Reply #22: Should the Fed Save Wall Street Firms?

[Demeter]

http://blogs.wsj.com/economics/2008/03/17/should-the-fe... /


Joseph Mason, an economist at Drexel University who has studied bailouts, weighs in on the moral hazard problem created by the Federal Reserve’s intervention (in the name of market stability) to prop up Bear Stearns on Friday and the Fed’s $30 billion loan to support J.P. Morgan Chase’s purchase of the firm.

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.

The regulators need to end their denial and come to terms with the fact that the credit losses will substantially harm some firms. Getting away with realizing those losses and dealing with them effectively by attracting capital to the sound institutions and closing the unsound will speed recovery and ameliorate the recession.