Might the Fed profit from the financial crisis?

Most economists would agree that the world's financial markets are facing an extraordinary crisis with the credit freeze, the failure of some prominent financial institutions, and deep losses at other firms.

It's a "financial panic," says John Coffee, a finance professor at Columbia University in New York. He sees a "real chance" that losses could exceed those from the savings and loan institution disaster in the United States from 1986 to 1995. The failure of 1,043 thrifts cost the federal government some $153 billion.

The trouble in the American housing market has certainly hit the financial markets. But so far, economists are mostly predicting a run-of-the-mill, mild and short recession in the US after some six years of economic expansion.

"We have yet to see any really significant effect outside of the housing industry, broadly construed," says Ben Friedman, a finance professor at Harvard University in Cambridge, Mass. Spreading home foreclosures, declining home prices, and other housing troubles could spread to the economy as a whole, he notes. But up to now, the financial crisis appears to be largely "contained in the financial market."

The recent unusual remedial actions by central banks and governments are aimed at preventing the panic from spreading to other financial institutions and the economy in general.

Of course, the world's financial community is worried. Since last fall, a committee of the Institute of International Finance (IIF) in Washington has been preparing a report to address the crisis and avoid future panics. The financial CEOs in the committee plan to present the report before the April 11 meeting of central bankers and finance ministers of the Group of Seven major industrial nations in Washington.

The IIF represents the world's largest 375 financial institutions – commercial banks, investment banks, insurance companies, and others – in more than 60 countries. Its report will make suggestions as to more regulation of the financial industry, including sellers of home mortgages. It will deal with weaknesses in the management of financial risk, including that of complex structured financial products involved in the current crisis. It will address the valuation of such products and the adequacy of secondary markets where they are bought and sold after their primary sale to investors. It will touch on the adequacy of the documentation and information provided on these products. It will tackle the failure of rating agencies, such as Standard & Poor's, to provide accurate evaluations of the risk of failure of these financial products.

And, as a source notes, it will discuss the question of whether the executives of financial institutions should be compensated so lucratively, even if their firms suffer severe losses, and whether such rewards encourage excessive risk-taking.

One positive element arising from the financial crisis is that the Federal Reserve has recognized a fundamental change in the nation's lending system over the last 25 years, given the Fed's rescue of the New York investment banking firm, Bear Stearns, earlier this month. One duty of the Fed, established in 1913, was to act as "lender of last resort" to a commercial bank facing a run. If a rumor circulated that a bank was failing, depositors could be assured that the Fed would come to its rescue. Depositors would see that their fears were not justified and stop withdrawing money.

Today, less than half of the nation's credit is provided by commercial banks. Small businesses may still take loans from commercial banks. But big companies get their credit primarily from investment banks, says George Feiger, CEO of Contango Capital Advisors, managers of $1.9 billion in investments.

These banks buy and sell short-term commercial paper, medium-term financial notes, and long-term bonds.

Commercial banks, says the Berkeley, Calif., executive, are "minor players" now in the credit system. "The Fed figured that out just recently," he says. Considering the freeze in the commercial-paper market last summer, the central bank opened up its credit windows to investment banks almost "a year too late," he says.

As a result, packages of business loans, known as collateralized loan obligations, that sold on Wall Street at full face value last July had lost nearly 20 percent of their value by January – "a pure consequence of hysteria," Mr. Feiger says.

What the Fed should do when it rescues an investment bank from bankruptcy, Feiger proposes, is act like a hedge fund: Take half the increase in the firm's value as a result of its action. In the case of Bear Stearns, that would have given the Fed $500 million. Shareholders would split the remaining $500 million.

So far, the Fed has taken some $400 billion in collateral from various banks by propping up the nation's financial system with loans. Unless financial markets calm down suddenly and unexpectedly, it will pile up as much as $2 trillion in collateral before it is over, Feiger predicts. And the Fed may not lose "one penny" on these rescues, he says, since the collateral has real value.