From the March 18, 2008 The Times (London)
March 18, 2008
by Irwin Stelzer
This was the weekend that was, one on which the Federal Reserve Chairman Ben Bernanke must have looked back longingly at those lazy, hazy weekend days when he chaired Princeton University’s economics department. All he had to do these past few days was prevent the passing of a major investment bank from triggering the collapse of the US financial system.
When it became clear that Bear Stearns was on the verge of collapse, taking with it who-knows-how-many institutions with which it was intimately interconnected through a web of financial dealings, Mr Bernanke moved from crisis prevention to crisis management. He put paid to Bear Stearns’s 85-year existence by arranging a takeover by JPMorgan Chase at a price equal to 1 per cent of Bear Stearns’s value just 17 days ago, less than the value of the company’s headquarters.
Mr Bernanke then announced a new Primary Dealer Credit Facility. Dealers can now lend the majority of the $50 trillion of credit market instruments to the Fed in return for cash equivalents, “allowing the Fed to be able to support the debt structure that underpins the American economy,” according to the Lindsey Group, a leading consultancy.
We won’t know for some weeks whether the Fed’s weekend work will relax taut nerves or tighten them, although early signs are mildly encouraging. Past efforts to bring down long-term interest rates by cutting the short-term rates over which the Fed has control have not been successful. But we now have new weapons. In addition to the reassurances offered by the Fed’s activism this weekend – appreciative noises were emitted by the White House and the US Treasury – by month’s end there will be an auction at which banks will bid for $200 billion of risk-free Treasury notes, which they can receive in exchange for some of the AAA-rated mortgages sitting on their books, unloved and unsaleable. That exercise will give them Treasury paper they can trade for cash, and take $200 billion of mortgages off a glutted, indeed, frozen market.
Unfortunately, that is rather like bailing out the ocean with a teaspoon; the Fed’s $200 billion, even all of the $400 billion of its remaining holdings of Treasury notes, counts as little in the $11 trillion mortgage market. Worse still, the swap will do nothing to halt the decline in house prices. Until the bottom of the housing market is reached, the value of mortgages will continue to decline.
So here is the state of play. The Fed, worried less by already-intense inflationary pressures than the possibility of a collapse of the financial system, has cut short-term interest rates and will cut them again. It has channelled funds to ailing institutions, announced that it will do so again if necessary, and bailed out an investment bank - “wiped out” is the shareholders’ preferred description.
Now, like Catherine Zeta-Jones’s Velma Kelly, desperately seeking a partner for her nightclub act in the musical Chicago, Mr Bernanke is privately thinking “I can’t do it alone.” The next steps will come from the federal government, protestations from the White House about the dangers of “moral hazard” notwithstanding. Look for direct intervention in the housing market to provide government backing for moves by lenders to write down the value of mortgages, and cut interest payments to levels commensurate with the lower value of those mortgages.
Look, too, for nationalisation of some of the outstanding debt, as occurred in the 1980s and 1990s when some 1,000 savings and loans banks (thrifts) went bust. The taxpayer will end up assuming the risk that outstanding loans on the banks’ books will not be repaid. That might sound improbable, given Treasury Secretary Hank Paulson’s loud opposition to any such move but this is an election year, and congressmen up for re-election are less impressed with the risk of moral hazard than with the risk of having to seek employment back in their home towns or in the lobbying firms that line Washington’s K Street.
Meanwhile, the pressure on the banks to find new sources of capital remains intense. The Fed may have injected liquidity but it has not added capital. The sovereign wealth funds did just that at first but have pulled back a bit, as the falling dollar steadily shrinks the value of their investments. The banks have so far resisted pressure from Mr Paulson to add to their capital by cutting their dividends but will eventually have to send just that bad news to their shareholders.
My own guess is that there is more bad news to come – those “events, dear boy, events” that so terrified Harold Macmillan. Worse even than current upheavals in credit markets would be a cataclysm in the currency markets. The Fed has cut rates and is likely to cut them again. Each cut has added fuel to the fire that is burning the value of the US currency. As it drops, its value to oil producers and others falls, so they raise prices. But at some point these sellers-to-America will be joined by China and other holders of large stacks of dollars in deciding that enough is enough. If they start dumping dollars, and end their semi-pegs to the dollar, Americans might find that their worldwide purchasing power dictates importing little, travelling less, and living less well, while the rest of the world hunts desperately for new customers.
But the cumulative effect of Mr Bernanke’s tossing the kitchen sink at the problem, the moves yet to be made by the congress and the White House, the fiscal stimulus that will put about $150 billion into consumers’ pockets this summer, and continued healthy earnings in most segments of the economy just might trigger a turnaround.
While we wait, Americans have stopped sneering at Britain for nationalising Northern Rock. After all, the Fed needs White House and Treasury approval for taking $30 billion of Bear Stearns’s liabilities on to its own balance sheet because in the end taxpayers are now on the hook. If it looks like nationalisation, and feels like nationalisation, it is nationalisation. And there is more to come.
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.
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