What the Fed Did for Bear Stearns
ALEX CHADWICK, host:
Kenneth Kuttner is a former staff economist for the Federal Reserve. He now teaches at Oberlin College in Ohio.
Kenneth Kuttner, welcome to DAY TO DAY.
And you must have seen the front-page article in yesterday's New York Times - this is by Edmund Andrews - detailing what he said is the transformation of Fed chair Ben Bernanke from this sort of low-key, stability-seeking, stay-the-course manager last summer to this risk-taking gambler creating, as the paper puts it, policy on the fly. Isn't that a pretty extraordinary turnabout for the chairman of the Federal Reserve?
Professor KENNETH N. KUTTNER (Oberlin College): Well, I think that's being a little bit unfair to Ben Bernanke. It is true that the Fed has had to improvise policy on the fly in recent weeks as the situation in the credit market has evolved very rapidly, but it's important to stress that the principle underlying the Fed's recent actions is pretty well-established.
As lender of last resort, the Fed's job is to stand ready to provide liquidity to prevent credit markets from seizing up just as they have done in the past few days.
And as a scholar who studied the Great Depression, Bernanke is very familiar with the consequences of failing to take such actions, and he's on record of having urged proactive policies of this sort in Japan when the central bank there was faced with a banking crisis 10 years ago.
So as for imposing policy on the fly, yes, they've kind of had to do that because who could have predicted the way things have evolved? But I wouldn't describe this as gambling in any sense. This is not gambling. This is taking out insurance against a complete meltdown.
CHADWICK: But the insurance in this case is based in part on the mortgage market, isn't it? I mean, isn't the Fed saying we're going to take some of these mortgage loans that you've made and use that as collateral against these loans?
Prof. KUTTNER: What the Fed is having to do is trying to assess on the fly whether those mortgages are legitimate collateral for the loans it wants to make. Now, I believe the Fed is accepting only the very highest grade mortgages, mortgage backed securities in its discount window lending. So in that sense its exposure to risk is probably pretty small. It's not taking any of the subprime stuff.
But still, you're right. It does - it is going to expose the Fed to a little bit of credit risk, which sets a precedent I'm sure it's not entirely comfortable with.
CHADWICK: In trying to stifle financial panic, how does the Fed balance the prospect of overreacting? I mean, if the Fed is doing all this, things might be even worse than I know, you know? Don't they worry about sending that kind of signal?
Prof. KUTTNER: Well, I'm sure they do. And what you mentioned is clearly your risk. But of course on the other side is the risk that if it did nothing, the liquidity crunch would create a domino effect as creditors withdrew their funding, not just from Bear Stearns but from other financial institutions as well - Lehman Brothers, even JP Morgan.
So the Fed's decision to open the discount window to primary dealers was clearly an attempt to prevent just such a scenario. Having that discount window open will hopefully assuage the creditors of these institutions and encourage them not to make a run on them as well.
CHADWICK: You mentioned Bear Stearns. We're back to them.
Here's Bear Stearns, this long-time bank, publicly traded. Its shares closed Friday at $30 each, $30 a share. Over the weekend JP Morgan agrees to buy it for two dollars a share. How does any investor look at something like that and not conclude really the entire financial system is some of kind of insiders' game? I mean, how can you believe in any kind of valuation?
Prof. KUTTNER: Well, that is indeed a spectacular declining in value, and I can't remember anything quite like that. But ultimately the value of a company is what somebody else is willing to pay for it - no more, no less.
And the problem that all these financial firms are facing is that there - as they're dealings become more complex and more sophisticated, they also become more opaque. And what that means is that it becomes harder for outsiders, that is to say potential buyers, to determine just exactly what assets they have on their books and what risks they're exposed to. And this creates what economists like to call the classic lemons problem. That is, if you're unsure about what the firm is really worth, then you're not going to be willing to pay a lot for it, because I mean what if it turns out to be not to be worth very much?
And so if these kinds of doubts - doubts about the value of the underlying assets - spread to other financial institutions, we'd be in for a bumpy ride, of course. Now, what we have to hope is that the Fed's actions over the weekend will prevent that from happening.
CHADWICK: Kenneth Kuttner, a former staff economist for the Federal Reserve, teaching now at Oberlin College in Ohio.
Ken, thank you so much.
Prof. KUTTNER: You're very welcome.