From the desktop of Brad DeLong, a very good synthesis of the evolving state of Federal Reserve policy:
We now have two precedents. If the Federal Reserve judges that a major financial institution:
- is too big to fail in that its failure will generate systemic risk
- has followed portfolio strategies that have produced inappropriate and excessive leverage
- requires immediate action
then the Federal Reserve will intervene to structure and support a deal that leaves principals and investors in the offending systemic risk-creating institution with effectively zero entity. Counterparties will be rescued. Principals and investors will not--even if normal more lengthy legal and bargaining processes would give principals and investors a share of the equity value on the table.
This is not the arms-length equal-treatment impersonal-rule-of-law ideal to which a government should aspire. This does, however, seem to get the incentives about right.
The Federal Reserve faces a big dilemma late this year and next year: How long can the Fed wait to raise rates and to cut back this liquidity injection? The Fed remains quite concerned about inflation; however, it has a more immediate priority -- to keep the financial system from seizing up.
On Sunday, March 16, the Federal Reserve crossed a big line directly bailing out a non-depository financial institution and our fifth largest investment bank, Bear Stearns, for the first time since the Depression. The Fed forced Bear Stearns out of existence by loaning J.P.Morgan Chase $30 b. to purchase it at a fire sale price of $236 million on Sunday after Bear Stearns stock closed with a market valuation of $3.5 b. on Friday, March 14th.
The transaction raises a lot of questions. The ones I would like to deal with are: Why didn't the Fed just let Bear Stearns go bankrupt? How big a windfall was this for J.P.Morgan Chase? What risks does this Fed action pose for the future?
We don't know why the Fed took this action. Their press release announced the action in one sentence without any explanation.
I'm just starting to understand why The Daily Show is the most-watched "news" program for college students (and, I hear, Wall Street analysts).
In a front page story in today's Washington Post about Alan Greenspan's about-to-be-published book, "The Age of Turbulence: Adventures in a New World," Bob Woodward says that Greenspan lashes out at George W. Bush, the Bush administration, and congressional Republicans for terrible economic stewardship.