Tuesday, December 07, 2010

The Fed's Rescue Details

Many pundits and media personalities are expressing outrage after reading details of the Fed's assistance to various private entities during the 2008-09 financial meltdown.

Of particular mention in a Wall Street Journal article was the Fed's aid to money-market funds, while a CNBC discussion highlighted the otherwise-frozen commercial paper market.

It's disconcerting to read of Goldman Sachs borrowing a total of $600B from the Fed. Obviously, loan totals over the period would be staggering.

Since, as the Journal article notes, "it is tough to see how the Fed will ever convince investors it won't again ride to the rescue when required," can we not at least expect the Fed, Treasury, and perhaps Congress, in concert with financial sector players, to devise better ways of providing said insurance during financial crises?

Is it not feasible for the Fed to sell insurance, rather than simply lend trillions? Can't some market-oriented solution utilize risk-pricing so that institutions may acquire protection, but at prices related to their risk and in consequence of their mistakes?

Or perhaps, through significant rewriting of the deeply-flawed Dodd-Frank bill, provide clear, objective, quantitative tests, failing which will send a firm immediately into Chapter 11, while passing would allow it access to temporary federal aid, though priced according to risks measured in said tests?

Anna Kagan Schwartz went on record first, back in 2008, noting that the crisis was, in reality, one of solvency, not liquidity. But Paulson and Bernanke provided a solution to a liquidity crisis.

What would the proper solution have been for a solvency crisis? Wouldn't it have been, as Schwartz suggested, more orderly closing of insolvent institutions, thereby relieving counterparty pressure on the remaining institutions, which then would be judged safe and solvent? Wouldn't that take far less capital from the Fed, and create far less panic in the first place?

Given the immense scale of the Fed's bailouts of 2008, and the increasing indebtedness of the US, and possible pushback by global investors the next time the Fed tries to blithely expand its balance sheet so quickly and to such a large extent, it seems prudent to develop less capital-intensive, more discerning methods of avoiding financial panic and complete breakdowns short of simply lending out hundreds of billions, to trillions of dollars to one and all without any regard to the riskiness of the situation at each institution.

We have some time, hopefully, before the next incident of such widespread financial catastrophe. Surely there are suitably-capable minds available. Can't we expect our government's institutions to engineer better financial crisis solutions pre-emptively, rather than simply repeat the awkward and questionable practices of the Fed and Treasury during the recent financial crisis?

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