The Fed to the Rescue

The Federal Reserve today singlehandedly created a 2% rally in the stock market and put to rest at least some fears of a credit crunch. I applaud Ben Bernanke and his colleagues’ move.

The critical distinction here is between bailing out investors who made bad decisions versus preventing a classic financial panic, of the “run on the bank” variety. I give my vote to the idea that there was indeed risk of a credit crunch, with a cascade of negative opinion creating feedback that was preventing capital from flowing to positive net present value projects.

The classic bank run occurs when depositors come en masse to a bank, demanding their deposits. These deposits are not, of course, in a vault at the bank but instead have been lent out to borrowers, with only some small percentage kept close at hand. If too many depositors demand their account balances, the bank must begin calling its loans, and therein lies the contagion effect.

In today’s market, the problem is not so much with traditional banks. But consider an investment bank like Bear Stearns. Bear Stearns discloses that one of its in-house investment funds held mortgage-backed securities that has declined in value so much that the fund is worthless – presumably the fund managers had leveraged their investments, so a relatively small decline in value could wipe out the net assets of the fund. Once disclosed, and given the overall worries about mortgage-backed securities, negative sentiment about Bear Stearns increases. In the normal course of business, an investment bank needs to borrow large sums of money to finance its activities. But given the concerns, and lack of knowledge of how bad the problems really are, who will want to throw money into a pot that might turn out to be rather empty? Afraid of being the claimant of lowest priority, nobody wants to lend money to such an institution under almost any conditions. This causes the investment bank to reduce its activity in a whole host of areas, and to sell assets it otherwise would hold, in order to raise funds. The vicious cycle begins, with lower prices in asset markets putting other institutions at risk…

I have been hearing from friends on Wall Street since at least June of the funny conditions in the credit markets. Credit was drying up, in the sense that lenders were just saying no, rather than just increasing prices by a reasonable amount to cover new risks.

It is funny how long it took for those fairly wide-spread debt market fears took to spread to the equity markets. One of those (many) instance where if only I had known for sure, I could have made some money. Ah, but how many times have I suspected some disaster only to see stock markets rise thereafter? Much better to buy and hold.

What the Fed did, in lowering the discount rate, was really quite genious. Very little additional credit will enter the economy as a result, and what does enter can be offset at an opportune time via open market operations.

But the Fed showed investors that they do understand that conditions are unusual and that there is a risk of a credit crunch. Credit crunches, panics, and runs should be prevented, and that is the job of the Fed. Bailing out mortgage bankers who loaned 100% of a home’s appraised value to buyers without verifying income is not the job of anyone.

By the way, I know folks in Hanover who had to pay for private mortgage insurance when they bought a house, and these are people with great jobs and in a great housing market. How is it that people in Florida and California are getting by with 100% loan to value mortgages, no income verification, and no PMI??