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strategy and business
 / Winter 2008 /Issue 53(originally published by Booz & Company)


The Thought Leader Interview: Allan Meltzer

Once people in the financial markets have an idea of where prices will settle — prices don’t have to necessarily get there, but people have to have an idea of where they’re going to go — the markets will be able to price the mortgages. So today a banker will lend to other bankers for one day or maybe one week, but he won’t lend for one month because there’s just too much uncertainty about the value of the assets on a bank’s portfolio. And until that problem is resolved, this so-called crisis is going to continue.

Lenders of Last Resort

S+B: When you say “so-called crisis,” do you doubt that it’s a crisis at this point, or again, is that just a question of terminology?
It’s a crisis for the housing sector, but that sector is used to crises — it’s a very up-and-down business. And it is a crisis for banks and the big Wall Street firms, par­ticularly those banks that are heavily invested in mortgage securities, which turns out to be a large number of them.

S+B: One of the aspects of this crisis that seems distinctive is the way it has shaken the investment banking business and the insurance business, rather than just commercial banks or mortgage finance companies, beginning with the bailout of Bear Stearns. There has been much discussion about whether the Fed’s role in that failure — as well as in some other recent instances — was appropriate, especially in acting as “lender of last resort” for an investment bank, with a 28-day emergency loan of and an agreement to guarantee $30 billion in assets. [The deal included Bear Stearns’s ultimate sale to J.P. Morgan Chase at $10 per share.] How big a change does that episode represent?
Historically, there have been few failures of Wall Street firms, partly because they mark their portfolios to market every night. They have to borrow enough to balance their assets. If they cannot borrow enough, the problems come to light pretty quickly. But most investment banks have not gotten into trouble in the past, and not all of them got into trouble this time. Some have taken losses — some of them very large losses — but that’s the nature of their business.

The fact that the Fed acted as lender of last resort in the Bear Stearns case was not, by itself, inappropriate. They have done that in the past. The Fed should be lender of last resort to the whole financial system. In the past, if an investment bank became insolvent, if it posed a systemic risk to the markets, the Fed would provide liquidity to the market to avoid a contagion effect, and they would let the investment bank go out of business. In the Bear Stearns case, that’s what they did. They stepped in, made credit available through the discount window, and then allowed Bear Stearns to fail, wiped out the equity, and replaced the management.

But they made a mistake in guaranteeing $30 billion of Bear Stearns’s portfolio. That transferred potential losses from the market to the taxpayer. As I said, the Fed should be the lender of last resort to the financial system. It in fact took them a long time to learn that, and they didn’t really learn it until the [Penn Central] commercial paper crisis of 1970. But the Fed should not be the permanent financier of any individual — especially not people who are selling them risky, illiquid paper, as was the case with Bear Stearns and AIG. If the Fed had said to these institutions, “Sure, we’ll lend to you through the discount window if you have Treasury bills or the equivalent,” that’s one thing. But to say, “Come and sell us,” or, “We’ll lend to you against assets that no one else will buy,” that’s a mistake. This is not what a central bank is supposed to do.

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