The US government has bailed out Fannie Mae and Freddie Mac. The market now seems to view Lehman Brothers and Washington Mutual as next in line, with possibly more to come. It is time for the authorities to step back. Further such rescues should be avoided like the plague. It is the job of a government to save the financial system, not individual institutions. What has been done so far should be enough.
Yes, banks are going through tough times. The loss of shareholder value in Fannie and Freddie adds to losses from exposure to the housing market and consumer debt. The settling of the credit default swaps on the two mortgage giants may also be messy. Raising fresh capital is also increasingly difficult. This is not surprising, however, given how bad news has kept dribbling out.
Yet a sudden failure, such as that of Bear Stearns in March, seems unlikely, since liquidity is assured by the Federal Reserve’s decision to open the discount window to investment banks. This is buying damaged institutions time needed to come up with a private sector solution. That is what they must seek.
Apart from offering short-term liquidity, the Fed and the Treasury should remain on the sidelines. It is not obvious how they could help a bank such as Lehman, other than by injecting equity. It is even less obvious why they should.
The government was right, however, to bail out Fannie and Freddie. Their failure would have been a disaster for housing finance. Given their scale and the implicit government guarantees of their debt, failure would indeed have had systemic consequences. Yet this is not true for other US institutions.
The authorities now need to draw a line. Provided the system as a whole is kept functioning, weak institutions must be allowed to fail, as part of the ongoing adjustment. Equity holders have suffered in previous bail-outs, but creditors should also lose where banks prove insolvent. In the case of commercial banks, the Federal Deposit Insurance Corporation takes charge. No such scheme exists for investment banks. But, having addressed market panic, through the provision of short-term liquidity, orderly wind-ups must be allowed, where needed.
It is only if house prices fall much further and losses mount to enormous magnitudes that the authorities might have to contemplate a fiscal bail-out, as in Japan and Sweden in the 1990s. Fortunately, from what one can identify at present, the US financial system is a long way from that. An accommodative monetary policy and an aggressive fiscal policy is as much as markets should now hope for.