Jewish World Review April 2, 2008 / 26 Adar II 5768

The last thing the Fed needs is to be assigned the role of Risk Hunter for the entire economy

By Robert Robb

http://www.JewishWorldReview.com | Treasury Secretary Henry Paulson wants to turn the Fed into the Risk Hunter, prowling freely throughout the economy to manage anything that threatens the "stability" of financial markets.

This is a task that's impossible to define sensibly, much less do.

Markets are always moving. Some things are going up, others are going down. Some people are making money, others are losing. Some firms are expanding, others are contracting.

This inherent instability of markets is what makes them work effectively and efficiency to allocate resources.

Paulson wants to assign the Fed the job of the impossible because the federal government is apparently unwilling to step aside and let the market impose its own discipline by allowing big boys to go broke.

Big investment banks are in trouble over the housing downturn because they acted imprudently.

About 93 percent of all mortgages are current. Even around 80 percent of subprime mortgages are current.

People who bought mortgage-backed securities with cash as an investment are OK. Mortgages are being paid, income is flowing to those holding the securities.

The return on their investment may end up being less than they expected. But they don't need the federal government to bail them out.

Those in trouble borrowed to buy the securities or put up the securities as collateral for borrowing.

The big investment banks are highly leveraged and rely on churning their debt. A decline in the value of what they do own jeopardizes their game. So, should the federal government care?

There doesn't seem to be any compelling reason why it should.

Clients with custodial accounts with these big investment firms might experience some inconveniences if they were to fail. But they still own what they own and can find others to manage it for them.

If the game is called, a lot of securities might go on the market, temporarily depressing their value. However, prices for long-term holders will eventually return to intrinsic values based upon actual cash flows.

Non-speculators who nevertheless need to liquidate for cash will be hurt during the transition. But investors with cash will get some real bargains. A lot of big boys would lose a lot of money. So what? You make big bets, you run the risk of big losses.

The federal government, however, seems unwilling to let big boys go broke.

The Fed is now helping investment banks churn their debt, accepting as collateral securities private lenders are shunning. It agreed to guarantee $29 billion in collateralized debt securities to facilitate the sell of Bear Sterns to JPMorgan Chase.

This is widely outside the historical role of the Fed as the lender of last resort. The Fed has this role to stave off commercial bank panics, when depositors demand more money than banks have in reserve. In this case, the Fed is lending to stave off the consequences of overborrowing by the investment banks themselves.

This is supposedly to maintain orderliness in the financial markets. But disorderliness may be precisely the right tonic needed to correct and discourage overleveraging.

The Fed is ultimately, of course, us. And some observers are already worried about the stress unconventional lending activity is putting on the Fed's own balance sheet and the risk that poses to taxpayers.

Meanwhile the Fed is doing a lousy job of its main function in the economy, providing a stable currency. Inflation has topped 4 percent and the dollar is in a free fall against other currencies.

The last thing the Fed needs is to be assigned the role of Risk Hunter for the entire economy. In Britain, the central bank doesn't even have supervisory oversight of commercial banks. Maintaining a stable currency is thought to be a big enough job all by itself.

Some argue that if the federal government is going to provide the same backstop to investment banks as commercial banks, then they should be subject to the same requirements and oversight regarding capital and liquidity.

There's sound logic in that. But the better resolution is to deny investment banks the same backstop, for the federal government to declare a willingness to allow big boys to go broke.

Such a declaration would do more to impose market discipline than all the regulations in the world.