Do Washington policymakers listen too much to Wall Street? A possible bailout of Fannie Mae and Freddie Mac, on the heels of similar action involving investment firm Bear Stearns, seems to send a loud signal to financial companies that the government will clean up their messes.
That's the feeling of some analysts and academics here Saturday, the final day of a high-profile economics conference. The Federal Reserve's handling of the worst financial crisis to hit the country in decades spurred much debate.
"The Fed listens to Wall Street," said Willem Buiter, professor of European political economy at the London School of Economics and Political Science. "Throughout the 12 months of the crisis, it is difficult to avoid the impression that the Fed is too close to the financial markets and leading financial institutions, and too responsive to their special pleadings, to make the right decisions for the economy as a whole," he wrote in a paper presented to the conference.
Critics like Buiter worry that the Fed's unprecedented actions — including financial backing for JPMorgan Chase & Co.'s takeover of Bear Stearns Cos. — are putting taxpayers on the hook for billions of dollars of potential losses. They also say it encourages "moral hazard," that is, allowing financial companies to gamble more recklessly in the future.
Fed Chairman Ben Bernanke, who spoke to the conference on Friday, defended the Fed's actions, saying they were "necessary and justified" to avert a meltdown of the entire financial system, which would have devastated the U.S. economy.
Yet, Bernanke also acknowledged that mitigating moral hazard is one of the critical challenges policymakers face as they weigh steps — including strengthening regulation — to make the financial system better able to withstand shocks down the road.
"If no countervailing actions are taken, what would be perceived as an implicit expansion of the safety net could exacerbate the problem of `too big to fail,' possibly resulting in excessive risk-taking and yet greater systemic risk in the future," Bernanke said.
At the start of the conference, on Thursday night, Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, which sponsored the forum, gave Bernanke a white hard hat — like those worn by construction workers — in case he needed protection from critics during the sessions.
Even as Bernanke and others discussed these thorny issues, concern on Wall Street grew about the financial health of Fannie Mae and Freddie Mac. Investors are becoming increasingly convinced that a government bailout of the mortgage giants will be inevitable. Those fears hammered the companies stocks again this week.
The Treasury Department, under a new law enacted last month, has the power to inject the companies with huge amounts of cash — through loans or buying stock in them.
"It creates a troubling perception when Washington policymakers appear to be hitting the fast-forward button when major institutions are on the line but are between the pause and the slow-motion button when massive home foreclosures are on the line," said Gene Sperling, a former official in the Clinton administration and now a senior fellow for economic studies at the Council on Foreign Relations.
The roots of the current crisis can be traced to lax lending for home mortgages — especially subprime loans given to borrowers with tarnished credit — during the housing boom. Lenders and borrowers were counting on home prices to keep rising. But when the housing market went bust, home prices plummeted in many areas of the country. Foreclosures spiked as people were left owing more on their mortgage than their home was worth. Rising rates on adjustable mortgages also clobbered some homeowners.
"Market participants failed to soundly manage, measure and disclose risks, with ignorance, greed or hubris playing their customary roles," said Mario Draghi, the governor of the Bank of Italy, who is involved in international efforts to deal with the worldwide financial crisis.
As U.S. financial companies racked up multibillion-dollar losses on soured mortgage investments, and credit problems spread globally, firms hoarded cash and clamped down on lending. That has crimped consumer and business spending, dragging down the national economy — a vicious cycle the Fed has been trying to break.
To brace the wobbly economy, the Fed has slashed its key interest rate by a whopping 3.25 percentage points, the most aggressive rate-cutting campaign in decades. Yet, those cuts also aggravated inflation. Some wonder whether the Fed made money too cheap, something that could feed into other bubbles in the future.
"The alarms of the financial sector have been overstated. The real economy has slowed down but is not yet in severe difficulty," said C. Fred Bergsten, director of the Peterson Institute for International Economics.
Anil Kashyap, professor of economics and finance at the University of Chicago's Graduate School of Business, however, said the Fed did the right thing. "It headed off disaster. The history of financial crises tells you the economy doesn't get sick the next week. It takes a while."
In fact, a growing number of analysts believe the economy could hit a deep pothole later this year as the bracing impact of the government's tax rebate checks wears off.
The Fed also has taken a number of unconventional — and some controversial — actions to shore up the shaky financial system and to get credit, the economy's lifeblood, flowing more freely. It agreed in March to let investment houses draw emergency loans directly from the central bank. And, in July, the Fed said Fannie Mae and Freddie Mac also could tap the program. For years, such lending privileges were extended only to commercial banks, which are subject to stricter regulatory supervision.
In providing financial backing to JP Morgan's takeover of Bear Stearns, the Fed worried that the investment house's collapse could cascade, taking down others. But some were skeptical.
"In the case of Bear Stearns it is not clear from publicly available information how much contagion there would have been had it been allowed to fail," according to a paper presented at the conference by Franklin Allen, professor at the University of Pennsylvania, and Elena Carletti, professor at the University of Frankfurt.