To fix U.S. credit mess, timing is critical

Risks rise if the Federal Reserve and Treasury move too slow – or too fast.

from the March 11, 2008 edition

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A rush to mark down loan balances may seem painful for banks, he conceded. But "measures that lead to a sustainable outcome are to be preferred to temporary palliatives, which may only put off foreclosure and perhaps increase its ultimate costs," he said.

The Treasury and the Fed have drawn plenty of criticism. Some say that by intervening in an effort to calm markets, the government could prolong the day of reckoning on bad loans.

Moves such as the Fed's interest-rate cuts and short-term loans – extended in anonymous auctions – are allowing problems at weak banks to fester and grow unseen, says Joshua Rosner, an industry analyst at Graham Fisher in New York. A fire sale of bad assets would be preferable, in his view, to the current lack of activity in debt markets.

"There's no price discovery," Mr. Rosner says. He says debt markets can be rekindled through more transparency, less federal intervention, and an effort by banks to make their debt securities easier for investors to understand.

In the past, such transparency and loss recognition by banks have been necessary steps to emerge from crisis, economists say.

Other analysts argue that the tough-love approach could result in a tidal wave of bad assets hitting the auction block at once and making the bank crisis worse.

Already, in a fire-sale environment, banks are being hammered by rules that force them to report their assets by valuing them at current market prices, even if the market is distressed.

Some analysts say that today's prices for many assets are unrealistically low and that banks suffer real consequences as they report balance-sheet weakness.

"The fair-value issue is causing a lot of pain ... that is totally unnecessary," says Christopher Whalen, senior vice president of Institutional Risk Analytics in Torrance, Calif.

He and others recommend that the valuation rules be waived, at least temporarily,

Home prices are another factor where the speed of adjustment could matter.

Most economists say that prices will need to fall further before the housing market stabilizes. But some argue that if the foreclosure problem isn't contained, the result could be a needlessly sharp downward spiral in real estate values – and more cutbacks in bank lending to the whole economy.

"It'll spiral downward much further than it would have had you intervened," says Mark Thoma, an economist at the University of Oregon in Eugene.

He says the Fed and Treasury are right to focus on trying to slow the pace of foreclosures.

He sees a calculated trade-off in intervention: "You end up prolonging the recovery [while] not making it so severe."

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