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When the Federal Reserve stepped in and made it possible for JP Morgan to buy Bear Sterns, and when it began providing several innovative ways for investment banks to access huge amounts of money, American capitalism changed. David Wessel provides a brief overview of how fundamental these changes really are.
- When the Federal Reserve came to the rescue of Bear Sterns and forced it to be sold to JP Morgan, the Fed agreed to take losses or gains, if any, on up to $29 billion of securities in Bear Sterns’s portfolio. The outcome will influence the sum the Fed turns over to the US Treasury.
- For the first time in history, the Fed lent money to Wall Street securities firms. Up to this point, the Fed lent to Main Street commercial banks. Such banks are closely regulated. But since the change was announced, during the first three days, securities firms borrowed an average of $31.3 billion a day from the Fed. For that reason, Treasury Secretary Henry Paulson leaned on two shareholder-owned, though government-chartered companies—Fannie Mae and Freddie Mac—to raise capital that their boards did not want to raise. In exchange, the government permitted these companies to increase their leverage so that they could buy about $200 billion more in mortgage-backed securities.
- There is some evidence that all this unprecedented activity is working. The gap between interest rates on mortgages and safe Treasury securities is narrowing. It has dropped from 2.92 percentage points above the relevant Treasury rates to 2.22; the normal rate is about 1.5 percentage points.
- Paulson has also announced significant increases in Federal Reserve regulatory power and influence over investment banking.
The danger of all this of course is that it may not be enough. Mortgage payment failure will no doubt increase (at least in the short term) and place a heavy burden on families and communities. Further, there is the danger of a downward spiral in which falling prices of houses and mortgage-backed securities lead lenders to pull back, hurting the economy and dragging asset prices down further. In ordinary times, a capitalist economy allows prices (e.g., of homes, mortgage-backed securities and stocks) to fall to the point where large investors begin buying again. So far that has not occurred. Large amounts of cash remain on the sidelines, waiting for the bottom to be hit in the finance markets. Until that occurs expect the US Treasury department and the Federal Reserve to be proposing radical solutions. The US government, and thereby the US taxpayer, has a much larger stake in the success of these elements of the American economy. If all this fails, the US taxpayer will need to pay the bill!
See Wessel’s essay in the Wall Street Journal (27 March 2008). |
