Saturday, August 11, 2007

Kudos to the Fed for wise handling of the current financial crisis

We finally hit a true financial crisis for the first time under Ben Bernanke's tenure and the Fed handled it extremely effectively. A hint of crisis had been brewing for the past month, and finally the problems at BNP Paribas had enough of a psychological effect to cause a credit liquidity crisis. Central banks stepped in and "injected" liquidity into their respective banking systems. The bulk of the crisis is now over, but there may be lingering aftershocks for the next few weeks or maybe into September. The Fed, et al showed magnificently how well prepared they are to handle the kind of "screwups" that are caused by the undisciplined practices that pervade Wall Street and its global brethern.

I applaud the Fed and other central banks for refraining from cutting interest rates as a number of misguided individuals rabidly clamored for (yes, Cramer, you were one of them.) Cutting interest rates would have been precisely the wrong thing to do since this was a liquidity problem in the financial system and not a money problem out in the "real" world. Plenty of credit is available to real people and real businesses who are qualified for normal credit (e.g., the Freddie Mac survey has 15-year fixed home mortgages down to a rate of 6.25%.) Sure, people and businesses with weak qualifications may go wanting or have to pay higher rates, but that is the way it should be. You don't build or maintan a strong economy by facilitating unfit players. The Fed did not aid any "weak" banks, but simply compensated for the irrationality exhibited by a lot of irresponsible traders and speculators on Wall Street who had been attempting to "go after" any banking operation (or hedge fund) that they thought might have some exposure to mortgage securities.

The Fed engaged in "open market operations" to add money to the banking system so that banks could more easily lend to each other and at a rate close to the Fed funds target rate. That is why they call it a "target" rate. The market (the banks borrowing from each other) charges a rate needed to clear lending transactions, which can push actual rates higher or lower. The Fed then steps in to either add or withdraw money to guide that inter-bank lending rate back towards the target rate. That is the normal process that the Fed engages in every single day, even on normal days. The only difference lately is that the amount added by the Fed has been significantly higher than is usual. This is one of the Fed's primary jobs, assuring that inter-bank lending has just enough reserves to keep the lending rate near the target rate.

There was talk that the Fed actually engaged in repurchase agreements (called "repos") for mortgage-backed securities, but I could find nothing more than a few mentions in the press coverage to confirm such transactions. The Fed usually uses Treasuries for repurchase agreements.

I know that there are a lot of people who disagree with the Fed on just about everything the Fed does, but it was truly amazing to see the Fed so calmly step in and offer a little adult supervision for the kindergarten antics of the so-called "professionals" on Wall Street.

Go Fed!

-- Jack Krupansky


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