Painful days ahead

The Federal Reserve’s extraordinary response Sunday to Bear Stearns Cos.’ looming collapse signals an unnerving new phase in the protracted credit crunch. No longer is the Fed simply pumping money into the economy to promote lending. It is now putting taxpayers on the hook for investments of uncertain value and extending federal help to Wall Street firms whose activities haven’t been regulated as closely as commercial banks.

The escalating efforts by the Fed reflect how stubbornly the frozen credit markets have resisted efforts to thaw them. Lenders have become so skittish about risk that they pushed Bear Stearns, one of Wall Street’s storied institutions, to the brink of insolvency. Its board agreed Sunday to sell the troubled firm to JPMorgan Chase & Co. for about $250 million, or less than a quarter of the value of the Manhattan building that served as Bear Stearns’ headquarters.

The Bush administration tried to dole out a ration of calm Monday. The country is going through challenging times, President Bush said, but “our capital markets are functioning efficiently and effectively.” White House Press Secretary Dana Perino later added, “This isn’t about bailing anyone out.” Neither happens to be true, though, and that’s why the stock market gyrated from open to close.

Contrary to the president’s assessment, U.S. capital markets seem anything but healthy. The innovations that helped extend credit to more borrowers are now showing a flip side that asleep-at-the-switch regulators and policymakers didn’t anticipate. Foremost among these double-edged innovations are the complex securities that bundled scores of sub-prime and other risky mortgages into packages. These proved wildly popular around the globe, largely because they were supposedly structured to guard against losses. But when housing values started slipping and defaults multiplied, the securities turned into financial albatrosses that firms could no longer sell or use as collateral to raise cash.

Bear Stearns’ problems are just the most acute example of the crisis of confidence that those securities helped cause. Other firms that rely on short-term borrowing to finance their operations could face the same challenges, depending on how much of their balance sheets are taken up by exotic and unmarketable financial instruments. In addition, investment banks, hedge funds and commercial banks around the world have become so interconnected that the failure of one could send shock waves through the entire industry. That’s why the Fed bailed out Bear Stearns, sealing the deal by JPMorgan with what amounts to $30 billion in taxpayer-backed guarantees for the firm’s assets. The Fed’s board believed that the effect of a swift collapse would cause too much damage not to Bear Stearns’ shareholders, who were not spared in the deal, but to the entire credit system.

But the Fed’s efforts, including its widely expected move to cut interest rates today, address the credit markets’ psychology rather than their structural problems, which await a painful day of reckoning. The Fed can’t declare how much the shaky securities are worth; that’s ultimately up to the credit market to decide. Their values are likely to remain in flux until the housing market bottoms out and foreclosures decline sharply. Although lenders have a strong interest in minimizing foreclosures while housing prices are in free-fall, they have been slow to head them off. That’s why Congress and the administration need to find more incentives for lenders to move more aggressively to write off mortgage debt that they can’t collect and put realistic values on the loans that have clouded the credit markets’ vision.