Monday, August 20, 2007

Is the Fed bailing out Wall Street?

Now that everyone has had a couple of days to digest the Fed's actions, many have come to condemn them as the latest edition of the "Greenspan put", that is, bailing out Wall Street's scoundrel speculators. None other than the great James Surowiecki dixit.

Trends in credit spreads support this view. As James Hamilton points out, they've certainly risen, but only towards their long-term average (BAA-rated corporates are only slightly above 200 basis points above Treasuries).

While I do believe this view has a lot going for it, there are two big caveats.

First, we still don't know (and won't know for many months) where the weakest link is in the financial system and the disruption it may cause. The Fed obviously has a lot more inside info than any analyst and is in a better position to judge this. If it's worried by what it sees, a down payment on further easing makes sense.

Second, there's still the fundamental issue: house prices. While so far the adjustment is in line with the last big housing downturn in the early 1990's, leverage is much, much higher today, so things could get uglier. Certainly, the Fed foolishly downplayed the whole supbrime mess over the past few months, as many are pointing out. Nevertheless, some monetary easing might be justified to avoid a vicious circle from developing.

Talking about bailouts is not helpful. The losses for investors and homeowners are real, justified and won't disappear even if the Fed eases rates some more. The Fed's job is simply to make sure they are absorbed in an orderly fashion and we should judge it by this parameter.