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Traders at the Frankfurt stock exchange in Germany. (AP/Bernd Kammerer)
Twice this month U.S. stock indices posted their biggest one-day gains in five years—only to surrender them again in sell-offs, dragging global markets down in their wake. Yet March’s most dramatic financial tribulations weren’t on Wall Street. Rather, they were hundreds of miles down the Eastern seaboard, in Washington, DC, where the U.S. Federal Reserve responded to financial turmoil with a series of aggressive policy interventions.
The trouble came to a head when Bear Stearns, the fifth-largest investment bank in the United States, seemed on the verge of outright collapse. The Fed swooped in (WSJ), assuming the risk of Bear’s bad debt to convince another banking giant, JPMorgan Chase, to buy the beleaguered company at a heavily discounted price. The Economist declared the move pragmatic—it saved Bear from defaulting on some $10 trillion of derivatives contracts, the argument goes, and thus served to stop the financial bleeding at its source. But other analysts questioned the wisdom of the move, noting that U.S. taxpayers will bear the burden of the bailout (ABC News).
The Fed didn’t stop at the Bear-Morgan deal. The board opened an umbrella over all of Wall Street, agreeing to lend directly to brokers through a new lending facility at the reserve bank of New York. Less than a week before, the Fed had announced a different new lending service, one of the many steps (RGE Monitor) the Fed has taken to boost liquidity since December. The Fed also sharply dropped the interest rate it charges banks, adding to its quickest monetary loosening in decades.
Final judgment of the Fed’s wild week will hinge on whether these policy maneuvers restore confidence in credit markets. Analysis here varies markedly. The Fed’s most urgent short-term mandate, some say, is to prevent the kind of panic that might have been stirred by a Bear Stearns implosion. An analysis from Dow Jones says many traders think the Bear Stearns breakdown brought the financial system precariously close to systemic collapse—and that the Fed prevented this outcome by adding emergency liquidity just when it was needed.
But with so many problems remaining, economists hesitate to cheer too loudly. First and most basically, there may still be a lot of bad debt out there, infecting the portfolios of the world’s biggest banks. Indeed, analysts say the debt situation could get worse before it gets better, particularly if U.S. property values continue their downslide and force more homeowners to default on mortgages. The Financial Times adds that defaults could spread beyond mortgage loans, to credit card debt or auto debt, potentially broadening the crisis.
With a daunting task at hand, the Wall Street Journal reports policymakers are now looking beyond short-term cash injections and considering long-term regulatory fixes. Doing this effectively will mean walking a tightrope. Over the past decade, economists say a system of loose credit and endless leverage led to a murky “shadow banking system” (IHT) beyond the purview of regulators. But experts also warn against going overboard. One analyst comments in the FT that a regulatory backlash against banks could have “costly” and “unintended consequences.” Examining the underlying financial system, the Economist article cited above says: “This system worked; indeed, at its simplest, it still does, spreading risk, promoting economic efficiency and providing cheap capital.”
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