Fed Watch: End Game:

Tim Duy assesses the financial crisis, and what the Fed is likely to do at its next rate-setting meeting:

Endgame?, by Tim Duy: News is flowing in faster than the ability to process the implications.  When I went to bed Saturday night, the only sure thing looked like the liquidation of Lehman Monday morning.  A scant 24 hours later, to that liquidation is added the sale of Merrill Lynch to Bank of America and, later the possibility of a collapse of AIG by midweek.  The Fed and Treasury suddenly play hardball, and the floodgates break open.

Mark Thoma is working overtime to keep readers informed. 

Fed officials likely now understand the can of worms they opened with the Bear Sterns bailout.  At that point, Wall Street realized that attempting to solve their own problems was a sucker’s bet – better to string things along with the expectation that the Fed would ultimately solve the problem of bad assets by bringing them into the public domain.  Arguably, this is one reason the Lehman issue was allowed to fester for another six months.  Moral hazard.  With policymakers now drawing a line in the sand, market participants can no longer cling to the hope that the Fed will absorb additional bad debt (notice how quickly Merrill moved when policymakers claimed they will serve only as matchmakers, rather than put additional public money explicitly at risk).  It is looking like the endgame is finally here.

To give the Fed the benefit of the doubt, earlier this year they likely saw the financial crisis as primarily a liquidity event.  Thus, they could make the analogy that market participants just needed a “slap in the face,” and some rapid rate cuts and fresh sources of liquidity would give confidence that much needed boost.  By now, however, officials probably realize this is a solvency crisis.  Too many debt instruments hinge on the state of the US housing market, and too many homeowners took on loans that are simply unaffordable. 

A solvency crisis can only be addressed by eliminating the bad assets (since analogies to Japan are all the rage, note that the unwillingness to eliminate nonperforming assets helped prolong that banking crisis).  Moving the assets onto the Fed’s balance sheet via temporary repo operations does not eliminate the problem, it just moves it around.  Instead, the questionable assets need to be eliminated, and some agent needs to accept the loss.  Who will that agent be?  Wall Street obviously prefers that the taxpayer ultimately absorbs that loss; the Bear Sterns bailout provides the precedence for such an outcome via the Fed’s financial backstop. 

Repeated Bear Sterns type bailouts would eventually force taxpayers to absorb the losses of the entire crisis and, more importantly, do so without legislative approval.  We can cordially debate the appropriateness of taxpayer support, but we should all be clear that that decision needs to be made in a democratic fashion.  It is too big an issue for an “ends justify the means argument,” a justification that Bernanke & Co. need to do whatever is necessary to make the trains run on time.  Bernanke & Co. likely understand this now, encouraging their hesitation to continue down that road.  Of course, if Lehman is forced to liquidate assets, that too has obvious consequences, such as setting prices for those assets that further destabilizes the investment banking community, pushing financial markets to an end game in the crisis.  Still, even with that crisis in the making, the Fed has already pushed their legal boundaries; some would argue they have stepped well beyond those boundaries.  And it hasn’t stopped – the Fed expanded the collateral it will accept in repo operations, putting taxpayer dollars at risk in a less explicit manner (I see no legal justification to open a credit line to AIG – if them, why not Ford or GM?).  Still, despite the Fed’s creative efforts to date, the crisis is moving to a stage that is simply too big for the Fed; Congress needs to step up and define the parameters of any mass bailout of the financial sector.  Some version of the Resolution Trust Corporation is the most likely outcome.  I suspect that taxpayers will ultimately absorb significant losses, but it will be a crime if such a bailout does not entail a radical reevaluation of financial regulation.  But to what extend will Congress be willing to perform a hard look as an industry that has brought the illusion of wealth that hides gaping and undeniable equity flaws in the US?

The FOMC is gathering this week for a decision on interest rates.  I imagine all bets are off regarding the outcome; indeed, we may get an emergency rate cut by the time I get to the office.   As of Friday, policymakers were widely expected to keep rates steady; only the language of the statement is in doubt.  Specifically, market participants will be looking to validate growing expectations of a rate cut later this year.  At issue is the use of the term “significant” to qualify the inflation threat.  Given the collapse of commodity prices, there appears to be room to remove that qualifier.  I suspected they would be wary, however, of giving hints that a rate cut is in the making – they are probably just now breathing signs of relief that Dollar/commodity dynamic is no longer working against them.  They do not need to trigger a fresh run on the Dollar; moreover, Chinese policymakers likely are happy that they foreign currency value of their Dollar assets is on the rise, and do not want a reversal of that situation.  After last week’s nationalization of Freddie and Fannie, we can no longer hew to the illusion that policy is based only on domestic considerations. 

Cutting interest rates, I suspect, will make little if any difference at this juncture.  That said, the Fed has delivered a rate cut at each critical juncture of the past year.  I am at a loss to convincingly explain why this week is any different.