March 13, 2008: 4:47 AM EDT
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How a lender bailout hurts the economy

The Federal Reserve's efforts to ease the credit crunch risk stoking inflation - and letting reckless, well-paid execs off the hook.

By Colin Barr, senior writer
Bernanke's efforts to shore up troubled lenders may have some negative side effects.

NEW YORK (Fortune) -- The government is showing considerable ingenuity in devising new tactics to fight the credit crunch. But some observers fear that the innovations risk making matters worse - by fueling inflation and insulating executives who made reckless bets from the full wrath of the market.

The Federal Reserve set off a ferocious stock market rally Tuesday with its plan to lend banks as much as $200 billion over 28 days later this month. The plan sent shares of hard-hit lenders such as Fannie Mae (FNM), Freddie Mac (FRE, Fortune 500) and Washington Mutual (WM, Fortune 500) soaring, because the Fed will allow borrowers to use privately issued mortgage-backed securities as collateral. Investors have fled those securities because they see a rising risk that mortgage bonds will become impaired as housing prices slide and defaults tick higher.

Tuesday's plan, dubbed the Term Securities Lending Facility, wasn't the first Fed move aimed at loosening up the debt markets. Late last year the Fed rolled out a similar plan called the Term Auction Facility that briefly succeeded in bringing down the interest rates banks charge one another for overnight loans.

"Think of Ben Bernanke as action hero," Felix Salmon wrote this week at "Every time the credit markets seize up and threaten to bring down the U.S. financial system, he pulls out a new weapon."

Not quite a fan club

Not everyone is a fan of Action Ben, however. David Rosenberg, chief North American economist at Merrill Lynch (MER, Fortune 500), wrote Wednesday that this week's Fed action will do little to counter the impression that Bernanke & Co. is struggling with problems that the Fed ultimately has little control over.

"This latest experiment, as with the others undertaken thus far, does not address underlying credit problems, does not materially improve the solvency of the institutions exposed to assets under stress, does nothing to put a floor under home prices," Rosenberg wrote in a note to clients. "We see no reason based on this for anyone to change their economic or earnings outlook despite the stock market's initial reaction to this latest initiative."

Rosenberg, who has been predicting for some time that the economy will slip into recession this year, expects the Fed to cut its fed funds rate to as low as 1% later in 2008, down from 3% now and 5.25% back in August. Observers expect the rate cuts to continue next week, with a cut as deep as 75 basis points at the Fed's regularly scheduled meeting. But there's little optimism that the cuts will do anything to stimulate demand for houses, which remain pricey by historical measures, or even bring down mortgage rates, which have been rising since the Fed's slashed rate by more than a percentage point over eight days at the end of January.

The fear is that by expanding its emergency lending programs and sharply cutting rates, the Fed will turbocharge already healthy parts of the economy - at the cost of reduced purchasing power by dollar holders. Meanwhile, the big problem - bad loans tied to houses whose value is now declining - continues to fester.

"We're in the helicopter phase now," says Howard Simons, a strategist at Bianco Research in Chicago. He references the nickname Helicopter Ben, which Bernanke got tagged with after a 2002 speech on how central banks can steer away from deflation by dropping money into the economy.

Simons says he appreciates the Fed's need to make sure the economy has sufficient liquidity. But with gasoline prices approaching an all-time inflation-adjusted high and the price of milk having jumped 12% last year, inflation "is a very real concern," Simons says.

Betting on inflation

He points to the action in Treasury Inflation Protected Securities - bonds whose principal amount is adjusted upward when the consumer price index shows inflation and drops when it shows deflation. The yield on five-year TIPS recently turned negative - meaning that investors buying the securities now are accepting a lower interest rater than they would get on comparable Treasury notes, in the expectation of making up the difference in coming years via the inflation adjustment. In essence, they are betting that buying TIPS will shield them from the loss of purchasing power they would suffer over time by holding nominal Treasurys.

David Merkel, chief economist at broker-dealer Finacorp Securities, agrees that inflation is worrisome but adds that the makeup of the current board of governors ensures the Fed will "err on the side of inflation." Along with Bernanke, Fed Vice Chairman Donald Kohn and governor Frederic Mishkin "are students of the Great Depression," Merkel says. "So you're going to see more loosening" of monetary policy when the economy runs into trouble.

Inflation isn't the only worry on the minds of Fed critics. Dean Baker, co-director of the Center for Economic and Policy Research in Washington, says the Term Securities Lending Facility and moves like it amount to a government bailout of corporate executives who made reckless bets - and who should be made to pay the tab with their jobs.

"The Fed's actions are keeping banks from having to write down large losses and quite likely go into bankruptcy," he writes on his blog at the American Prospect. "The result is that the bank executives, whose inept management pushed them into bankruptcy, get to keep their jobs and their salaries, which run into the tens of millions a year." Meanwhile, homeowners facing foreclosure - not to mention ordinary savers who are watching inflation erode the value of their nest eggs - remain quite unbailed-out.

Simons says the whole mess points up the limitations of the Fed. "They're not crisis managers," he says. "There's no playbook for this."  To top of page

Company Price Change % Change
Ford Motor Co 8.29 0.05 0.61%
Advanced Micro Devic... 54.59 0.70 1.30%
Cisco Systems Inc 47.49 -2.44 -4.89%
General Electric Co 13.00 -0.16 -1.22%
Kraft Heinz Co 27.84 -2.20 -7.32%
Data as of 2:44pm ET
Index Last Change % Change
Dow 32,627.97 -234.33 -0.71%
Nasdaq 13,215.24 99.07 0.76%
S&P 500 3,913.10 -2.36 -0.06%
Treasuries 1.73 0.00 0.12%
Data as of 6:29am ET

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