The US Federal Reserve has stepped in to bail out the financial sector, cutting its discount rate and, more importantly, encouraging banks to borrow directly from the Fed to finance mortgage lending. This action demonstrates that the famous “Greenspan put” has survived, and is now the Bernanke put.
A “put” in finance jargon is an option to sell an asset to to the issuer of the option at a “strike price”, typically selected to protect the holder of the put against disastrous loss. The put is exercised only when the market price falls below the strike price. Credit markets provide a range of put options for assets including equities, bonds and so on. From the viewpoint of financial market participants, the great thing about the Bernanke put is that it’s free. The masters of the financial universe can make bilions betting that things will go right. If things go wrong, the Fed is there to pick up the tab.
Of course, things have to go wrong in a bad enough way to threaten the stability of the financial system as a whole, and yesterday’s rescue shows what that means. The fact that a large proportion of subprime mortgages were going to go bad, with at least a million families losing their homes, 100 000 workers losing their jobs and so on was known months ago. The big news of the last few weeks is that the losses won’t be confined to this group, but extend to hedge funds, issuers of commercial paper and so on. Another group facing problems were homebuyers seeking mortgages too big to be covered by the quasi-official loan guarantee corporations, cutely called Fannie Mae and Freddie Mac. These ‘jumbo’ loans (over about $400 000) have become very hard to get and will now be effectively guaranteed by the Fed.
So, the Bernanke put is great for Goldman Sachs and JP Morgan and good for high-income homebuyers. But it won’t do any good for the low-income, poor-credit households who lined up for subprime loans. In fact, they represent the first line of defence for the financial system, made more effective by the Bankruptcy Reform Act of 2005, which has closed off this option for many.
It’s hard to criticise Bernanke for the choices he’s made, given the way the system works. On the other hand, it’s equally hard to see why we as a society are rewarding the financial sector so richly for an activity which involves little risk and big payoffs, whether decisions are good or bad.