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The Great American Bailout, Part 2

Yesterday in “The Great American Bailout, Part 1” I talked about how politicians were planning to aid U.S. homeowners going into foreclosure. In particular, I highlighted the misguided proposal of U.S. Senator and presidential candidate Hillary Rodham Clinton to establish a $1 billion fund for bailing out these individuals. The discussion then focused on the importance of personal responsibility. Jonathan Hoenig, writing for SmartMoney, explained yesterday that “the real reason to oppose a bailout isn’t that it’s impractical, but that it’s immoral.” Hoenig, a hedge fund manager, went on to say, “As traders, we are unquestionably comfortable with this sort of personal responsibility. If we make poor investments and lose money, we certainly don’t expect the government or anybody else to bail us out.”

I’m not sure I agree. I’d argue that American investors today expect to be bailed out in a financial crisis. The expectation stems from years of practice by the Federal Reserve Bank. The traditional weapon of choice- interest rates (more specifically, the federal funds rate, which is the target rate for overnight bank lending). In 1998, the Fed cut interest rates to support the bond market after a Russian debt default and the near-collapse of Long-Term Capital Management. In addition, the Fed prodded banks to assist in the rescue of LTCM. As a result, the beaten-down stock market quickly recovered. In 1999, the Fed slowed rate increases and pumped money into the system with the Y2K situation. Stocks surged again as a result. By January 2001, with the market in decline, the Fed began cutting the target rate for overnight bank lending to 1% by 2003. The U.S. economy avoided a deep recession, but cheap money fueled a housing market bubble and is at the source of other problems today.

Which brings us to the present. The Federal Reserve Bank and the European Central Bank have been responding to an apparent shortage of lendable funds in their markets, made worse in part by a widespread reluctance to accept mortgage-backed securities as collateral in the wake of rising defaults on home loans. Losses have piled up in financial markets around the world in response to the credit crunch. As a result, the Fed and ECB have been injecting a massive amount of cash into the money markets. The Fed has injected $64 billion since last Thursday while the ECB has pumped out €203.7 billion during that same period. “Things seem to have calmed down a bit, and we’ve started out the week certainly far better than we ended it,” said Neville Hill, a Credit Suisse economist, to the Wall Street Journal today. The European Central Bank said that money market conditions are “normalizing.” Tuen Draaisma, Morgan Stanley’s chief European equity strategist, even recommended in a note to clients (as reported by Fortune today) that they should go “overweight” in equities because “we may already be at the point of maximum bearishness and uncertainty, which by definition is the right moment to buy.” Critics claim that the recent activities of the Fed and ECB were carried out to put a halt to the recent decline in the prices of stocks, bonds, mortgage-backed securities, and other risky assets. Once again, it appears the cavalry has saved the day.

Yet, Wall Street still clamors for that elusive rate cut. And sooner (rather than later) the Fed will lower the target rate for overnight bank lending because the Fed will be faced with the difficult decision of having to save either the U.S. dollar or the U.S. financial markets. As the Street has powerful friends in Washington, there is no doubt in my mind that the dollar will eventually be sacrificed. And the rate cut will only encourage more speculation. As one veteran trader told the Wall Street Journal on Monday, “You don’t want to see the Fed bail out these guys who have made a lot of money. They have made their bed and you want to see them lie in it.” He added, “Then again, you don’t want to see the economy go into recession.”