Should We Cheer or Jeer Bernanke and the Fed?

A reader asked if I would share my thoughts on the views expressed in a Yahoo! Finance article written by Wharton Professor Jeremy Siegel on Thursday regarding the Fed and whether or not it should be flooding us with rate cuts.

The piece, entitled Don’t Blame the Central Banks — Thank Them, was well written and sought to comfort readers that coming to the aid of the banking industry is a good thing and could potentially help avoid a recession. Opponents of the Fed’s recent rate cut point to the fact that it is a bail out, and contributes to a moral hazard problem.

From my perspective, I think it is important to differentiate between a bail out and a Fed that provides additional liquidity and reduces the discount and federal funds rate. I am firmly against a bail out of any kind because it rewards (or at the very least seeks to reduce the negative repercussions from) poor decision making by the private sector. I agree that moral hazard is a real concern.

We live in a nation that is fueled by incentives. In most cases, people make decisions based on the incentive structure that is present at the time. If we bail out lenders who made stupid loans as well as the borrowers who were so eager to borrow money than they couldn’t afford to pay back, then nobody will learn from their mistakes and they will be made again and again, at the expense of taxpayers.

An important point to make, however, is whether or not the Fed’s actions thus far should be considered a bail out. Surely the Congress and President Bush could sign into law some sort of plan that essentially bails out troubled lenders and borrowers, but let’s focus on what our central bank has done so far. As Siegel points out in his article, the Fed has taken the lead in increasing the level of available liquidity. It allows those who want access to capital but can’t get it due to short-term market inefficiencies to have ways to get it. Our market-based economy will be better suited when we can eliminate, or at least sharply reduce, a liquidity crisis.

In my view, this is not a bail out. No borrowers are having their loans forgiven and no lenders are getting reimbursed for unrecoverable loans. When you have market participants providing capital into a market based system, and the system temporary stops working (i.e. capital becomes scarce), I applaud the Fed for stepping up in their role as a lender of last resort. We can argue how much of an impact it has had thus far, and will have in the future, but I have no doubt it is helping in some measurable way.

What I find interesting with this mortgage crisis so far is that the companies that have filed for bankruptcy (there have been more than 50 mortgage lenders go under so far) and the companies that have stopped making new loans, have fallen upon hard times due more from a lack of liquidity than loan defaults and property foreclosures. Interestingly, most home loans are being paid on time. As of August 31st, the nation’s largest mortgage lender had 95% of its loans being paid on time. Other lenders have seen their loan portfolios perform even better than that (delinquency rates at another banking institution company discussed last week on this blog are 50% below those of Countrywide).

Now, that is not to say that there isn’t a problem. The sub-prime sector of the market has seen delinquent rates reach more than 20% at some of the more careless lenders, and many of them are no longer in business as a result. I just hope that the actual performance of these loans is what ultimately causes the lenders to sink or swim. If you made bad loans, you deserve to go face the consequences, with no help from anybody.

However, companies whose loans are performing okay also found themselves teetering on the brink due to a lack of capital in the marketplace. If the Fed can provide liquidity to maintain an orderly market, I think they are doing the right thing. That won’t have any impact on how many loans are defaulted on, and I think that is what should determine how much money these firms lose and whether or not they can continue to stay in business. The might lose a lot of money in the short term, but very few can argue that isn’t justified based on the lax nature of their lending standards in recent years. What I’d prefer not to see is a lender be forced into bankruptcy due to lack of liquidity, only to see their loans bought up by third parties who actually recoup most of the outstanding money.

I am all for the Fed’s aiding in the liquidity crisis, but let’s make sure the people who lent money to people who couldn’t pay it back don’t get bailed out, even if that means a family has to give up their house in the process. If they can’t afford the house, I see no reason to fight hard for them to stay in it when they can move into another one (or rent) they can afford.