Fed staves off disaster, but that's not enough

http://www.mercurynews.com/opinion/ci_8635232

Editorial: Fed staves off disaster, but that's not enough
Mercury News Editorial
03/20/2008

The Federal Reserve probably staved off an economic meltdown this week, but investors on Wall Street remain jittery. Congress may have to step in to ease fears of cascading foreclosures.

On Sunday, the Fed, the nation's central banker, orchestrated the unprecedented takeover of one distressed brokerage, Bear Stearns, and announced it would make loans available to others. That prevented panic from spreading throughout the credit market. On Tuesday, the Fed dropped a key interest rate again. But the thrill on Wall Street was short; one day later, the markets gave up most of their huge one-day gains.

You don't have to be a day trader to know that better times aren't imminent. The Federal Reserve's intervention sidestepped disaster but didn't cure the ailing economy. A possibly long and nasty recession is at hand amid worries of inflation. If another big broker or bank announced huge losses, it would set off a new crisis of confidence.

Wall Street has been hypertense since last summer, when trouble in a narrow band of sub-prime mortgages overwhelmed the real estate market. Waves of foreclosures sent home values plunging nationwide, and investors who had purchased those mortgages had to write off the losses.

But contraction is unavoidable after a market binge. For years, Americans feasted off the paper wealth of home equity and easy credit detached from ability to pay. The Fed bore some blame, to the extent that it kept interest rates low and ignored signs that banks, hedge funds and investment houses were dangerously exploiting the subprime market.

Alan Greenspan, the sainted former Federal Reserve chairman, ignored signs of trouble and praised new methods of repackaging mortgages to far corners of the world. Now investors have been bitten by complex financial instruments they didn't understand or even know they held.

The Federal Reserve until now had vowed not to cover the bad bets of capitalists with public money. It crossed that line when it put together the purchase of Bear Stearns at a fire sale price. The Fed assumed responsibility for $30 billion of the worst investments that buyer JPMorgan Chase didn't want.

The downside to the unprecedented intervention is that Wall Street wizards may shrug off the lessons of failure and continue daredevil investments, confident that U.S. taxpayers will rush in with a safety net. The biggest investment houses may believe that, like Bear Stearns, they're too big to be allowed to fail. The Fed must make clear that its actions of the past week are an exception, and Congress must pass tighter regulations to prevent subprime excess and abuse.

The Fed has struggled to pump life into the failing economy in recent months through lower interest rates on money it lends to banks. But banks have resisted passing on the savings. Interest rates on credit cards and 30-year mortgages barely budged.

Congress should seriously consider loan guarantees to some of the 8 million homeowners overwhelmed by subprime loans, helping them to obtain affordable mortgages and pay off debts. Collectively, those homeowners too are too big to fail.