Saturday, May 3, 2008

The Fed and Moral Hazard/Being Superman has reprocussions

As Wall Street cheers the Fed's new image of being Superman and saving any damaged financial company, everyone that's in trouble is beginning to believe they can get a free handout.

This is the moral hazard that Wall St. never addressed as they decided to become the Superman of Wall St. As a result, everyone is starting to come to the Fed wanting their piece of the financial pie.

Criticism is starting to mount from the guru's because the rules of who would be helped and where the Fed would draw the line were never established.

Bloomberg addressed this today:

"May 2 (Bloomberg) -- A month after the Federal Reserve rescued Bear Stearns Cos. from bankruptcy, Chairman Ben S. Bernanke got an S.O.S. from Congress.

There is a potential crisis in th "student-loan market'' requiring ``similar bold action,'' Chairman Christopher Dodd of Connecticut and six other Democrats wrote Bernanke. They want the Fed to swap Treasury notes for bonds backed by student loans. In a separate letter, Pennsylvania Democratic Representative Paul Kanjorski and 31 House members said they want Bernanke to channel money directly to education-finance firms.

Former Fed officials and other Fed-watchers say that Bernanke's actions in saving Bear Stearns will expose the central bank to continuing pressure to use its $889 billion balance sheet to prop up companies or entire industries deemed important by politicians. The Fed satisfied Dodd's request today, expanding the swaps to include securities backed by student debt."

Criticism is mounting over the Feds new handout policy:

``It is appalling where we are right now,'' former St. Louis Fed President William Poole, who retired in March, said in an interview. The Fed has introduced ``a backstop for the entire financial system.''
Critics argue that the result will be to foster greater risk-taking among investors emboldened by the belief that the government will bail them out of bad decisions.

The Fed's loans to Bear Stearns were ``a rogue operation,'' said Anna Schwartz, who co-wrote ``A Monetary History of the United States'' with the late Nobel laureate Milton Friedman.
`No Business'
``To me, it is an open and shut case,'' she said in an interview from her office in New York. ``The Fed had no business intervening there.''
There are already indications that investors perceive the safety net to be widening as a result of the actions by Bernanke, 54, and New York Fed President Timothy Geithner. The Bear Stearns bailout and an emergency facility to loan directly to government bond dealers triggered a decline in measures of credit risk for investment banks and for Fannie Mae, the Washington-based, government-chartered company that is the nation's largest source of funds for home mortgages.

It is very hard in the middle of a crisis to know where to draw lines,'' said Harvard University professor Kenneth Rogoff, a former research director at the International Monetary Fund. ``They reduced the immediate risk of a crisis, but upped the ante of raising the possibility of a bigger crisis down the road.''

The facility now includes all AAA rated asset-backed investments, including bonds backed by student loans. Former Fed officials say it is risky for the central bank to use its portfolio to address specific markets and satisfy Congress without saying where it will stop.
``If there is a public purpose in lending to investment banks, and taking dodgy mortgage securities as collateral, then it is a question of degree about other potential lending,'' Vincent Reinhart, former director of the Fed board's Division of Monetary Affairs, said in an interview. ``That's the consequence of crossing a line that had been well established for three- quarters of a century.''

My Take:

What former Fed officials are starting to ask is: Where does the Fed draw the line? Almost every area of Wall St. is hurting right now. The Fed has already used up $500 billion of the $800 billion it has in its reserves. They are running out of bullets folks.

They can probably get as much money as they want from the treasury once they run out, but this will have consequences like inflation and a reaction from the bond market. The risk here is the moral hazard. The Fed cannot bailout everyone.

As I warned you yesterday, the Countrywide deal is falling apart because BofA has announced they want no part of $38 billion in crappy loans that Countrywide has on its books.
Who knows how much more bad debt Countrywide has. This will be the next big test for the Fed. Do they bail this $38 billion out as well?

If they do bail out Countrywide then won't every other bank want their subprime loans bailed out as well? This is where not drawing the line gets you in trouble and moral hazard becomes a huge risk.

If the Fed agrees to bailout the 38 billion from Countrywide then expect a violent reaction from the bond market. They may tell the Fed to go pound sand because Countrywide preferred shareholders will take a bath.

Remember, the Fed gets killed if these loans from Countrywide go under because the Fed probably owns much of this due to accepting these garbage MBS's at the discount window as collateral.

There is nothing they can do about it either if these AAA Mortgage backed securities are worthless. Zero is zero and they can't change this. So expect the Fed to take a bath on the $38 billion in bad Countrywide loans. Countrywide probably has more to dump that haven't even been announced.

Bottom line:

So what does the Fed do? Do they turn into a garbage dump and take on every ones garbage which forces a bond market collapse, or do they let the financials that made mistakes go under and make them take the losses?

Kind of a lose/lose situation isn't? The Fed has backed itself into a corner and there is no way out. The bond market will be the kryptonite to this new Superman.

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