The Pros and Cons of the Fed's Action Last Week

Last week has a historic week for the Federal Reserve. Going back to the end of the previous week we learned that one of Wall Street's oldest and most venerable investment banks was basically bankrupt. Over the weekend we learned that JP Morgan was working to buy Bear. And then we learned that JP Morgan purchased Bear for $2/share with a $30 billion guarantee from the Federal Reserve in the event some of Bear's loans were bad (which some pretty much have to be in the current environment). Now that all of this is over, let's look at the pros and cons of what the Federal Reserve did.

First let's look at what the Federal Reserve did. On March 16 they made this announcement:

First, the Federal Reserve Board voted unanimously to authorize the Federal Reserve Bank of New York to create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets. This facility will be available for business on Monday, March 17. It will be in place for at least six months and may be extended as conditions warrant. Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities. The interest rate charged on such credit will be the same as the primary credit rate, or discount rate, at the Federal Reserve Bank of New York.

Second, the Federal Reserve Board unanimously approved a request by the Federal Reserve Bank of New York to decrease the primary credit rate from 3-1/2 percent to 3-1/4 percent, effective immediately. This step lowers the spread of the primary credit rate over the Federal Open Market Committee's target federal funds rate to 1/4 percentage point. The Board also approved an increase in the maximum maturity of primary credit loans to 90 days from 30 days.

With this action the Federal Reserve greatly broadened their lending program. Before this action the Federal Reserve only made loans to member banks. In addition, the Federal Reserve only accepted high-grade debt instruments (think US Treasuries) as collateral for those loans.

Now the Federal Reserve will lend to "primary dealers". That means the largest Wall Street investment banks will be able to borrow money from the Federal Reserve. This means firms like Merrill Lynch and Bear Stearns can borrow directly from the Federal Reserve.

Secondly, these loans will be "collateralized by a broad range of investment-grade debt securities." That simply means the instead of only accepting Treasury securities for loans the Federal Reserve will now accept any investments with a rating of A or better. It's important to note that a lot of the problems in the bond market have been caused by high-rated paper, so this qualification isn't worth what it once was.

Third, in addition to the above mentioned action, the Federal Reserve helped to facilitate the Bear Stearns transaction by guaranteeing up to $30 billion of Bear Stearns' portfolio. That means that after JP Morgan buys Bear and takes charge Bear's investment assets, if up to $30 billion of those assets goes bad the Federal Reserve will pay JP Morgan for the losses. In other words, the Fed is essentially guaranteeing up to $30 billion in losses related to Bear Stearns portfolio.

So -- what's good about this deal?

The central reason why the Federal Reserve acted like it did was to prevent a financial sector meltdown. While there is no way of knowing for sure there was a strong possibility that a Bear Stearns bankruptcy would have frozen the credit markets. This would have had chilling effect on the credit markets and could have frozen them solid. This could have sent the economy which is already teetering on the edge of recession (if it's not already in one) into a very deep recession. It's important to remember that leading up to this event were signs of extreme distress in the credit markets. Auction rate securities -- a primary way that municipalities obtain short-term funds -- pretty much dried up over the last 2-3 months. Structures Investment Funds -- SIVs for short -- were experiencing the same problems. In effect, the Bear Stearns situation occurred at the end of a building problem in the credit markets. If Bear had failed there is more than a small likelihood that the end result would have been a much deeper recession than we will have.

On the con side, the Federal Reserve clearly bailed out a firm who's own decisions were responsible for its downfall. Bear decided of its own free will to get involved in the hedge fund and mortgage market. That was a bad decision and they have paid the price. In a free market economy (which we're supposed to be in) stupidity of this type is supposed to fall by the wayside by being unprofitable and therefore eventually going bankrupt. Some commentators have correctly noted that the Fed's action essentially "privatizes the gains and socializes the losses" of the investment community. Finally the Fed's action creates what economists call a "moral hazard". This simply means that by bailing out stupid behavior the Federal Reserve is essentially allowing it to happen again.

In conclusion, I will first note that I called Ben Bernanke a socialist for his actions. Frankly, I couldn't resist that line. As a financial writer the irony was just too rich to ignore. However, the situation is far more complicated than merely labeling a free market advocate a socialist. Bear's collapse would have had far-reaching implications and ramifications that no one would want to be responsible for. If Bernanke had let them fall he would have been burned in effigy for not doing anything. But letting them collapse would have been a sure way to make sure the reckless lending practices of the last 2-3 years wouldn't happen again. But by bailing out the situation Bernanke is now called a "socialist" -- which is probably deeply insulting to him. In other words, this is the economic no win scenario. Whatever you do you're damned.