It has been an amazing 10 days. I have never seen anything like it and I hope we never need to repeat it. Consider for a moment all that has happened. In a dramatic effort to head off the spreading liquidity crisis, the Federal Reserve has:
Allowed investment banks direct access to the Fed's discount window - something not done since the 1930's.
Offered to lend $100 billion in cash to commercial banks and $200 billion in U.S. treasury bonds to investment banks. As collateral for these loans, borrowers are able to post mortgage-backed securities, the very assets at the center of the current crisis.
Cut the interest rate at the discount window to 3.25 percent.
Arranged for emergency funding to keep Bear Stearns afloat.
Engineered the fire-sale of Bear Stearns to JP Morgan.
Lowered the Federal Funds rate by 0.75 percent to 2.25 percent.
While the magnitude of these actions may be difficult to fathom for those who don't spend their lives watching the Fed, trust me when I tell you that all of these steps taken together in such a short period of time is nothing less than heroic. It is certainly the most vigorous response by the Fed to any crisis in my lifetime and probably the most dramatic since the Great Depression. Treasury Secretary Henry Paulson was not exaggerating when he said we are in uncharted territory.
It is too early to tell whether these events mark a turning point for the financial system or a bottom for the market. I tend to think we have more struggles ahead of us. Hopefully the mavens on Wall Street will begin taking the painful but necessary steps to get their businesses back on track.
In my view, a workout scheme analogous to the strategy that got us through the savings & loan crisis in the late 1980's is likely necessary to fix this one. Financial institutions will need to segregate their bad loans into a separate entity that would be spun off to shareholders while the good assets would stay in the parent company. We may even need to set up an institution akin to the Resolution Trust Company to facilitate the sale of failed or failing firms.
This strategy, known as "good bank/bad bank" would be very painful for shareholders and I'm sure they will resist it. However, if the Fed's approach to Bear Stearns is any indication of its current mood, shareholders may not have a choice.