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By Mohammed Akacem

The credit markets have been jolted lately by a big dose of market reality. The subprime market mess has spread across the globe, forcing central banks from the United States and Europe to Asia to intervene and inject liquidity to calm both markets and perhaps nerves. Groundhog Day may be here again, as we could possibly relive the experience of the 1998 financial crisis.

The question, however, that we must ponder is: Should the Federal Reserve or foreign central banks for that matter be in the business of rewarding bad investment decisions?

While the Asian crisis of the late 1990s and the subsequent failure of the hedge fund Long-Term Capital Management had their root cause outside the U.S. financial markets, this time the crisis appears to have emanated from right here in the United States. However, these days it does not really matter where the crisis starts. The global economy has no borders to speak of, particularly in the area of financial capital. The latter has no passport or allegiance. It will move at the slightest opportunity for a gain, and run at the slightest possibility of a loss, forcing central banks around the world to react — if they so choose.

What we have here is a classic case of moral hazard. Rewarding bad decisions only encourages more of the same and the market ceases to be relevant in doing what it does best, which is to punish those who make bad decisions. This is true for governments as well as for private investors.

In 1994, the United States and the International Monetary Fund helped bail out Mexico. The same story repeated itself in 1998 when Russia defaulted. Again, through some prodding, the IMF came through for Russia. Why? Russia was too nuclear and too big to be allowed to fail. The world’s taxpayers came through again via the IMF for Brazil and now our central bank is trying to lend a hand to the mortgage market.

In this attempt to rescue the credit markets, the Federal Reserve actually did something that is not usually done. It accepted as collateral for the loans it made — the new money it injected into the economy — mortgage-backed securities instead of the good old U.S. Treasury securities.
This is what is known as an open-market operation. When the Federal Reserve needs to inject money into the banking system, it buys securities. When it needs to reduce the amount of money that circulates, it sells securities.

Let us be clear: The Federal Reserve is totally within its rights and charter to do what it did by buying mortgage-backed securities instead of standard Treasury securities. The target for federal funds rate — the rate that banks lend each other for overnight loans — increased to 6 percent, much higher that its target of 5.25 percent. So the Fed intervened to get it back to where it was supposed to be by flooding the market with new money.

Still, do we want a central bank that is intervening in the market to help prop up one segment of the economy? That could potentially be a slippery slope down a very bad road and, once traveled, we are destined to make a precedent of it and do it again. The goal of any intervention should not be dictated by changes in one area or segment of the economy. Yes, spillover effects from the subprime market can extend throughout U.S. and world financial markets — as they have. Still, we need to be careful not to subsidize bad financial decisions by either small or large players in financial markets and certainly by large banks who fueled the credit markets with money with which to extend the many loans that are now in question.

Why not extend this generous help to everyone’s 401(k) so that we can all sleep better at night? Or is this sort of generous assistance reserved for a chosen few who are too big to fail? The Federal Reserve has a stellar reputation around the globe and the U.S. dollar is the reserve asset used by many foreign central banks. However, this reputation might slowly erode if we keep intervening in markets when we do not have to. Throughout this saga, the Bank of England is the only one that showed any sense or courage and did the right thing: nothing.

Mohammed Akacem is a professor of economics at Metropolitan State College of Denver.

READER COMMENTS

This is not a market bailout, its the ultimate recognition that interest rates have been pushed way too high for way too long. Ultinately, such a historic imbalance puts a good economy at risk.

Did anyone notice that the Fed's overnight ffed funds rate was higher than the 91-day, 180-day, 2-year, 5-year , 10-year, 20-year and 30-year rates? Since when is 24-hour money supposed to cost more than 30 -ear money? Hello, are all of you "bailout " imbeciles that financiially illiterate? Do you still carry your interest only mortgages?

National news08/20/2007,prisioner usage for picking the harvest. Wonderful idea but I have some more. Is there a website for the everyday American to provide ideas to our farmers without the commercialized web site??If so, please direct, I am willing share my thoughts without costs.

Thanks
Rebecca

Hank,

Or should I call you 'Mr. Bubble?'

Mr. Akacem merely points out [correctly] the moral hazzard that a Fed action in this environment carries with it. The Fed must balance the need to keep new credit flowing without bailing out those who made bad decisions in the past.

So far, the Fed has behaved appropriately in its role as lender of last resort since the Fed's actions to date have kept the credit markets from completely seizing. However an easing of the Fed Funds rate at the September meeting comes dangerously close to a concessionary rate cut.

In the long run, a correction in housing and consumer spending that makes us less dependent upon inane lending practices will allow our economy to heal itself faster.

Concessionary rate cuts will only prolong the pain and undermine confidence in our banking system.

Rarely in history has the Fed fallen this far behind markets:

This from Bloomberg this A.M. : In recent action, the three-month Treasury bill was rallying, while its yield fell 137 basis points to 2.51%. Meanwhile, the benchmark 10-year Treasury note was up 9/32 as its yield fell to 4.628%. Those are 91-day and 10-year market rates versus the Fed's target overnight rate of 5.25%. I can't ever recall a near 300 basis point discount for 91-days versus the Fed's overnight rate--the Fed remains WAY out of line with the market. They have no choice, the bond market is running the financial ball game and the wheel has been ripped out of the Fed's hands. They remain way behind the curve. More Fed cuts are needed and needed fast!

This entire financial fandango could have been avoided if folks like Greenspan and Bernanke would set their PC's to supply money at an annual growth rate of about 5-7% and then let the markets determine the proper rate. Constant fiddling and fine-tuning is the problem, not the solution.

"...rewarding bad investment decisions?"

Nope that's not the reason why the Fed moved. The Fed moved because (1) they wanted to contain the problem and didn't want it to spread as the economy began softening and (2) the market's equivalent of Fed's administered overnight fed funds rate (5.25%), the 91-day T bill rate, plunged to under 4% and then headed even lower. That means with the Fed pumping liquidity into the system, their 5.25% target rate is no longer defendable. This target gets cut too.

Bottom line: the Fed simply did what they always do--they followed market forces and market prices that screamed for lower rates for the past several months. We just got the first installment of overdue Fed easing. You might call it a targeted bailout (which it clearly wasn't), I call it doing their job.

Mr. Marr,

You make it sound as though everyone is being punished for a few bad loans, but the story is more complicated. 'Everyone' also benefited from the easy money of the past half decade as well. The easy money fueled asset prices, provided high paying jobs in the real estate and construction and finance industries, fueled demand in durable goods and home improvement retailing while bolstering the balance sheets of many Americans by making their houses more valuable. What people chose to do with this added liquidity and asset base determines if they are now being punished harshly, or merely riding out a natural business cycle.

There is, indeed, a risk that the credit crunch will expand to harm the wider economy, however your proposals are ludicrous as they represent the very moral hazzard Mr. Akacem points out. Raising the Fannie/Freddie lending limit from $417,000 to $650,000 would effectively forgive all of the irresponsible consumers, bankers and investors for their bad decisions and return us to our bubble-happy ways!!! In capitalism, even liberal capitalism, it is imperative that the persons assuming the greatest risks be allowed to fail when their decisions fail. This is not Kindergarden where you get to just sit in the corner for ten minutes and then come back and play. This is real life, where you must live with the consequences of your decisions. You might be able to come back and play, but it might be without that shiny new toy house you just bought!

And you are coorect in pointing out that secondary debt and real estate prices may contract, new construction may continue to slow and many businesses, hedge funds, investors and consumers will have to pay the price of excessivly easy money over the past 5-6 years. But that is far better than the alternative in our society: a lack of confidence in our monetary system.

We are blessed with a diverse and expanding population, an equally diverse and expanding economy fueled by one of the most transparant and flexible banking systems in the world. We can handle a 5-10% correction in the real estate market. However, we can't handle a loss of confidence in our monetary and banking system. It may be painful for some to hear, but this credit crunch and real estate correction is necessary to make up for the excess of our past 5-6 years. If you feel you're being punished right now, either you profited excessively from the bubble over the past 5-6 years and now you're just coming back to earth, or you're paying for your bad decisions. Either way, I find it hard to feel sorry for you.

The rest of us may feel some of the pain, but in the long run we'll all be better for it.

AMEN!

Let the sub-prime lenders go bankrupt and start either enforcing strict lending laws or strenthen lending laws.

It is a slap in the face to millions of Americans who have maintained perfect credit and have always paid their bills on time.

Sub-prime loans are just ripping off stupid people who have no idea how to manage money,read documents,or plan for future interest raises tied to their loans.

I don't want to pay for greedy lenders and stupid people.

Mr. Akacem’s views, free market as they are, misses some important points: How much pain is too much before it’s ok for the government to step in? Should the bad decisions of a few cause harm to the many? Is it ok for the government to restore confidence in the marketplace in a shorter timeframe than the markets could do on its own?

I’m all in favor of letting bad decisions have their own consequences. As a mortgage broker I’ve got a dog in this hunt, but up until a short while ago it didn’t seem as though I was a part of those bad decisions. Millions of people participated in the liberalization of obtaining credit which the essence of Mr. Akacem’s ‘bad decision’ article. Those that provided the money believed that credit could be successfully made available to borrowers that did not satisfy all four elements of a good loan: income and asset documentation, home valuation, and credit rating. If the borrowers were satisfactory on one or more of these elements, the risk based underwriting models could approve them for a loan. As that concept took hold and competition being what it is, liberalization moved from common sense into ridiculous.

But now what? Home valuation that millions of homeowners rely on has been inflated by the millions of transactions created by people that now will not be able to get financing. Sub prime loans were at most 20% of the market, but the current credit crunch affects Alt-A loans, Jumbo loans, and ‘Lite Doc’ loans. The net effect of eliminating those loans from the marketplace which constituted about 40% of all loans over the last few years could create a spiraling down of home values, destroy the new home market, do away with the 2nd mortgage market, increase foreclosures, and dramatically affect GDP. The result, if left alone from government intervention, would without question end in recession.

Those that have made bad decisions, hedge funds, investors, mortgage companies, etc. have all felt pain, loads of it. The problem is that investors don’t want to make that same mistake again; ergo there isn’t any money to lend. Without some action by the government, investor confidence is unlikely to return any time soon leaving only fully documented loans with substantial equity or mortgage insurance along with government loans (FHA, VA) as the only financing available. The economic consequences of so few choices could be devastating. What can the government do? Raise the Fannie Mae/ Freddie Mac lending limit to $650,000 from its current $417,000. That action would provide much needed liquidity and confidence to the markets.

So is it sense or courage that prevents action as Mr. Akacem believes or does it require the same to take action? It depends on who you think should pay the price for the last 6 years of credit liberalization. Who I think will end up paying the price? Everyone.

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