Fed: Investor of last resort? (thanks, NYT)

September 18, 2008 at 5:09 am | Posted in credit, Housing | Leave a comment
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This NYTimes article characterizes the Fed, long the lender of last resort, as the new investor of last resort.

The shortfall of capital in the system needs to be met somehow. Wish that it wasn’t after the fact, but then, equity investors wouldn’t feel too good about diluting their stake by raising capital when the times are good. The only way this would work is if risk regulations forced stricter capital norms, which would force equity holders to dilute for growth. Since they didn’t do this enough, the capital is raised after the fact. Basically, the bank says that they lost money, their capital base is eroded, so they need more equity to keep going. Sometimes, an investor comes in and buys into the bank at bargain basement prices. Sometimes, they buy into a falling stock and it keeps going down. But in any case, the bank is advertising its distress. Instead of raising capital early, saying “We’ve got this growth opportunity and need money to take advantage of it”; it is raising capital from a position of weakness. Sometimes, then, no one buys in. If you don’t think your $2 billion will be enough to save the bank, you wouldn’t put in the money – why back a foundering horse?

So then, maybe the Fed steps in, and says: “If this institution fails, the consequences to the economy (the taxpayer) are worse than the cost to the taxpayer to save this institution”. The Fed may not always be right.

But it is better to think about this issue and decide whether, in each case, a failure or a rescue is worse for the public, than to rigidly follow dogma and leave it to the markets. A failure or a rescue does not just affect one institution; there are externalities for the public. A rescue is not always the answer. I am against public ownership in general. But I know that sometimes, the alternative is worse.


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