Fed Weighs Options as Credit Crunch Lingers

Having already bailed out the financial system with its rescue of Bear Stearns (BSC Quote) last month, the Federal Reserve is under pressure to expand its extraordinary encroachment into the markets even further as the credit crisis persists.

But as the Fed wrestles with how best to guide the economy through the credit crunch, calls for a fiscal response from elected officials are growing. While the Fed has not pledged to backstop the flagging mortgage market, The Wall Street Journal reported Wednesday that internal discussions are already under way at the central bank about contingency plans for expanding its lending power should the crisis continue and get worse.

"It would be a big mistake for the Fed to backstop the mortgage market," says Nouriel Roubini, an economics professor at New York University and chairman of RGE Monitor. "It's a case for fiscal policy to consider whether to nationalize a big chunk of mortgages. There likely would be a huge fiscal cost to this, so it's an issue of spending and taxation, and having the Fed do that is inappropriate and reckless."

First Recession, Then Regulation

On Tuesday, the Fed released the minutes from its March meeting, which was held just days after Bear Stearns, the fifth largest U.S. investment bank, notified the central bank that its liquidity position was eroding and it was on the verge of bankruptcy. In response, the Fed backstopped nearly $30 billion of Bear's riskiest mortgage-related securities to orchestrate a swift acquisition of the bank by JPMorgan Chase (JPM Quote) for a stunning $2 a share, a controversial price that was later renegotiated up to $10 a share.

In recent congressional testimony, Fed Chairman Ben Bernanke justified the action as a defense against a systemic unraveling of the financial system that Bear's bankruptcy could have triggered. He disputed the view that his actions surrounding Bear amounted to a government bailout for the investment bank but also allowed that they could be interpreted as a bailout for the U.S. financial system.

That led lawmakers to question why the government should rescue Wall Street in order to help the economy without rescuing the growing mass of homeowners facing mortgage foreclosures for the same reason. The Bush administration has taken steps to reduce mortgage burdens for some homeowners, but Democrats are claiming that a much broader and more aggressive effort is needed, particularly in light of the sketchy lending practices that proliferated as the housing bubble grew.

The Fed minutes painted a gloomy picture for economic trends in the U.S., and while the central bankers reiterated their forecast for an economic recovery in the second half of 2008, they also said that "considerable uncertainty" surrounded the forecast, with risks to the downside. They also acknowledged the potential for a deep and prolonged downturn in the economy.

On Wednesday, the Journal reported the Bush administration is exploring a plan would help 100,000 homeowners reduce their monthly mortgage payments. Lenders and investors would be asked to write down the value of the mortgages and the federal government, through the Federal Housing Administration, would assume the risk of default.

The plan amounts to a smaller-scale version of a competing plan being pushed by Rep. Barney Frank (D., Mass.), the House Financial Services Committee chairman, that would have the FHA insure up to $300 billion in restructured loans for homeowners facing foreclosure.

Roubini favors Frank's plan.

"Until you buy the mortgages, reduce their face values and refinance people with fixed rates and a lower principal, you're not going to remedy the problems in the financial market," he says. "You have to reduce the face value of the debts outstanding, and someone is going to have to take losses."