What the Fed Can Do to Fix Subprime Mess

When are investors like termites? When they are trying to avoid government rules.

And that is one reason new regulations won't prevent another crisis like the subprime housing mess, Boston College finance professor Edward J. Kane said at the recent annual financial risk roundtable held by the Wharton Financial Institutions Center and the Oliver Wyman Institute. Writing new rules is tempting, but it leads to "regulation-induced innovation," Kane said. "People being regulated are like termites. They go away from the poison and go after the wood. They're intelligent."

This year's roundtable focused on the housing and banking crises. And while participants identified a host of problems that led to the bailout of Bear Stearns and capital crises at other banks, agreeing on solutions proved as challenging as destroying pesky bugs.

William C. Dudley, executive vice president of the Federal Reserve Bank of New York, kicked off an afternoon discussion on the role of central banks by explaining how the Fed analyzes market risks and how it developed some new responses to maintain liquidity in current markets.

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Higher loan loss provisions and write-downs on security portfolios have pressured bank balance sheets and forced them to raise capital, Dudley said. This limits the Fed's control over deteriorating markets. But the Fed can provide a way to financeless-liquid collateral on the balance sheets of banks and primary dealers, the banks and securities dealers allowed to trade directly with the Fed. By reducing this risk, the Fed can lessen the chance that forced asset sales at big discounts will destabilize markets.

During the recent crisis, Dudley added, the Fed created three new lending programs aimed at giving markets what they need most in times of crisis: confidence. By providing backup financing, the Fed hopes to reassure investors that banks and primary dealers won't run out of cash.

One example of a new Fed program is the Primary Dealer Credit Facility, which operates in the tri-party repurchase, or repo, market. Repos are contracts in which a seller of securities agrees to buy them back at a specified time and price. In a tri-party repo, a custodian bank or international clearing organization acts as an intermediary. Many people believe the Fed rescued Bear Stearns because it was such a big player in the market for mortgage-backed securities, but Dudley said Bear's role in the tri-party repo market also affected the decision.

'Stopgap Measures'

Robert A. Eisenbeis, chief monetary economist for Cumberland Advisors and a former director of research at the Federal Reserve Bank of Atlanta, said the Fed's efforts to deal with current market turmoil are "essentially stopgap measures and a form of forbearance to give large complicated financial institutions time to recover."

But those institutions faltered because they had assets of questionable quality, including asset-backed commercial paper, on their balance sheets, not because markets did not have the funds necessary to trade. It's like saying that what a sputtering car needs is not more oil, but a new engine. "I don't really believe current problems were liquidity problems but solvency problems," Eisenbeis said.