I get tired of getting yelled at in comments for saying that the Fed should help to rescue financial markets, so I'm going to let Alice Rivlin say it this time. But I do agree with what she says:
The Fed’s Money Well Spent, by Alice Rivlin, Commentary, NY Times: One benefit of the Federal Reserve’s rescue of Bear Stearns is that public outrage has aroused the political system to action in mitigating the foreclosure crisis.
Never mind that the supposed conflict between Wall Street and Main Street is a false one — Main Street runs on credit and cannot prosper if the financial system is in shambles and credit dries up. Never mind that the supposed Fat Cat “bailout” was a disaster for Bear Stearns stockholders, and that the idea of a “moral hazard” risk — that other investment banks will be tempted to emulate Bear Stearns — is preposterous. Never mind that if markets head back up and the collateral can be sold at a profit, taxpayers may lose nothing.
In the end, the Fed’s action was not aimed at rescuing those who made bad decisions out of greed or stupidity, but at protecting the rest of the country — and indeed the world — from the possibly devastating consequences of a financial meltdown.
Nevertheless, the outrage is both understandable and useful. Public money has been put at risk...
Like the failure of a financial behemoth, spreading foreclosures engulf the innocent as well as the imprudent and unwise. To be sure, many homeowners were shortsighted and greedy. Like their Wall Street counterparts they borrowed too much and got caught when the music stopped. Like the Bear Stearns shareholders, they should take losses. But putting them out of their homes does not merely harm them and their children, it endangers whole neighborhoods and drags down the assets of their more prudent neighbors.
Congress and the Bush administration should move quickly ... to enact laws to ease the renegotiation of mortgages and keep homeowners who are able to pay the new charges in their homes. Public money will have to be put at risk, but it is worth it. The deals should be structured so that the taxpayer shares in the gains if markets recover...
When the immediate crisis is past, however, we must turn to the difficult task of reducing the chances of a replay. It will not be easy to design regulations that do more good than harm, but at the very least all financial institutions that stand to benefit from Federal Reserve help in a crisis must be subject to regulatory scrutiny to make sure they are managing their risk prudently. There must be higher capital requirements and limits on excessive leverage. ...
After that, we must take on the even harder job of sorting through the explosion of financial instruments ... and deciding which belong in our kit of tools and which should be relegated to the waste heap. If they genuinely spread risk and help move capital into more productive uses, they should stay. But some exotic derivatives ... may entail more systemic risk than social value.
The folks who devise these exotica are talented enough to create something useful. We would all be better off if they were productively employed in the “real” economy — or pursued wealth in Las Vegas, where the risks the smartest gamblers pose to the house are carefully controlled.
The only policy on the list I'm not too enthusiastic about (if it is on the list, it's not explicit), is allowing courts to reset the terms of mortgage contracts. I'd rather preserve the original contracts and find some other way, e.g. HOLC type buyouts or guarantees, of lowering the mortgage payments and preventing foreclosures. That way, when contracts are written in the future, they won't have to charge higher interest rates to compensate for the risk of a court enforced renegotiation of terms.