Dude Fed, stop the morale hazards

In an extraordinary weekend intervention, the Fed announced the most dramatic expansion yet of its lending, promising to lend for up to six months to securities dealers under terms normally reserved only for tightly regulated banks. The central bank also cut the rate on such direct loans by a quarter of a percentage point, just two days before it is likely to slash interest rates more broadly. It also made a rare weekend cut in the discount rate -- ordinarily charged on direct loans to banks, and now also to securities dealers -- to 3.25% from 3.5%, while helping bring Bear Stearns into the arms of J.P. Morgan Chase. That narrows the spread with the more economically important federal-funds rate, now 3%, to a quarter of a point. The Fed is also expected to cut the fed-funds rate target by at least half a point at its meeting Tuesday. The moves were the latest and most aggressive yet in a series of steps that demonstrate how the Fed's traditional tools aren't suited to dealing with a crisis now sweeping the modern financial system. But, by also agreeing to lend up to $30 billion to J.P. Morgan Chase to finance illiquid assets inherited from its purchase of Bear Stearns Cos., the Fed is taking on new risks. The Fed was created in 1913 in part to be "lender of last resort" during crises such as the one now sweeping through the financial system. But it was equipped for an economy in which banks provided most credit. Now banks share that role with institutional investors, finance companies, asset-backed pools and securities dealers such as Bear Stearns. Even as it innovated in the current crisis, the Fed had avoided favoring a particular firm or class of securities. On Friday it crossed that line, stepping in to provide emergency funding to keep Bear Stearns afloat amid a severe cash crunch at the Wall Street firm. That funding will now be replaced by $30 billion lent to J.P. Morgan but secured solely by hard-to-value assets inherited from that firm's purchase of Bear, meaning if the assets decline sufficiently in value, the Fed will bear a loss. set a precedent for future troubled firms. Adam Posen, a central-banking expert at the Peterson Institute for International Economics in Washington, said other troubled firms claiming an equally critical position at the nexus of the financial system now "have political and legal precedent to ask for" help. He said the expectation of such help could also harden the negotiating position of a troubled firm, potentially complicating private-sector solutions. The Fed has intervened from time to time in specific situations, from Treasury loans to Mexico in 1994 to brokering the rescue of the hedge-fund Long Term Capital Management in 1998. But it has been rare for the Fed to put its own money at risk. The most important example of this was in 1984 when it and the Federal Deposit Insurance Corp. lent billions to Continental Illinois. Efforts to find a buyer were fruitless and the federal government ultimately ended up owning most of the failed bank. The financial system is much more interconnected and opaque than in 1984. Since the 1980s, Congress has limited the ability of regulators to prop up weak banks. At the same time, the financial system has moved away from insured deposits to other sources of funding. Securities dealers' "repo" borrowings -- short-term collateralized loans that grease the market for a wide variety of securities -- have more than doubled to $4.5 trillion and now exceed banks' federally insured deposits. Fed officials believe that multiple sources of credit have made the economy more resilient and less exposed to problems in banks. Less than a year ago, Fed Vice Chairman Donald Kohn predicted that with a more market-based and less bank-based system, the Fed would rely more on interest rates to stem crises than direct loans to market participants. But the Fed has already learned that interest-rate cuts alone aren't enough to stem the current crisis, and has not only had to use the discount window, but in ways it never thought likely.