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It's Out Of Bernanke's Reach


By Peter Coy If Ben S. Bernanke were a Broadway playwright, the next day's headline in Variety might have been "Fed Chief Lays An Egg." By cutting the largely symbolic discount rate on Aug. 17, the Federal Reserve hoped to calm nerves and return borrowing conditions to normal. Instead, conditions got worse. Terrified to hold anything but ultrasafe securities, investors stopped buying IOUs from corporations and poured their money into Treasuries. A reliable measure of panic—the difference in yields between safe and less-safe securities—widened to the biggest gap in more than 10 years. Five days later, markets remained severely impaired.

Why didn't Chairman Bernanke's script play as well as many hoped, at least in the early going? Simply put, the Federal Reserve did not—and cannot—fix the problem at the root of the market crisis. That problem is a lack of crucial information.

Lenders know there are billions of dollars of weak assets out there, such as securities backed by foolish or fraudulent mortgages. What they don't know is who holds those weak assets. So when borrowers come to them offering suspect securities as collateral for a loan, the safest thing to say is no. When everyone says no at once, the result is a credit crunch that, if unabated, could cause a recession.

Bernanke, who initially underestimated the spillover from the subprime lending debacle, is coping with the first major crisis of modern finance. The world has changed dramatically since the last global crisis a decade ago. In times past, banks mostly held loans on their own books, so it was easy to tell which banks were sitting on bad debts, shut those down, and tide over the others. Today the Fed's job is harder because most loans are packaged and sold. So credit creation, the lifeblood of the economy, depends on a chain of investors around the world. The further out on the chain you are, the less you know about the assets underpinning the securities.

Things blew up when investors suddenly decided they would no longer buy assets they didn't understand. "There was an abrupt recognition of extreme uncertainty about the valuation of collateral," says Peter R. Fisher, a managing director of the investment firm BlackRock Inc (BLK)., who as a New York Fed official was instrumental in coordinating the private sector rescue of the hedge fund Long-Term Capital Management during the 1998 financial crisis.

This year's calamity is 21st century finance's version of a bank run. In the 1930s, banks closed because they suddenly lost their sources of funds—namely, short-term deposits. This time it's mortgage lenders and other players who are in danger of failing because they're losing their sources of funds, which in this case are instruments such as short-term IOUs that are sold to money-market mutual funds. These IOUs, most of them known as asset-backed commercial paper, are typically rated AAA because they're backed up by plenty of collateral.

Trouble is, the traditional buyers of these IOUs have gone on strike. Why? Incomplete information. Buyers don't know whether the assets backing the paper are worth what the issuers say. A portion of those assets are iffy subprime mortgages. Typically, the rates that issuers have to pay on their 30-day asset-backed commercial paper are rock steady. But they started shooting higher after the Fed declined to cut interest rates at its Aug. 7 meeting. As of Aug. 22 their yield was up nearly a percentage point, making the paper prohibitively expensive for many borrowers.

History shows that panicky runs can end when information improves. A bank run in Chicago in June, 1932, ended on July 1 when banks simply put out their monthly financial reports, revealing which were in bad shape and which were fully solvent, according to Joseph R. Mason, a professor at Drexel University's LeBow College of Business. Today, says Mason, markets would function better if banks, hedge funds, and others disclosed more about their holdings, either voluntarily or under pressure from the Fed. "Bernanke could knock some heads together," Mason says.

There's no sign the Fed chairman is doing a Three Stooges number. What he's doing is buying time until the market works out its own problems. With his options limited, he is trying to build confidence by letting banks know they can borrow directly from what's known as its discount window. (To make the option more desirable, the Fed cut the discount rate by half a percent, to 5.75%, and extended the term to 30 days from overnight.) The idea isn't that banks necessarily will rush to borrow at the discount window, though four big banks set an example by taking out loans on Aug. 22. Instead, the Fed is signaling it's willing to lend liberally to banks that have many kinds of collateral, including mortgage-backed securities. Once banks realize that those types of collateral can get them loans from the Fed, they'll be more willing to accept such collateral for loans they themselves make. In theory, that should loosen up lending. But it's clear now that the process will take some time.

Fed officials expect the first markets to return to normal will be those where loan information is already reasonably solid. One example: financing for leveraged buyouts, where the repayment of loans depends on the fairly predictable cash flows of the companies being bought. Jumbo mortgages—those for $417,000 or more, which aren't eligible to be purchased by Fannie Mae (FNM) or Freddie Mac (FRE)—should also become more available because default rates on them are relatively low and predictable. Jumbo rates have already retreated slightly. Subprime mortgage lending, where the trouble started, will probably take the longest to recover. The problem there is rampant fraud by borrowers and lenders alike.

Fed officials hope to see clear improvement in market functioning by the next meeting of the rate-setting Federal Open Market Committee on Sept. 18. If they do, they might not go through with a widely anticipated cut of the federal funds rate, the rate at which banks lend reserves to one another. On the other hand, if things get even worse, the Fed may not wait until Sept. 18 to trim that rate. By flooding the economy with money, the Fed would bail out good and bad actors alike—helping to revive the economy but also encouraging lenders to make the same ill-advised loans next time.

The lending mistakes of the past several years were too serious to be fixed by a quick rewrite at the Fed. The best the chairman can do is tide the economy over until lenders sort out their mistakes and gather the crucial information they neglected the first time.

Coy is BusinessWeek's economics editor in New York


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