mortgage-backed paper. The
market surged more than 4% on Tuesday as financial concerns eased further and the Fed cut the
overnight lending rate (for the third time in as many months) by 75 basis points. With Tuesday’s gain, the
S&P is virtually flat for March, but it is still down 9% year-to-date and down 15% since its peak last
October.
Each day it seems we watch financial history, and new precedents, unfold. Except during the Great
Depression, the Fed has historically used the discount window to make direct loans only to commercial
banks. Investment banks were not eligible. On Friday, the Fed sidestepped this by loaning money
through JP Morgan to avoid Bear Stearns’ bankruptcy. The Fed then facilitated the sale of Bear to JP
Morgan over the weekend, providing $30 billion in financing backed by Bear’s least liquid assets. As
such, it appears that the Fed (and US taxpayers) accepted much of the risk in the transaction while JP
Morgan has all the upside. (JP Morgan rallied 10%, or $12 billion in market cap, on Monday thanks to the
generous terms of the deal, which taxpayers underwrote.) On Sunday, the Fed formally opened the
discount window to major investment banks and cut the discount rate from 3.5% to 3.25%. These
aggressive actions have lessened the odds of similar runs on other investment banks deemed “too big to
fail.” While one can argue the appropriateness of some of the measures, they probably have reduced
systemic risk.
While the Fed’s actions helped in this crisis, and Tuesday’s cut in the Fed Funds rate will inject liquidity,
markets remain fraught with risk. Recent economic releases suggest we are probably in a recession,
which portends further deterioration in earnings and an increase in bond defaults. At the same time, the
Fed’s drastic rate cuts risks a further pummeling of the dollar and elevated inflation. The VIX index, a