Fed gives no hint it plans to bail out lenders

One reason the economic crystal ball is so cloudy is that prices of some of the riskier bonds at the center of the meltdown have been based on computer models. Now, as the latest cycle of unusually cheap money rapidly comes to a close, the financial markets haven’t figured out where the bottom is.

"It's in the hundreds of billions, perhaps trillions affected," said David Kotok, chief investment officer at Cumberland Advisors. "It has got to be repriced to reflect a market-based pricing system. That is a process in which there will be losses, and the markets know it. They just don't know how big it is and who it hurts the most."

That uncertainty about just how much bad paper is out there is at the heart of the fear gripping the markets. While the Fed has strict guidelines on how banks report their assets, much of the recent easy-money mania was financed with bonds sold to money managers and hedge funds that don’t have to report their holdings.

It’s also not clear just how many more loans will go bad. On the mortgage front, some borrowers who are delinquent on their loans may be able to negotiate new terms to avoid default. Some announced private equity buyouts, meanwhile, may not be able to get the financing that looked like a sure thing just a few weeks ago.

"Banks have a serious question; they have to make a judgment call," said Dan Primack, editor of the Thomson Financials Private Equity HUB Web site. "Either we stick with these deals which we think are bad deals from our perspective, the bank's perspective, or bail on them." Canceling deals would hurt a bank's credibility for future financings, said Primack.

Ironically, the current market crisis is the result, in part, of an extended period of financial stability engineered by the Fed. That may have prompted lenders and investors to “underprice” the risk of lending. Mortgage brokers overlooked borrowers' shaky credit histories. Wall Street snapped up hundreds of billions in bonds, at low interest rates, to back an explosion of private equity buyouts.

Greenspan's example comparisons
The Fed’s response to the market's turmoil has drawn comparisons between Bernanke and his predecessor, Alan Greenspan, who became Fed chief just a few months before the stock market crashed in October 1987.

Greenspan was praised for helping the market stabilize by announcing the Fed would make available as much money as needed to keep the markets from seizing up.

The current slow-motion collapse of the bond market presents the Bernanke Fed with a tougher call. For one thing, the known losses haven’t yet approached the magnitude of the Crash of ’87.  For another, if the Fed moves to make money cheaper by cutting rates, the cycle of easy-money lending — with investors ignoring credit risks — could start all over again.

On the other hand, if lenders and investors get too cautious, and money gets too tight, the economy could slip into a recession. Despite the recent heavy losses on Wall Street, that spillover to the wider economy hasn't happened, according to Stuart Hoffman, chief economist for PNC Financial Services Group.

"The Fed's mission is not to protect the vested interests of Wall Street," he said. "It's to protect the vested interests of the American economy. So I think the Fed got it right."

Tuesday's decision also signaled to Wall Street that Bernanke may be slower than his predecessor to open up the money taps in times of financial crisis.

"I think Bernanke has a much longer view of things (than Greenspan)," said John Silvia, chief economist at Wachovia Securities. "He's not going to react as quickly" as Greenspan did to crises.

An informal survey of roughly 50 economists by CNBC confirms that view. The survey found that the group thinks Bernanke is less likely to ride to the rescue of the financial markets than his predecessor. About two-thirds said he’s less likely to cut rates; a third said the odds of such intervention are about the same.

But a lot depends on how quickly the markets stabilize — and how much collateral damage hits the economy. If the bond market doesn't find its footing, and market psychology shifts to panic-mode, the Fed may have no choice but to step in and put the fires out.

"(Bernanke) understands the dynamics," said Robert Barbera, chief economist at ITG. "But you can be a war theorist and never have hit the beaches on D-Day. He has now changed from someone with an academic interest in this to having to respond to it."  

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