Fed Watch: Quite a Day

Tim Duy assesses the day's events:

Quite a Day, by Tim Duy: I am in Portland tonight, taking a breath to assess the day’s events as I mentally prepared for a three hour presentation on the economy for a friend’s business group. A spectacular harvest moon was hanging over the Cascades as I approved the city; the deepest orange moon I have ever seen.

That can’t be a good omen.

To say the least, this was an interesting 24 hours. My son took his first swimming lessons. A forest fire is raging within spitting distance of the family cabin. I understand the local bar has burned to the ground; I can’t see how that is going to be good for property values. And the Fed bought an insurance company.

I seem to remember that the US owned at least one “gentlemen’s club” in the wake of the S&L crisis, so what’s the big deal with an insurance company?

But I get ahead of myself – consider first the Fed’s interest rate decision. It was the logical choice one would have expected at the end of last week. The Fed Funds rate was held steady at 2%, risks are equally balanced between inflation and growth, and it was acknowledged that commodity prices have moved significantly lower. That the Fed did not cut interest rates in the face of arguably the most treacherous period of the financial crisis says little about moral hazard concerns, in my opinion. Instead, it indicates the Fed sees little that lower interest rates can do to alleviate the crisis. Policy is directed to the real economy, and by virtually every measure, rates are already lower than one would expect given the flow of data. That is not to say that the state of the real economy is healthy. Anything but, to be sure. But, while one can say that the Fed has been behind the curve with respect to the financial market turmoil, we have seen in the past a considerably slower reaction to real economic data.

More interesting is the AIG loan/purchase/bailout. I have to imagine the employees of Bear Sterns and Lehman Brothers are currently thinking that they clearly did not take on enough risk over the past several years. Lehman employees, in particular, were fed into the moral hazard grinder that was operational for a scant two days. How unfortunate. Which leads me to my most significant concern about Fed policy over the past year – the inconsistency. Facilitate the liquidation of Bear Sterns by backstopping $29 billion of questionable assets. Then, recognizing the moral hazard created by that move, let Lehman collapse. Then, recognizing the consequences of vanquishing moral hazard, effectively purchasing AIG. At this point, the endgame should be clear to policymakers – a taxpayer bailout. The bad assets need to be consolidated and eliminated. Congress needs to be working on a mechanism to make this happen, a new RTC. Any Congressional action needs to include a reevaluation of the state of financial regulation. Perhaps, just a thought here, insurance agencies need to be separate from investment banks. And if, as is often threatened, the shadow banking industry just moves offshore, maybe we should just let it do so.

Yet, in all fairness, Bernanke & Co. are faced with a historic crisis that moves as fast as a trader can initiate a sell order (I feel somewhat charitable tonight, as the hotel lounge remains open another hour and I am confident Willem Butier will have something to say that is less than charitable[update]). They often lack the time to consider the consequences of their actions. For example, John Jansen asks:

Preferred shareholders? If the deal calls for making them whole, I ask why. There does not seem to be any reason to bail them out.

The answer can be found via Yves Smith:

Fannie and Freddie preferred were held by banks, so any losses on the preferred would reduce already stressed bank capital. But far worse, preferred stock was the best hope for financial firms to raise new equity. Trashing the Fannie/Freddie preferreds meant that any sane investor would worry that future bank rescues could similarly damage preferred shareholders, and they'd avoid financial firm preferred stocks, including new issues. And indeed, financial preferreds got whacked in the wake of the GSE bailout.

Uncharted waters, to be sure. What I think we do know can be summarized as:

1. The Fed is pushing the bounds of its legal limits with the AIG deal.

2. The taxpayer will bear a portion, perhaps a significant portion, of the financial crisis, whether or not the Fed is involved. Arguably the cost will be less if the Fed acts now than if the Fed drags its heels. Again, moral hazard is interesting topic on the way to Starbucks, but is not feasible public policy, especially when policy is behind the curve.

3. We should all be very concerned that the Fed is pursuing a Jack Bauer policy approach, as much as we should be concerned about illegal wiretapping. We should not view this as an acceptable approach to policy. To do so leads to very unhappy places.

4. We should all be very concerned that Congress appears simply unable to understand the financial crisis, especially now that they likely understand they are far behind the curve and are having policy dictated to them by the Fed. Perhaps Congress will now view a bit more suspiciously the claims of Wall Street lobbyists that “everything is under control; we have dispersed the risk.”

Bottom Line: It is easy to take potshots at the Fed; I have taken my share over the past year. I think, as an institution, they abdicated their regulatory responsibilities, and we are all now paying the price. I think their communication strategy, and their lack of policy consistency, is maddening. But I think we are now all realizing where we are headed. We are moving into the endgame, when Congress socializes the losses after privatizing the gains.