News Analysis Rescue Puts Fed Credibility on the Line

The Federal Reserve is putting its vast resources and its reputation on the line to rescue Wall Street’s biggest institutions from their far-reaching mistakes.
Von Edmund L. Andrews

Far more than at any time before, the Federal Reserve is putting its vast resources and its reputation on the line to rescue Wall Street’s biggest institutions from their far-reaching mistakes.

Over the next few months, the central bank will lend hundreds of billions of dollars to banks and investment firms that financed a mountain of mortgages now headed toward default.

No one knows how many financial institutions will be looking for money, or how much they will seek. No one knows how much in hard-to-value securities the central bank, in return, will have to hold as collateral.

And no one knows how much the Fed could lose if the borrowers fail to repay their loans or whether hundreds of billions of dollars will ultimately have to come from taxpayers to shield the nation’s financial system from ruin.

In recent weeks, the central bank announced a series of emergency short-term loan programs that totaled about $400 billion (€254 billion). But on Sunday, Fed officials raised the stakes by offering investment banks a new loan program without any explicit size limit.

These moves, along with a $30 billion credit line to help JPMorgan Chase take over the failing Bear Stearns, is fraught with more than financial risk.

The biggest danger is damage to the Federal Reserve’s credibility if it is seen as unwilling to let financial institutions face the consequences of their decisions. Central banks have long been acutely sensitive to “moral hazard,” the danger that rescuing investors from their mistakes will simply encourage others to be more reckless in the future.

Fed officials for years have cringed at the mention of a “Greenspan put,” an allusion to the belief of some investors that Alan Greenspan, the former Fed chairman, would use the Fed’s powers to protect them against a plunge in financial markets and provide them with a metaphorical “put” -- an option to unwind their positions at an acceptable price.

But the moves undertaken by the current chairman, Ben S. Bernanke, amount to a much bigger insurance policy than anything Mr. Greenspan provided.

Mr. Bernanke had made clear for months that he wanted to avoid a bailout of Wall Street. But as an economic scholar who spent years studying the Depression of the 1930s, he had also drawn the lesson that panics in financial markets can transform a modest downturn into a cataclysm.

Fed policy makers now contend that the consequences of not coming to the rescue would have been a cascade of bankruptcies and defaults on Wall Street that could have undermined the financial system and risked severe damage to the economy.

Few analysts were ready on Monday to question the Fed’s uncomfortable effort in balancing risks. But it could be months or years before the full consequences become apparent.

Alan Blinder, a professor of economics at Princeton and a former Fed vice chairman, commented: “These kinds of crisis- prevention measures always have to balance potential moral hazard costs down the line against the clear and present danger that something is going to happen right now.

“You’re taking on substantial risks when you do something virtually unprecedented or you put money at risk. The Fed has now done both.”

Another big risk is that the central bank, in providing a cushion of emergency loans, could jeopardize its reputation as an inflation fighter. On Tuesday, Fed officials are all but certain to sharply reduce their benchmark interest rate on short-term loans, the federal funds rate -- for the sixth time in six months. The Fed has already reduced the rate in rapid stages to 3 percent from 5.25 percent, and many analysts predicted Monday that it might lower it by a full percentage point more.

Complicating the task, inflation pressures are unmistakable, even though the economy is widely thought to already be in a recession, and a downturn usually leads to slower increases in consumer prices.

On Monday, the dollar continued to decline in value against the euro and the yen, a trend that tends to push up import prices. And in commodities trading in New York, the price of gold for April delivery was quoted as high as $1,006.90 an ounce before falling back to settle at $1,002.60. Those increases stem at least in part from growing concerns among global investors about inflation in the United States and the weakening dollar.

Fed officials acknowledge that inflation has picked up slightly, but they assert that the much bigger risk is a recession caused by the squeeze in the financial markets.

There were hints on Monday that the central bank’s rescue operation might have bolstered confidence in the battered credit markets.

US Taxpayers Could End up Footing the Bill

Several measures of risk aversion receded slightly. Spreads between the higher yields that investors demand for debt securities compared with those for safer Treasury bonds declined slightly. So did prices for credit default swaps, which amount to insurance premiums paid to protect bondholders in the case of a default.

“The early evidence is that the Fed is starting to get some traction,” said Michael Darda, chief economist at MKM Partners, a hedge fund and trading firm in Greenwich, Conn. Mr. Darda, who has been critical of the Fed for being inattentive to inflation pressures, said he nonetheless sympathized with policy makers’ fears about a financial market crisis.

“This is really a very ugly situation for the Fed to be in,” Mr. Darda said. “They’re making a calculation about what is the greater evil, and they’ve made a decision that letting the credit crisis exhaust itself is too big a risk.”

Analysts caution that for all its might, the Federal Reserve and its loan program face limits unless officials decide to start printing more money to pay for the rescue.

At the moment, the central bank has committed cash and Treasury bonds that are in its own reserves, totaling about $800 billion. But having agreed to provide at least $400 billion in short-term loans, and probably more, it is pledging a big share of its resources to the rescue.

“The Fed is now running on less than a half tank of gas,” Laurence H. Meyer, a forecaster at Macroeconomic Advisers and a former Fed governor, wrote in a note to clients. “The Fed seems to be running out of room for these types of measures.”

Officials at the central bank brushed aside such concerns, noting that many of the loans would be limited to 28 days and that the longest-term loans have to be repaid within 90 days. Fed officials also say that the combined rescue effort is not as big as the sum of the individual loan programs implies, because some institutions will simply shift from an earlier program that is less convenient to the newest one announced on Sunday.

If the rescue effort fails, taxpayers could indirectly wind up having to assume part of the cost. Tax revenue does not pay for the Federal Reserve’s operations, including the rescue effort, because the Fed earns income from its trading operations.

But the Fed does pay the Treasury a regular stream of money every year out of its trading profits, lowering the amount it needs to borrow from outsiders. If the new borrowers on Wall Street are unable to repay, and if the market value of the securities they pledge as collateral continues to drop, the losses will come out of the Fed’s payments to the Treasury.

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