The fed engineered a "rescue" of the investment banker Bear Sterns last week.  The firm was bought by JP Morgan  for a song. It was the first serious move by the fed to address the inability of the marketplace to price bad loans.  Until now simply lowering the fed funds rate was the tool of choice by Ben Bernanke.   Eight month's ago, two day's after the crisis broke, I wrote that the cause of the crisis was the following: 

"Recently, the packaging of loans has become popular and some sub-prime loans, have been sold together with prime loans.  Normally the market would re-price suspect loans.  They would be discounted by the market to a price that the market could clear.  But because they are in a package, they are not visible to the market."

"And there's the rub.  There is no market, yet.  There is no way that the market can identify and price these suspect loans.  There is no way for the market to know how many bad loans there are, or to what degree they should be discounted.  The market hates uncertainty and we have plenty of it today.  The problem in a nut shell is that there is no market for these securities.  What you can't see or define can not be dealt with -- hence, panic selling.  The solution is to break these suspect loans out of their packages and then let the market price them.  If that happened I believe the panic would be over and done with immediately."

"It could be argued that the inability of the market to perform this function amounts to  structural damage.  I am open to that argument.  It is possible that the market will not be able to resolve this problem."  End quote.

This was written August 9th, 2007.  It took until now for the fed to come to the same conclusion.  The amount of damage done along the way has been considerable.  I give the fed a failing grade for tardiness in actions that should have been taken at first -- not at last.  And I also give the fed a failing grade for not lowering interest rates quickly, to the market rate of interest.  By delaying drastic cuts only until the last month or two, the fed has been promoting a tight money policy in the face of a credit crunch and economic slow down.

However, better late than never.  The fed has been moving on several fronts to encourage these bad loans out of invisible packages and into the light of day.  The credit crisis is simply a matter of lack of transparency and lack of pricing ability by the market resulting in a lack of confidence and lack of liquidity.  These moves are attempts to allow the market to function.  It has been frozen for 8 months.  And the frantic lowering of the fed funds rate, to at least a little closer to the 90 day treasury bill, is a step in the right direction.

Many have called the deal between the fed and one of the two biggest investment banks in the nation, a government bail out.  They claim that Bear Sterns was saved because it's "too big too fail". Tell that to Bear Stearns investors who have seen their stock fall from 160 a share to 2 dollars; tell that to the top executives who are now unemployed; tell that to the 7000 employees who have lost their jobs, and the 14,000 who have lost their pensions, their stock options, their 401k's, and watched as their kids college funds melted away. This was an institution that has survived every hard economic period in past years, including  the great depression, and is now gone forever.

No, this was not a bail out. Chrysler, where the government bought the company and saved all and everything involved, was a bail out.  What bothers me, is not the central banks actions to facilitate Bear Stearns' sale to JP Morgan, but that had the fed acted one week earlier and opened up the discount window as it eventually did to all other investment banks, Bear Sterns would exist today.  Congress gave the fed the authority to do this in 1999.  They altered the Glass-Steagall act, which separated commercial banks from investment banks.  Under the new law the fed was given the power to allow investment banks to come to the discount window in times of trouble just the same as commercial banks.  Why they did not open the discount window last August is a mystery to me. Why they allowed Bear Sterns to be taken over -- then open the discount window to all it's competitors is also a mystery to me.

But, they finally have now, and I believe this, together with several other actions the fed and the treasury is embarking on, will end the financial crisis soon.  So, are we out of the woods?  Not a chance.  The problems we face are the following:

1)  The lingering inability to price bad loans

2)  Falling home prices and defaults

3)  The real estate recession

4)  Possible national recession/depression

5)  Mounting inflationary fears

6)  A falling dollar

The solution to #1 is what the fed and the treasury is now in the process of doing.  It is the least of the bad solutions in that the actions are to assist the market, in an orderly way, to function where it could not function on its own.  This is the task of a Central Bank -- to be the lender of last resort.  I just hope the fed has thought through the fact that since these are temporary loans they've made, there will come a time when they will have to liquidate this paper.  How and when they do this becomes crucial.  So, let's call solution #1" in the process of being solved" with much work yet to be done.

The solutions to number 2 & 3 falling home prices and defaults and a real estate recession is to do nothing -- absolutely nothing.  Let the market do exactly what it has been.  The market provides a clearing and pricing  process.  It quickly and efficiently finds the price where buyers and sellers can meet and exchange.  It is in the process of doing this daily and any interference from government will only serve to impede that process.

The solution to #4, fears of a recession or depression are the same -- do nothing.  Of course congress has already passed an economic "stimulation" program that is both expensive and probably unnecessary.  Although Congress, the Administration and two-thirds of the American people say we are in a recession and one-third believes we are going into a 30's style depression, we have yet to see even one month of negative growth.  We need 6 consecutive months to qualify as being in a recession.  Doing nothing about a so far, non- existent recession is the best thing that government can do.

Numbers 5 &6, mounting inflation fears and a falling dollar have somewhat already been addressed by the fed.  The money supply has been slowed substantially over the last year -- too substantially for my money.  This indicates to me that we are in for a bout of disinflation soon.  Interest rates are still high in real terms.  Monetary policy has been very tight since the beginning of 2007.

This together with the latest fed policy statement which accentuated the need to focus on inflation may have been the first fed moves to publicly shore up the dollar and begin fighting inflation.  The fed statement included a new full paragraph underscoring their concern about inflation.  It was this that caused commodities to fall and the dollar to reverse not the .75 basis point cut in the funds rate rather than the hoped for 1%.  The mere attention the fed was willing to give to inflation was an alarm bell to speculators.

More, if foreign central banks lower interest rates soon, the differential between the dollar price of money and the price of money in other currencies should curtail the money flows out of dollars and into foreign currencies, at least to some extent.  The fed is headed toward ending the credit crunch and starting to turn its attention toward the inflation/dollar concerns.

To be sure their will be lingering bankruptcies, lousy statistic, lots of foreclosures and continued falling home prices.  Many of these concerns will probably be resolved in the second half of the year, for better or for worse.  My view is that we will avoid a recession.  But recessions are being replaced by panics and crises in various forms into the future as far as the eye can see.  This opens a new world of vulnerability and opportunity.  The financial crisis is hopefully ending, but we are not out of the woods by a long shot.  The next crisis and panic is probably just around the corner -- along with the next boom.  Welcome to the world of Never Never Land.

Paul Nathan