Might the Fed profit from the financial crisis?

Its intervention at Bear Stearns shows a change in attitude toward investment banks.

By David R. Francis | columnist

from the March 31, 2008 edition

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Most economists would agree that the world's financial markets are facing an extraordinary crisis with the credit freeze, the failure of some prominent financial institutions, and deep losses at other firms.

It's a "financial panic," says John Coffee, a finance professor at Columbia University in New York. He sees a "real chance" that losses could exceed those from the savings and loan institution disaster in the United States from 1986 to 1995. The failure of 1,043 thrifts cost the federal government some $153 billion.

The trouble in the American housing market has certainly hit the financial markets. But so far, economists are mostly predicting a run-of-the-mill, mild and short recession in the US after some six years of economic expansion.

"We have yet to see any really significant effect outside of the housing industry, broadly construed," says Ben Friedman, a finance professor at Harvard University in Cambridge, Mass. Spreading home foreclosures, declining home prices, and other housing troubles could spread to the economy as a whole, he notes. But up to now, the financial crisis appears to be largely "contained in the financial market."

The recent unusual remedial actions by central banks and governments are aimed at preventing the panic from spreading to other financial institutions and the economy in general.

Of course, the world's financial community is worried. Since last fall, a committee of the Institute of International Finance (IIF) in Washington has been preparing a report to address the crisis and avoid future panics. The financial CEOs in the committee plan to present the report before the April 11 meeting of central bankers and finance ministers of the Group of Seven major industrial nations in Washington.

The IIF represents the world's largest 375 financial institutions – commercial banks, investment banks, insurance companies, and others – in more than 60 countries. Its report will make suggestions as to more regulation of the financial industry, including sellers of home mortgages. It will deal with weaknesses in the management of financial risk, including that of complex structured financial products involved in the current crisis. It will address the valuation of such products and the adequacy of secondary markets where they are bought and sold after their primary sale to investors. It will touch on the adequacy of the documentation and information provided on these products. It will tackle the failure of rating agencies, such as Standard & Poor's, to provide accurate evaluations of the risk of failure of these financial products.

And, as a source notes, it will discuss the question of whether the executives of financial institutions should be compensated so lucratively, even if their firms suffer severe losses, and whether such rewards encourage excessive risk-taking.

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