Sunday, March 16, 2008

From Subprime to Prime Time

Bear Stearns and its rescue - a backgrounder;

By the way, Mr. Greenspan is still at it: accepting no blame, he continues to insist that “market flexibility and open competition” are the “most reliable safeguards against cumulative economic failure.”

The Federal Reserve on Sunday announced two initiatives designed to bolster market liquidity and promote orderly market functioning. Liquid, well-functioning markets are essential for the promotion of economic growth.

First, the Federal Reserve Board voted unanimously to authorize the Federal Reserve Bank of New York to create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets. This facility will be available for business on Monday, March 17. It will be in place for at least six months and may be extended as conditions warrant. Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities. The interest rate charged on such credit will be the same as the primary credit rate, or discount rate, at the Federal Reserve Bank of New York.

Second, the Federal Reserve Board unanimously approved a request by the Federal Reserve Bank of New York to decrease the primary credit rate from 3-1/2 percent to 3-1/4 percent, effective immediately. This step lowers the spread of the primary credit rate over the Federal Open Market Committee’s target federal funds rate to 1/4 percentage point. The Board also approved an increase in the maximum maturity of primary credit loans to 90 days from 30 days.

The Board also approved the financing arrangement announced by JPMorgan Chase & Co. and The Bear Stearns Companies Inc.

-Federal Reserve

The deal announced with J.P. Morgan still leaves the possibility that the Fed will retain significant counterparty risk. Such an arrangement is akin to the FDIC’s practice of covering all deposits, even those in excess of $100,000 during the thrift crisis. If counterparties are not deterred from contracting with weak institutions immediately the stage will be set for unsound institutions to sell risk on the cheap, on the presumption that the Fed will act as a backstop.

… Unlike a commercial bank there is no social need to rescue Bear. Commercial banks’ funding through consumer deposits necessitates a maturity mismatch: Bear chose a similarly mismatched funding structure. Bear also chose to be one of the largest originators of a mortgage product that turned out to be not only uneconomical, but economically harmful. To support such funding and investment practices would therefore be entirely socially and economically inappropriate.

-Joseph Mason

Recall the broad outlines of the Bush administration’s economic policy since 2001, when the White House inherited a substantial budget surplus and a rapidly slowing economy. The decision to reverse the Clinton tax increases of 1993 was easy to sell, in the name of stimulating the economy, but it left it the government somewhat vulnerable after 9/11. A second round of tax cuts on the eve of a war in Iraq that turned out to be far more expensive and longer than expected only left the US government more exposed. (Oil was $25 a barrel when the US invaded.) The decision to greatly expand elderly pharmaceutical benefits with no corresponding means to pay for them exacerbated the long-term Medicare deficit; the ill-fated attack on Social Security after Bush’s 2004 re-election postponed indefinitely the day when a compromise can be achieved. All the while, pressure on Alan Greenspan at the Fed to get the economy growing again produced the real estate bubble. Only the administration’s mid-term Congressional defeat prevented the appointment of a much less able man than Bernanke (or Feldstein) to the Fed.

Could the Bush administration have run American economic policy any worse? Welcome to a recession that threatens to be both deep and long, the result of bungling not seen since the presidency of Jimmy Carter.

-David Warsh

the Fed action is like spraying foam on the runways -- the plane is still going to crash and not fly again, but the people on board will hopefully walk away with just bruises. Or in english, having Bear collapse in a day would have led to problems with people who rely on them for clearing trades. The Fed action won't save Bear but will avoid fallout that disrupts markets by even more.

-Mankiw's friend

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