Bernanke Discards Monetary History With Bear Stearns Bailout

By Craig Torres

March 15 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke is being forced to throw out four decades of monetary history by a financial system choking on miscalculated risks and a deepening recession.

Bernanke and the four Fed governors voted yesterday to become creditors to Bear Stearns Cos., a securities firm that isn't a bank, by invoking a law that hasn't been used since the 1960s. Three days earlier, the Fed said it would swap Treasury notes on its balance sheet for privately issued mortgage-backed securities held by Wall Street firms.

``It's a re-drawing of the relationship of the Federal Reserve with the rest of the financial system,'' said Vincent Reinhart, former director of the Division of Monetary Affairs at the Board. Risks of so-called moral hazard, where firms will now come to count on bailouts by a federal agency, ``are considerable,'' he said.

The cost of doing nothing may have been even greater, say other former Fed officials. Bernanke is attempting to keep the nation's financial machinery working as record home foreclosures make investors reluctant to hold even bonds backed by Fannie Mae and Freddie Mac, government-chartered firms. The 54-year-old Fed chairman is also trying to contend with a worsening economic slump: Reports this week showed that retail sales unexpectedly fell and consumer confidence slid to a 16-year low.

Meyer's Experience

``As a governor, you never want to be placed in this position,'' said former Fed governor Laurence Meyer, who served during the central bank's coordination of the rescue of hedge fund Long-Term Capital Management LLC in 1998. ``Everybody has to be uncomfortable with this. But it is always, compared to what? Just imagine what would have happened today if this action hadn't been taken.''

Even with the bailout, stocks retreated. The Standard & Poor's 500 Index fell 2.1 percent yesterday to 1,288.14. The S&P Financials Index lost 4.1 percent. Bear Stearns tumbled $27, or 47 percent, to $30. Lehman Brothers Holdings Inc., Citigroup Inc. and Bank of America Corp. also declined.

``It has really spooked the market,'' Gregory Peters, head of credit strategy at Morgan Stanley in New York, said in a Bloomberg Television interview. ``It has unraveled so fast that investors are worried about the next shoe dropping.''

Bear Stearns is a market maker in mortgage bonds, a primary dealer in U.S. Treasury notes and clears or settles securities transactions for other brokers and investment funds. While it doesn't take deposits from the public, it's as intertwined with the financial system as any bank.

Cost of Lending

``Most lending happens outside of bank balance sheets,'' said Mark Gertler, who has written papers on central banking with Bernanke and is a professor of economics at New York University. ``We are seeing financial innovation, so you should expect innovation in the lender of last resort facility.''

Still, some economists said, the Fed may encourage risky behavior by backstopping financial institutions. Willem Buiter, a London School of Economics professor and former Bank of England policy maker, called the Fed's move ``socialism for the rich, which is both inefficient and morally objectionable.''

Only last week, senior bank supervisors from the U.S., U.K., France, Germany and Switzerland blamed the crisis on poor communication, bad risk analysis and an under-estimation of liquidity needs by large financial institutions.

``There is no doubt the Fed has been nervous about extending its lending reach beyond banks that have a role in the payment system,'' said Marvin Goodfriend, a former senior policy adviser at the Richmond Federal Reserve Bank and now an economics professor at Carnegie Mellon University in Pittsburgh. ``Is the credit crisis so bad that it requires a breach of longstanding conventions?''

Navigating the Storm

Former Treasury Secretary Lawrence Summers said the Fed is trying to navigate through a once-in-a-generation financial and economic storm.

Panic selling is lowering the value of stocks and bonds, spurring more selling. Unemployment is rising, reducing incomes and spending, and falling asset prices -- including homes -- are leading to a contraction in credit.

``That three-way combination feels like something we have not seen in this country in a very, very long time,'' Summers, now a professor at Harvard University, said in a Bloomberg Television interview in Washington. ``It's a near-certainty we are in a recession and there is a real prospect that it could be a serious one without strong policy action.''

Fed officials meet to set interest rates on March 18. Futures traders put the chances of a 1 percentage point cut at 50 percent. A reduction of that magnitude would be the first in the two decades since the federal funds rate has been used to steer the economy.

``The name of the game is preventing disaster,'' said NYU's Gertler. ``By letting one house burn down, you might have the whole neighborhood burn down. You want to avoid that.''

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net.

Last Updated: March 15, 2008 00:16 EDT