The Fed can, within certain limits, come to the rescue of commercial banks. But with the destruction of the legal wall that separated various types of financial institutions--commercial banks, investment banks, insurance companies, broker-dealers--the Fed assumed a more central role in respect of the entire financial system. And with the consolidation of financial institutions that has gone on over the last twenty years especially, the US now has a number of truly large financial institutions that have in many ways "marginalized traditional banking and that enabled lenders to evade much of the regulatory framework that had ... begun during the Roosevelt administration." Floyd Norris, F.D.R.'s Safety Net Gets a Big Stretch, New York Times, Mar. 15, 2008. As Norris notes, the regulators who let this happen, like Alan Greenspan, claimed that these new financial interactions would actually reduce risk--transferring risk from the highly leveraged banks to broader US and international networks of institutions.
But the banks didn't transfer all that risk--in fact, they retained quite a bit of the risk but it was packaged in securities that hid the danger and did not require the banks to set aside as much capital in reserve. Norris quotes the president of the New York Federal Reserve Bank here: "A sizable fraction of long-term assets--assets with exposure to different forms of credit risk--ended up in vehicles financed with very short-term liabilities."
These financial monsters may now be too huge to fail, because of their impact on the overall financial system. See Jenny Anderson & Vikas Bajaj, A Wall Street Domino Theory, New York Times, Mar. 15, 2008. The Fed has done just that for Bear Stearns. Faced with a run on the bank, the Fed, acting through JPMorgan, accepted Bear Stearns' mortgage securities as collateral for a big loan, even though it is quite likely that the short-term loan couldn't be repaid unless the bank is acquired by another bank with more resources (of course, at a significant discount). Landon Thomas Jr., Run on Big Wall St. Bank Spurs Rescue Backed by U.S., NY Times, Mar. 15, 2008. "If the Fed hadn't acted this morning and Bear did default on its obligations, then that could have triggered a very widespread panic and potentially a collapse of the financial system," according to James Melcher, head of a hedge fund in New York. A Wall Street Domino Theory
That has a regrettable effect--big banks took big risks and made big money out of the easy credit over the last 8 years, issuing and then securitizing various financial products, including subprime loans. If the Fed now comes to the rescue and takes that risk onto itself, those institutions and their investors may take the wrong lesson. They may conclude that risk doesn't matter--make money while you can, then if losses start to follow from the risky endeavors, count on the Fed to come to the rescue.
In the meantime, Mr. Bush has made it clear that he thinks the "fix" for ordinary Americans who are suffering from inflation in energy and food prices and deflation of their homes' value is the tax rebate checks scheduled to be mailed early this summer. See Steven Lee Myers & Peter S. Goodman, President Acknowledges Strains on the Economy, NY Times, Mar. 15, 2008. Juxtapose the action by the Fed to rescue Bear Stearns with the following statement:
"The challenge is not to do anything foolish," Mr. Bush said, flatly rejecting proposals on Capitol Hill for the government to buy up abandoned and foreclosed homes to stop prices from plunging."
It might be time for the Administration to consider what steps can be taken to assist US homeowners. Buying foreclosed properties might be an alternative--if the administration can essentially buy bad mortgage securities, it could also buy real estate. But it might make more sense for the government to negotiate to purchase some home mortgage loans from the banks holding them at steep discounts to their face amounts, letting investors and investment banks take their losses for their risky investments while providing a path to reasonable modification of those loans for homeowners. The problem with that approach is that most loans have been committed to those innovative securitization vehicles that the investment banks devised to spread the risk--the loans have been sliced and diced and the resulting "tranches" sold off to investors. That would make it hard to selectively purchase loans at their fair market value discount.
It appears that the bankruptcy alternative is more feasible. Lenders (and the same banks or others in their roles as servicers) are likely resisting modifying loans at this point because each such modification is another loss that will have to be recorded on their books. They would prefer to be able to determine the timing of the losses themselves--delaying as much as possible because of the credit crunch. That means they may be pocketing the spread from the lower interest rates and not passing it on to potential borrowers, at the same time that they are resisting modifying loans to avoid recognizing losses on their books. Congress can deal with that directly by making it possible for homeowners to modify their home mortgages in bankrtupcy.
I'm curious--what do readers think are reasonable alternatives for 1) ensuring that the financial system manages through this credit crunch and/or 2) making it possible for more homeowners to stay in their homes? Are there any answers that aren't being considered?
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