To cool a market meltdown, apply aid carefully

The immediate dilemma: How to let markets learn from mistakes but keep a lid on problems.

By Mark Trumbull | Staff writer of The Christian Science Monitor

from the November 30, 2007 edition

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Earlier this week, and in previous actions since August, the Federal Reserve has done what any self-respecting central bank would do during a time of severe financial stress: It has offered banks extra financing to avoid a contagious panic.

The aim isn't to bail out faltering firms, but to restore "liquidity," the normal flow of transactions and credit.

The question is: Is it enough?

Parts of the banking system still aren't functioning normally. With mortgage-related investments causing billion-dollar losses, banks' lending to one another has been disrupted. And the cost differential between a large home loan and a small one is wider than usual. Worries about a wider credit crunch in bank lending remain high.

In both the short and long term, policymakers must walk a careful line.

The short-run challenge is to let the markets learn from their mistakes, but prevent a credit contagion that could increase the risk of a recession. That's where the Fed's recent actions come in. Interest-rate cuts – including a possible move in December – and the Fed's action as a backup lender to banks helped fuel a midweek rally in stock prices.

In the longer run, lawmakers and regulators must weigh how best to oversee these increasingly complex investments.

"The key is to balance the need to let markets continue to innovate with protecting the public from the fallout during the rare times when those innovations go awry," says Eric Beinhocker of McKinsey Global Institute.

Financial innovation has brought big benefits, such as cheaper loans and better investment options, says Mr. Beinhocker, author of a book on financial complexity, in an e-mail interview. But it has also played a role in the recent turmoil in credit markets. Despite the Fed's early efforts, and this week's hopeful stock-market signals, those financial strains remain an urgent concern on Wall Street.

US banks are struggling to cover losses in complex investments that packaged together the income from various types of debt – including the riskiest home loans, known as subprime mortgages. When the housing market turned sour, those subprime loans began to go bad and hit these investments – called "collateralized debt obligations" or CDOs – with unexpectedly large losses.

Banks also face large related losses in off-the-books ventures called structured investment vehicles (SIVs). These ventures invested in bundles of long-term debt to earn a high income, and they paid for it with short-term loans. Now the sources of short-term funding have dried up for many SIVs. That leaves banks with a large liability to keep some $300 billion in SIV investments afloat.

The danger? If many banks are forced to sell the assets of these funds all at once, a fire sale could result in big losses. Right now, SIVs aren't finding buyers.

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