Will Greenspan’s Legacy be the Bernanke Bust?

by REIT Wrecks on March 17, 2008

The world, once awash with levered up Greenspan housing dollars chasing assets of almost any kind, is now drowning in debt. In response, Bernanke’s beleaguered Fed dramatically announced another cut in its discount rate late on a Sunday afternoon, just minutes after rapidly orchestrating and ultimately approving the sale of Bear Stearns (BSC) to J.P. Morgan Chase (JPM) for just $2 a share. Working in concert, The Fed and the Treasury Department accomplished these two unusual feats while most traders and bankers cowered under the cover of Friday’s closing bell.

In bailing out Bear Stearns, the Fed invoked parts of a rarely used law that allows it to lend directly to non-bank financial companies. Underscoring the seriousness of such a move, using the provisions under that law required a nod from at least five of the seven Fed Governors before the bailout could be implemented: the purposeful goal being to put a solution firmly in place before markets opened in Asia later on Sunday evening.

In a previous article, I noted the speech that then Fed Governor Bernanke gave to the National Economists Club in 2002, acknowledging the potential widespread detrimental effects of asset deflation to our economy. At the time, he said that the chances of widespread deflation in our economy were remote for two principal reasons. The first was “the resilience and structural stability of the U.S. economy itself. Over the years, the U.S. economy has shown a remarkable ability to absorb shocks of all kinds, to recover, and to continue to grow”.

He noted that the second and “particularly” important factor was “the strength of our financial system: Despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape”. With the fallout in home prices striking squarely at the heart of the U.S. consumer, and financial institutions worldwide reeling from the effects of financial over indulgence, neither is any longer true.

This move, and a widely anticipated cut in the discount rate of at least another 50 basis points on Tuesday, underlines uncertainty at the Fed over the magnitude of losses that will ultimately arise out of the US credit bust, the effect on consumers and questions over the real health of our financial institutions, all areas critical to avoiding the “years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors” described in Bernanke’s speech.

Ironically, this drama could wind up being the beginning of the end of the credit crisis. Our ever-wise policymakers will now finally be forced to recognize the need to preserve the health US financial system, one of the two primary bulwarks against the widespread detrimental effects of asset deflation outlined by Bernanke in 2002. A failure the size of Bear Stearns would simply have been cataclysmic to our financial system and national well being.

Unfortunately, while I would never be cynical enough to suggest that the political hazard of not being re-elected trumps the moral hazard of rewarding excessive risk, in this election year I would be very surprised if we tax payers were not drafted into a government-sponsored bailout of our financial system that will ultimately be larger and more far reaching than anything previously seen in the S&L crisis. Anyone care for a PIK toggle?


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