This Weekend’s Contemplation – What Should the Fed Do?

The Weekend’s Contemplation is from the WSJ and concerns what the Fed should do about increasing rates, taking short term action in the markets, etc.

Financial markets were roiled again yesterday, with the Federal Reserve and other central banks stepping in to bolster liquidity in the wake of the subprime credit seizure. Serving as lender of last resort in these conditions is the proper function of central banks. But going further -- with an emergency rate cut, as some in the market seem to be anticipating or hoping for -- carries the risk of introducing even greater moral hazard into the financial system.

It's worth recalling in this connection that the root cause of this credit correction was the Federal Reserve's willingness to keep money too easy for too long. The federal funds rate was probably negative in real terms for close to two years between 2003 and 2005. This led to a misallocation of capital into real estate and certain mortgage instruments that is currently being worked off. For the Fed to take its eye off the price-stability ball now in response to short-term market gyrations would only compound the original policy mistake.

The current skittishness has less to do with the severity of the mortgage problems than with the uncertainty over who is exposed to them and where the next surprise will turn up. Thus, BNP Paribas's disclosure that three of its investment funds were experiencing liquidity problems was troublesome because it came so quickly on the heels of the French bank's assurances, just a week earlier, that it had "negligible" exposure to the American subprime market. There was a similar mini-market panic this week when news that Goldman Sachs's internal Global Alpha hedge fund was liquidating some positions led to exaggerated rumors of the fund's collapse. Market players know that in these conditions more corpses are likely to surface, but no one can say exactly when or where.

That said, there's no indication at the moment of a fundamental breakdown in solvency. Liquidity is scarce, which is why the Fed and other central banks have stepped up. Mortgage lenders such as Countrywide have found that the market for their loans has dried up, at least for now. But when the shouting stops, we will probably discover that most mortgages were unproblematic -- that while some lenders and brokers got too aggressive, the vast majority of loans will be paid off as usual. This doesn't mean there won't be pain in the meantime, and possibly a good deal of it, especially for those holding the minority of loans that prove to be bad ones.

But note that in some cases there are buyers in the subprime market even now. Witness Citadel Investment Group's purchase of Sowood Capital's portfolio, sold under duress at about half its face value. That may have saved Sowood's investors from total loss. Citadel wasn't acting out of compassion, but out of a belief that, at a 50% discount, there was some value in Sowood's subprime portfolio. In other words, the market seems to be working things out, notwithstanding the protests from some quarters.

The biggest risks in the present market conditions may yet prove to political, rather than economic or financial. Senators Chris Dodd and Chuck Schumer have joined Fannie Mae and Freddie Mac's calls to lift their borrowing and loan limits, a move that would likely kill attempts to reform the scandal-plagued mortgage giants. The ubiquitous Mr. Schumer has also been pushing for lending "reforms" that would reduce access to credit to those most in need, while Senator Hillary Clinton has proposed a $1 billion federal bailout fund for homeowners at risk of default and foreclosure.
Talk about moral hazard. No one wants to see someone lose his home to foreclosure. But many of those most at risk bought their homes with little or no money down, and so have very little at stake economically. Bringing in the feds to bail them out would send precisely the wrong message -- that risky or overly aggressive borrowing will be rewarded by the government rather than punished in the marketplace. To the extent that bad loans were made, the market needs to clear, not be propped up by federal-aid programs.

The past couple of weeks, and especially the past few days, have been ugly -- as the bursting of a credit bubble of this magnitude always is. The pain probably isn't over. But if policy makers and central bankers can contain the damage and avoid making the problem worse, this too will pass. With the current market turmoil, Mr. Bernanke faces his first big test as Chairman of the Federal Reserve. The biggest favor he could do for himself and the markets is not to give in to the temptation to do favors for Wall Street or anyone else, and to remain focused on his price-stability mandate.

The U.S. and world economies continue to grow, and, short of a genuine solvency crisis, inflation should remain the Fed's chief concern. To that end, whatever short-term liquidity is needed now to keep the markets orderly deserves to be withdrawn when conditions normalize. Letting the markets know that there is no Bernanke Put will also help bring the markets' risk appetites back into line.