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To Bail or Not to Bail

The Fed's decision.

12:00 AM, Mar 18, 2008 • By IRWIN M. STELZER
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THE LIFE OF A self-styled paragon is not an easy one. So Eliot Spitzer found when it was revealed that he not only prosecuted prostitution rings, but patronized them. And so David Rubinstein discovered when Carlyle Capital Corporation's (CCC) hedge fund collapsed. "I don't think one fund out of 60 will spoil a reputation built over twenty years," the co-founder of the wildly successful Carlyle Group told the press. Perhaps not, but it has dented it. The awe-inspiring smartest guys on Pennsylvania Avenue have been shown to be less than infallible.

And the toughest guys on Wall Street--the cigar-chomping, go-it-alone bunch at Bear Stearns--have been shown not to be so tough after all. They first needed a bail-out by the Fed and J.P. Morgan Chase to survive for a few days until J.P. Morgan took the firm over, ending its tenuous hold on its existence and independence. The Fed has taken Bears' liabilities onto its own balance sheet, and Morgan got what seems to be a bargain: it paid 1 percent of the value of Bear Stearns just 17 days ago, and far less than the stricken firms' headquarters building is worth. Which is why Bear Stearns' shareholders are shopping for a better deal. Bear Stearns, it will be recalled, was the one firm that refused to cooperate in or contribute to the 1998 bail-out of Long Term Capital Management when the Fed pleaded for it to go along with other firms so as to avoid a systemic collapse. It had few friends upon whom it could call in its unsuccessful effort survive on its own.

The Bear Stearns deal was only one matter that kept Fed chairman Ben Bernanke from having a relaxed weekend of the sort that was his when he walked the quiet corridors of Princeton. He also arranged a new credit facility for troubled investment banks, and announced a cut in the short-term rates at which such institutions might borrow from the Fed.

The question now is whether the markets will see the takeover of Bear Stearns and the Fed's latest moves as a sign that out-of-control events are no longer in the saddle, or a sign of panic by Bernanke. It would not be unreasonable to assume that the CCC and Bear Stearns problems were only the tip of the iceberg towards which the U.S. financial ship is headed, and that recent history suggests that even an energetic captain can't change the credit markets' course.

After all, Bernanke has been cutting short-term interest rates in attempt to ease the credit log-jam, to little effect. Longer-term rates remain stuck on high. So the Fed then made the banks an offer they will find it difficult to refuse. Come to us with your AAA-rated mortgages, Bernanke told strapped financial institutions, and we will give you in exchange $200 billion of the risk-free Treasury securities that we hold on our own balance sheet. And for 28 days, rather than the few hours as is our usual custom. Still no peace in the canyons of Wall Street.

The Fed's swap offer is not quite the same thing as buying these mortgages from the banks, which would love to unload them permanently for cash. That would be a bail-out, something Treasury Secretary Hank Paulson is eager to avoid lest it create what economists call "moral hazard"--encouraging a repeat of bad behavior by shielding the players from the consequences of that behavior. In the case of the banks, saving their shareholders from losses would encourage them to repeat their recent willingness to lend to people in no condition to repay.

The Fed's non-bail-out is aimed at driving up the price of mortgages, increasing their valuation on bank balance sheets. That, along with the good paper (risk-free Treasury notes), would enable the banks to start lending again.

All of which puts me in mind of the Clintons, who in a desperate bid to salvage Hillary Clinton's campaign for the Democratic nomination decided to "throw the kitchen sink" at Barack Obama. Which they have done, but with only limited success as Obama remains on course to victory. Bernanke has now thrown the kitchen sink at the credit crunch. Optimists are hoping that credit markets will get a real kick-start when the Treasury notes are auctioned off on March 27. By that time, the Fed's weekend announcement of easier credit for investment banks will also have taken hold. Better still from the point of the banks, the Fed will probably also have cut short-term interest rates, a move that, regrettably, will add to the already-substantial inflationary pressures created by rising food and energy prices, and the falling dollar.