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Reaction Is Mixed After Fed’s Efforts to Boost Economy

March 17, 2008 at 6:10 PM EDT
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Amid a slumping economy, the Federal Reserve has resorted to some unusual methods to stave off a recession, most notably its role in coordinating the bailout of lending giant Bear Stearns. Economics experts examine the Fed's action and the state of the credit markets.
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RAY SUAREZ: Shockwaves rippled across international financial markets and Wall Street today, a day after the Federal Reserve took the unusual step of announcing on a Sunday it helped coordinate and provide loans to help JPMorgan Chase buy the troubled investment firm Bear Stearns.

To do that, the Fed secured a $30 billion loan to JPMorgan Chase. That loan will be backed by assuming direct control over the Bear Stearns assets. If those assets decline in value, the Fed will bear the cost.

The central bank also offered to be a lender of last resort to some 20 investment banks, and it reduced the short-term discount rate by 0.25 percentage points, which lowers the rate banks are charged for emergency loans.

Outside the White House today, Treasury Secretary Henry Paulson defended the Fed’s steps.

HENRY PAULSON, U.S. Treasury Secretary: I very much support the Fed’s action. I was working there right beside them, helping execute this strategy.

Again, to step back, we place a high priority on the orderliness of our financial markets, this is very, very important, and the stability in our financial markets.

Bear Stearns had a liquidity crisis. And so we felt it was very important that this be resolved as a way to minimize the impact on our economy. And so these actions were all consistent and it was important that this be resolved before the markets opened in Asia on Sunday afternoon.

RAY SUAREZ: Federal Reserve officials will weigh another big cut to a key interest rate in their meeting tomorrow.

Fed steps in

Joe Nocera
The New York Times
When you're an investment bank and you depend on trading, and you depend on liquidity, and suddenly no one will trade with you, it really doesn't matter how many securities you have, how much money you have.

RAY SUAREZ: For some analysis, we're joined now by Alan Blinder, professor of economics at Princeton University, he was vice chair of the Federal Reserve from 1994 to 1996; Sam Hayes, professor emeritus of investment banking at the Harvard Business School; and Joe Nocera, business columnist for the New York Times.

And, Joe, let me start with you. Explain as simply as you can, what happened to Bear Stearns?

JOE NOCERA, Business Columnist, New York Times: It's like something seizes up; that's really the best way to describe it. There was panic among its counterparties, the people they traded with, that they wouldn't have the money to pay them back.

So people, gradually first and then with increasing acceleration, stopped trading with them. In fact, hedge funds that did business with them were sending notes to their clients over the last week or so saying, "Don't worry. We've stopped trading with Bear Stearns."

When you're an investment bank and you depend on trading, and you depend on liquidity, and suddenly no one will trade with you, it really doesn't matter how many securities you have, how much money you have. You have no business and the securities that you hold have no value, because no one will trade with them.

So this is a classic -- this is the modern version of the run on the bank. And, you know, there's a reason their stock closed on Friday at $30 a share and by Sunday night they were bought for $2 a share. They had no business.

RAY SUAREZ: Sam Hayes, let me get you to jump in there, because Joe Nocera explains this sort of seizing up of the business, but didn't Bear Stearns still have things that had value that people recognized as having value? Heck, the building that served as its headquarters was worth more than the company is about to be purchased for.

SAMUEL HAYES, Harvard Business School: Well, it's true. They had a balance sheet with a lot of assets listed on the asset side of the balance sheet, but those assets were melting away.

The price at which you could sell the assets in a short-term time frame was very low. And as far as the building is concerned, I wonder if that's totally unencumbered.

I don't think that the deal would have been done at $2 a share with a underlying safety net given by the Federal Reserve of $30 billion for a declining value of assets if, in fact, there was substantially more value on that balance sheet.

RAY SUAREZ: Alan Blinder, can you explain the mechanics of what the Fed did in order to be the go-between between JPMorgan Chase and Bear Stearns?

ALAN BLINDER, Former Economic Adviser to President Clinton: Well, the Fed basically said that it would take, I believe, up to $30 billion of Bear Stearns' assets, some of which have questionable value.

But others, by the way, have clearly good value onto its balance sheet, if necessary, so that JPMorgan wouldn't be worried about potential losses. It had also -- by the way, everyone has forgotten this, on Friday, had offered to make a loan to JPMorgan to, in turn, on lend to Bear Stearns to keep them liquid.

RAY SUAREZ: But when the Federal Reserve bank makes a guarantee like this, takes possibly shaky assets and says, "Don't worry, if they lose their value, we'll pick it up," where does that money come from?

ALAN BLINDER: Well, if need be, the Fed can print money. That's the nature of a central bank; that's the power that a central bank has that no other bank has.

So as long as we're talking about U.S. dollars -- and that's crucial here, and that is what we're talking about -- the Fed, if necessary, if there's no other way out, can simply print them up.

Future still very uncertain

Samuel Hayes
Harvard Business School
What the Federal Reserve and the treasury secretary was trying to do was to, in a sense, like they did in that old movie about -- in which there was a local bank there, they piled the desk with money.

RAY SUAREZ: Professor Hayes, if the Federal Reserve is willing to make a deal like that in order to save a Bear Sterns, does it perhaps unintentionally undermine the value of other institutions that are trying not to have a Bear Stearns happen to them?

SAMUEL HAYES: Well, I think it's the very fact that they did make the deal with Bear Stearns that gives support to the other institutions. What the Federal Reserve and the treasury secretary was trying to do was to, in a sense, like they did in that old movie about -- in which there was a local bank there, they piled the desk with money.

What they've done here is to say, "There's plenty of money." And as Professor Blinder says, "We can print more of it." You don't need to make a run on any of the other investment banks. You be assured that your deposits and your commitments with these other firms is good.

RAY SUAREZ: So, Joe Nocera, no risk that people looking at a $50-a-share price at other institution might be saying to themselves, "Could it be $2?"

JOE NOCERA: There's absolutely that risk. Look, this is a series of fingers in the dike. Nobody knows where the bottom is. The Fed doesn't know; other Wall Street firms don't know.

There are definitely rumors swirling around other firms. Lehman stock dropped 20 percent, I believe, today. And you can't -- the Fed is not going to be able to do this every single time, although certainly one would hope the Treasury Department and other financial regulators would come up with some kind of long-term concerted plan that would prevent any of the big firms from failing.

And that's, you know, because if that were to happen, that would be pretty cataclysmic and would really cause the rest of the financial system to begin to seize up, as well.

But, you know, tomorrow Lehman Brothers is going to announce their earnings. I believe Goldman announces its earnings tomorrow, too. There are definitely going to be write-offs, loan write-offs. I mean, the value of securities and debt is a lot lower than it was six, eight months ago or a year ago.

So the notion that this is going to fix the problem is a giant guess. And we really don't know, and we really shouldn't be speculating that we have found the bottom, because I actually don't think we have.

Looking out for the system

Alan Blinder
Princeton University
When you talk about a bailout -- which this was, I guess -- the stock closed at $30 on Friday and now it's offered at $2, that's not much of a bailout.

RAY SUAREZ: Well, Professor Blinder, let's turn the question around. What if Bear Stearns had been allowed to fail? It's been commonly talked about today as something cataclysmic. What would have happened or could have happened?

ALAN BLINDER: Well, nobody knows what would have happened, and that's exactly what the Fed didn't want to find out. But the concern was with the so- called counterparties that Mr. Nocera was talking about before.

You know, if you have one big company or even not so big -- but it matters much more if it's big -- in the chain, it's receiving money, it's paying money. If it gets bottled up, and that entity cannot pay out to other entities, then those other entities down the road, other financial institutions, can themselves get into trouble.

And that's the abyss that the Federal Reserve didn't really want to look into very deeply.

But let me just say one more thing. When you talk about a bailout -- which this was, I guess -- the stock closed at $30 on Friday and now it's offered at $2, that's not much of a bailout. To me, this is pretty analogous, although legally different from an orderly bankruptcy.

It's not a bankruptcy. It's not going through bankruptcy court. But you have reduced the value of the shareholders to almost nothing and ensured that the financial plumbing, as it's often called, keeps functioning.

RAY SUAREZ: So, Professor Hayes, really, this deal was looking out for the health of the system, not so much for the Bear Stearns shareholder?

SAMUEL HAYES: That's right. And as Professor Blinder said, the shareholders got virtually nothing, and 30 percent of the shares were owned by the employees. And the employees have gotten nothing, because they have no security in their jobs.

And so I think that the resolution has actually punished those who deserve to bear the real burden of this.

RAY SUAREZ: Joe Nocera, did it really punish those who deserve to bear the burden? Let's talk a bit about moral hazard, the idea that, if you insulate people from making big mistakes, you don't discourage other institutions making those same mistakes.

JOE NOCERA: Well, there's two ways of looking at this, Ray. The first is, you know, if you're in another institution and you see what's happened to Bear Stearns, you're not cheering. You're not saying, "Oh, boy, I hope this happens to me. It will be a bailout."

I mean, it does not feel like a bailout. A lot of people are going to lose their jobs. There's a guy who invested over a billion dollars in Bear Stearns as part of a previous bailout attempt who has lost over a billion dollars.

You know, Mr. Cayne, the chairman, you know, he was off playing bridge last weekend. He's lost a lot of money. So it's not a great feeling of joy among other firms.

But if you look at it from the -- you know, it's interesting to me that moral hazard was a term everybody was using, including people on Wall Street and in the government, when it came to homeowners who had mortgages that were being foreclosed on because they had foolishly signed on to home mortgage loans that they really couldn't afford, in some cases were duplicitous.

And everybody said, "Well, you know, moral hazard. They need to take their lumps." And so I do think there's the same issue of practicality.

In other words, you're not letting Bear Stearns go down the tubes because, as a practical matter, it's bad for the system. So maybe one should apply the same rule to homeowners and say, "Well, maybe we should do something about all these foreclosures, because they're bad for neighborhoods and communities and also, in its own way, for the system."

RAY SUAREZ: Professor Blinder, how do you respond?

ALAN BLINDER: Well, I think, as you know, Ray, I agree with that very much. I wrote a piece in the New York Times a few weeks ago advocating that we re-establish something like the Depression-era Home Owners' Loan Corporation to do exactly what Mr. Nocera was saying.

As I think you may also know, Congressman Frank and Senator Dodd have a piece of legislation swirling around in the Congress that wouldn't do exactly that, but would do something similar to that, which I think would be hugely helpful in circumstances like this.

And it's really not right to say, as Mr. Nocera says, that we're really worried about moral hazard at the level of John and Jane Doe, but we're not worried about it at the level of Wall Street.

RAY SUAREZ: But the Fed isn't capable, is it, of continuing to do this?

ALAN BLINDER: No, this is not the Fed.

RAY SUAREZ: In the case of -- if there are more Bear Stearns in the pipeline.

ALAN BLINDER: The Fed is going to be reluctant to keep on doing this. I won't say it will never do this again, because you can never say anything like that. But the Fed certainly is not eager to do this repetitively, each time putting some money at risk.

You know, that to me is really the job of the administration and the Congress. If taxpayer money is going to be put at risk, the political leadership should be doing it.

Additional regulation likely

Samuel Hayes
Harvard Business School
I do think that that oversight of the valuation of securities and analysis of the risk inherent in some of these newer derivative securities is something that has been given short shrift.

RAY SUAREZ: Professor Hayes, there's been talk about risk management and how the science needs an injection of vigor and vitality right now. How does a system that's sort of looking over the precipice right now get that back without totally shutting down lending that helps keep people doing business?

SAMUEL HAYES: Well, I think the first thing you do is to assess where you made your mistakes in the past. And we have a pretty fresh example in the subprime loan securities example to look at.

I do think that that oversight of the valuation of securities and analysis of the risk inherent in some of these newer derivative securities is something that has been given short shrift.

And I think that, in exchange for the fact that there has been this resolution, which has not caused a bankruptcy for Bear Stearns, I think that the securities firms are going to have to be ready to accept some additional regulatory oversight.

RAY SUAREZ: Professor Hayes, Professor Blinder, Joe Nocera, thank you all.