“We are close to a financial system meltdown”

FT Alphaville quotes Jim Reid, a credit strategist at Deutsche Bank, in a letter to clients: The Fed has now stepped up a gear and ultimately we probably need the US Government to do so too. Even though we believe in free markets and believe that pain should be felt after such an unruly credit ...

FT Alphaville quotes Jim Reid, a credit strategist at Deutsche Bank, in a letter to clients:

FT Alphaville quotes Jim Reid, a credit strategist at Deutsche Bank, in a letter to clients:

The Fed has now stepped up a gear and ultimately we probably need the US Government to do so too. Even though we believe in free markets and believe that pain should be felt after such an unruly credit binge, we also think we are close to a financial system meltdown. At this stage moral hazard arguments need to be put in a wider perspective."

While the Bear Stearns debacle is certainly alarming and the broader financial system is blinking red, we should be careful in accepting such statements at face value. Banks that have made bad bets have an interest in seeing U.S. taxpayers foot the bill for their mistakes. Nouriel Roubini, who wrote the cover story for the latest issue of FP, blogged some sharp thoughts on the moral hazard problem Friday:

Unless public money is used on a very temporary basis to achieve an orderly wind-down or merger of Bear Stearns this is another case where profits are privatized and losses are socialized. By having thrown down the drain the decades old doctrine and rule that the Fed should not lend or bail out non-bank financial institutions the Fed has created an extremely dangerous precedent that seriously aggravates the moral hazard of its lender of last resort support role. If the Fed starts on the slippery slope of providing massive liquidity support to non-bank financial institutions that have recklessly managed their risks it enters into uncharted territory that radically changes its mandate and formal role. Breaking decades-old rules and practices is a radical action that seriously requires a clear public explanation and justification.

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