More Experts Disapprove of the Fed’s Salvage Operations

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Anytime you hear people on different ends of the political spectrum, such as Anna Schwartz (famed as co-author with Milton Friedman) and Harvard’s Kenneth Rogoff agree on anything, it’s worth taking notice. In this case, it’s the Fed’s extreme efforts to save the markets, in particular the Bear bailout, that is attracting widespread criticism. One rescue begets further rescue demands, which then lead to rescue expectations, which then leads to undue risk-taking and capital misallocation (code for hidden and explicit costs to the public at large).

Note this Bloomberg article was written before the increase in the Term Auction Facility and broadening of types of acceptable collateral was announced. No doubt that would have elicited even more disapproval.

From Bloomberg:

A month after the Federal Reserve rescued Bear Stearns Cos. from bankruptcy, Chairman Ben S. Bernanke got an S.O.S. from Congress.

There is “a potential crisis in the student-loan market” requiring “similar bold action,” Chairman Christopher Dodd of Connecticut and six other Democrats wrote Bernanke. They want the Fed to swap Treasury notes for bonds backed by student loans. In a separate letter, Pennsylvania Democratic Representative Paul Kanjorski and 31 House members said they want Bernanke to channel money directly to education-finance firms…

The Fed satisfied Dodd’s request today, expanding the swaps to include securities backed by student debt.

“It is appalling where we are right now,” former St. Louis Fed President William Poole, who retired in March, said in an interview. The Fed has introduced “a backstop for the entire financial system.”

Critics argue that the result will be to foster greater risk-taking among investors emboldened by the belief that the government will bail them out of bad decisions.

The Fed’s loans to Bear Stearns were “a rogue operation,” said Anna Schwartz, who co-wrote “A Monetary History of the United States” with the late Nobel laureate Milton Friedman.

“To me, it is an open and shut case,” she said in an interview from her office in New York. “The Fed had no business intervening there.”

There are already indications that investors perceive the safety net to be widening as a result of the actions by Bernanke, 54, and New York Fed President Timothy Geithner. The Bear Stearns bailout and an emergency facility to loan directly to government bond dealers triggered a decline in measures of credit risk for investment banks and for Fannie Mae, the Washington-based, government-chartered company that is the nation’s largest source of funds for home mortgages….

“The market understood that this is the method by which Fannie Mae and Freddie Mac could be bailed out if necessary,” Poole said….

Geithner defended the loans before the Senate Banking Committee on April 3, saying that the Fed needed to offset risks posed to the entire financial system….

While the Fed must by law withdraw its financing backstop for investment banks once the credit crisis passes, investors will probably still bet on its readiness to intervene.

“There is no way to put the genie back in the bottle,” Minneapolis Fed President Gary Stern said in an interview with Fox Business Network on April 18. “What worries me most about where we wind up is that we will have an expansion of the safety net without adequate incentives to contain it.”

Stern noted that he supported the Fed’s moves to restore financial stability….

“It is very hard in the middle of a crisis to know where to draw lines,” said Harvard University professor Kenneth Rogoff, a former research director at the International Monetary Fund. “They reduced the immediate risk of a crisis, but upped the ante of raising the possibility of a bigger crisis down the road.”….

The risk to the Fed is that it is routinely asked to step in and support insolvent companies whose creditors are on the run, economists say.

“Discount-window accommodation to insolvent institutions, whether banks or nonbanks, misallocates resources,” Schwartz said in a 1992 lecture available on the St. Louis Fed Web site. “Institutions that have failed the market test of viability should not be supported by the Fed’s money issues.”

Richmond Fed chief Jeffrey Lacker and policy adviser Marvin Goodfriend wrote in a 1999 paper that central bank lending creates ever-expanding expectations. “The rate of incidence of financial distress that calls for central bank lending should tend to increase over time,” they wrote. That “creates a potentially severe moral-hazard problem.”

Whatever regulations and incentives the Fed tries to put in place now would be evaded by the market’s innovation of new types of products, Goodfriend said in an interview. Investors would nonetheless still count on the safety net, he added.

“We have to start now to recognize the strategic instability of the path we are on,” said Goodfriend, now a professor at Carnegie Mellon University’s Tepper School of Business in Pittsburgh. The Fed needs to prepare markets for how it won’t intervene, which it didn’t do before the Bear Stearns meltdown, he said.

The Fed also influenced market incentives when it introduced the so-called Term Securities Lending Facility. The program is designed to lend up to $200 billion of Treasury securities from the Fed’s holdings to Wall Street bond dealers in return for commercial and residential mortgage bonds among other collateral. Congress has noticed the program favors mortgage credits, and Dodd asked the Fed to swap some of its $548 billion in Treasury holdings for bonds backed by student loans.

While Bernanke rebuffed Kanjorksi’s request for direct loans in a March 31 letter, Fed officials today expanded the collateral they accept under the TSLF. The facility now includes all AAA rated asset-backed investments, including bonds backed by student loans. Former Fed officials say it is risky for the central bank to use its portfolio to address specific markets and satisfy Congress without saying where it will stop.

“If there is a public purpose in lending to investment banks, and taking dodgy mortgage securities as collateral, then it is a question of degree about other potential lending,” Vincent Reinhart, former director of the Fed board’s Division of Monetary Affairs, said in an interview. “That’s the consequence of crossing a line that had been well established for three- quarters of a century.”

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  1. Anonymous

    Schwartz and Rogoff are I suspect both on the same side of the US political spectrum (“Rs”), though both are perhaps disillusioned Rs.

    Rogoff is a long-standing moral hazard hawk, so his views aren’t all that surprising.


  2. Anonymous

    Is there no sense of proportion in this rampant ideological paranoia?

    Private sector losses are estimated in units of $ trillion.

    Any reasonable estimate of downside risk to the Fed and the taxpayer has to be mimimal in this context.

    And do we really think these things jointly in context are irrelvant to the calibration of net ‘moral hazard’ and the logical implications for future behavior?

    But the indignates continue to scold the Fed for a little intelligent pump priming of the system.

    Really lop sided.

  3. Anonymous

    My impression of Schwartz’s and Rogoff’s political opinions is much the same, though likely less well informed, as Brad’s (bsetser). So no surprise that they agree on this as well (though their agreement doesn’t necessarily mean that the Fed’s moves are good and appropriate).

  4. a

    The people not only get the government they deserve, they get the currency they deserve. Since Reagan the American people have been fed on the notion that benefits are costless. Lower taxes, receipts are supposed to increase. Government-sponsored entities get the benefits of the full faith and credit of the U.S. without the full faith and credit actually being given. Investment bank is bailed out and its bondholders’ made whole. And now student loans are being backed via more financial legerdemain.

    It looks like the only possible endgame is becoming a T-bill/dollar crisis. Sure, the Fed can use T-bills to backstop all of the bad credit in the system. But nothing can force people to accept them.

  5. Robert Freeman

    Anonymous said: “Is there no sense of proportion in this rampant ideological paranoia…
    Private sector losses are estimated in units of $ trillion.”

    If there’s an ideological bias it is surely on the side of conservatives who seem to feel there should be no limits to what kind of risky/greedy/studip behavior by the banks the Fed should bail out, all with the taxpayers footing the bill.

    Notice, there’s no suggestion of limiting the scope or the amount the Fed might dump into this trillion dollar wealth transfer, nor terms on which private actions that imperil public well-being might reasonably be circumscribed.

    Ideological indeed.

  6. Yves Smith


    Not to generalize from my own point of view, but I am a moral hazard hawk and consider myself pretty liberal. I don’t think those views are incompatible (as in, you can be a pragmatic liberal and recognize that interventions even when necessary and desirable, have costs, and try to understand and minimize those costs).

    Rogoff writes for Project Syndicate, and the other authors range from fairly left wing to centrist, so I figured Rogoff had to be left-leaning enough to be willing to be included in that company.

  7. paul

    I was minding my own business when some entities decided to leverage mortgages and other ‘bright ideas’ and now I am still minding my own business but have to pay for someone else’s greed.

    I understand the fixes are a must to prevent a meltdown but that’s what I get for minding my own business.

  8. S

    Why is it that we have this parade of sages continiously telling us the credit crisis is behind us. Today it was Buffet’s turn. These guys are all delusional. They really need to get outside their loop to see how utterly foolish the they sound.

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