http://money.cnn.com/2008/03/12/markets/fedfollies.fortune/index.htm?postversion=2008031304
How a lender bailout hurts the economy
The Federal Reserve's efforts to ease the credit crunch risk stoking
inflation - and letting reckless, well-paid execs off the hook.
By Colin Barr, senior writer
NEW YORK (Fortune) -- The government is showing considerable ingenuity
in devising new tactics to fight the credit crunch. But some observers
fear that the innovations risk making matters worse - by fueling
inflation and insulating executives who made reckless bets from the
full wrath of the market.
The Federal Reserve set off a ferocious stock market rally Tuesday
with its plan to lend banks as much as $200 billion over 28 days later
this month. The plan sent shares of hard-hit lenders such as Fannie
Mae (FNM), Freddie Mac (FRE, Fortune 500) and Wa****ngton Mutual (WM,
Fortune 500) soaring, because the Fed will allow borrowers to use
privately issued mortgage-backed securities as collateral. Investors
have fled those securities because they see a rising risk that
mortgage bonds will become impaired as housing prices slide and
defaults tick higher.
Tuesday's plan, dubbed the Term Securities Lending Facility, wasn't
the first Fed move aimed at loosening up the debt markets. Late last
year the Fed rolled out a similar plan called the Term Auction
Facility that briefly succeeded in bringing down the interest rates
banks charge one another for overnight loans.
"Think of Ben Bernanke as action hero," Felix Salmon wrote this week
at ****tfolio.com. "Every time the credit markets seize up and threaten
to bring down the U.S. financial system, he pulls out a new weapon."
Not quite a fan club
Not everyone is a fan of Action Ben, however. David Rosenberg, chief
North American economist at Merrill Lynch (MER, Fortune 500), wrote
Wednesday that this week's Fed action will do little to counter the
impression that Bernanke & Co. is struggling with problems that the
Fed ultimately has little control over.
"This latest experiment, as with the others undertaken thus far, does
not address underlying credit problems, does not materially improve
the solvency of the institutions exposed to assets under stress, does
nothing to put a floor under home prices," Rosenberg wrote in a note
to clients. "We see no reason based on this for anyone to change their
economic or earnings outlook despite the stock market's initial
reaction to this latest initiative."
Rosenberg, who has been predicting for some time that the economy will
slip into recession this year, expects the Fed to cut its fed funds
rate to as low as 1% later in 2008, down from 3% now and 5.25% back in
August. Observers expect the rate cuts to continue next week, with a
cut as deep as 75 basis points at the Fed's regularly scheduled
meeting. But there's little optimism that the cuts will do anything to
stimulate demand for houses, which remain pricey by historical
measures, or even bring down mortgage rates, which have been rising
since the Fed's slashed rate by more than a percentage point over
eight days at the end of January.
The fear is that by expanding its emergency lending programs and
sharply cutting rates, the Fed will turbocharge already healthy parts
of the economy - at the cost of reduced purchasing power by dollar
holders. Meanwhile, the big problem - bad loans tied to houses whose
value is now declining - continues to fester.
"We're in the helicopter phase now," says Howard Simons, a strategist
at Bianco Research in Chicago. He references the nickname Helicopter
Ben, which Bernanke got tagged with after a 2002 speech on how central
banks can steer away from deflation by dropping money into the
economy.
Simons says he appreciates the Fed's need to make sure the economy has
sufficient liquidity. But with gasoline prices approaching an all-time
inflation-adjusted high and the price of milk having jumped 12% last
year, inflation "is a very real concern," Simons says.
Betting on inflation
He points to the action in Treasury Inflation Protected Securities -
bonds whose principal amount is adjusted upward when the consumer
price index shows inflation and drops when it shows deflation. The
yield on five-year TIPS recently turned negative - meaning that
investors buying the securities now are accepting a lower interest
rater than they would get on comparable Treasury notes, in the
expectation of making up the difference in coming years via the
inflation adjustment. In essence, they are betting that buying TIPS
will ****eld them from the loss of purchasing power they would suffer
over time by holding nominal Treasurys.
David Merkel, chief economist at broker-dealer Finacorp Securities,
agrees that inflation is worrisome but adds that the makeup of the
current board of governors ensures the Fed will "err on the side of
inflation." Along with Bernanke, Fed Vice Chairman Donald Kohn and
governor Frederic Mishkin "are students of the Great Depression,"
Merkel says. "So you're going to see more loosening" of monetary
policy when the economy runs into trouble.
Inflation isn't the only worry on the minds of Fed critics. Dean
Baker, co-director of the Center for Economic and Policy Research in
Wa****ngton, says the Term Securities Lending Facility and moves like
it amount to a government bailout of cor****ate executives who made
reckless bets - and who should be made to pay the tab with their jobs.
"The Fed's actions are keeping banks from having to write down large
losses and quite likely go into bankruptcy," he writes on his blog at
the American Prospect. "The result is that the bank executives, whose
inept management pushed them into bankruptcy, get to keep their jobs
and their salaries, which run into the tens of millions a year."
Meanwhile, homeowners facing foreclosure - not to mention ordinary
savers who are watching inflation erode the value of their nest eggs -
remain quite unbailed-out.
Simons says the whole mess points up the limitations of the Fed.
"They're not crisis managers," he says. "There's no playbook for
this."
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