly, that the Bear Stearns intervention was probably necessary. I don’t like it…but I don’t want to be playing the fiddle of ideological purity while American prosperity is burning…