Treasury Secretary Hank Paulson gave an upbeat interview to The Wall Street Journal Wednesday, assuring everyone that the current credit market turmoil will "extract a penalty" but not lead to recession. We tend to agree, but Mr. Paulson would have done better spending his time smoothing over KKR Financial Holdings's commercial paper blowup instead. His words didn't stop another wild market ride yesterday.
The point is that, in a market dominated by fear, what Mr. Paulson says means much less than what he does. The world is undergoing a change in investment quality preference, as they like to say in market circles, which means a flight to such safer assets as cash or Treasuries. That flight has caused a credit seizure for anything tainted with suspect mortgage assets. Losses are inevitable, and to the extent they punish bad decisions even desirable.
But what markets want from the Treasury and the Federal Reserve is evidence that they're skillful financial fielders. That is, that they're able to handle the financial choppers before they get through the infield and create greater trouble. This may not be headline-grabbing, but it's the best way to restore confidence and thus liquidity. The entire point is to avoid surprise headlines.
On that score, the feds went one for two this week. On the plus side, Countrywide Financial was able to call on an $11.5 billion bank credit line when that giant mortgage lender couldn't sell its commercial paper. It also said it would move its mortgage business under its bank unit, which will give it a further liquidity cushion. Countrywide is at the center of the subprime storm, and its stock price has taken a huge hit. But it retains significant earning capacity and a solid business in safer mortgages.
The last thing anyone should want is for an otherwise solvent business to go bust because it can't meet its short-term borrowing needs. The bank credit line will be expensive for Countrywide. But as the 19th-century journalist Walter Bagehot advised, in a financial crisis lend freely at a penalty rate. To the extent that Treasury and the New York Fed played an indirect role in creating this private financial cushion for Countrywide, this was effective crisis management.
The same can't be said of KKR Financial, which also couldn't find takers this week for its "asset-backed" paper. The real-estate affiliate of the private equity company has exposure to mortgage assets that are far safer than subprime, but amid the current panic all such assets are suspect. The KKR news rattled stocks on Wednesday, and the episode could have been better handled with a bank credit line a la Countrywide's, or a capital infusion of the kind Goldman Sachs provided to one of its funds on Monday.
Meanwhile, the clamor keeps building for the Federal Reserve to rescue everyone by reducing its target fed funds rate. So far, the Fed has been providing liquidity on a daily ad hoc basis, which to our mind is the proper way to behave. Investor demand for Treasuries is exactly what you'd expect in this altered risk environment. However, some on Wall Street are pointing to this week's plunge in Treasury prices as a signal that the Fed must go further and ease wholesale. The same people who've been saying for weeks that all was well are now the loudest in urging the Fed to reflate the bubble.
These pleaders ignore two major risks. The first is the "moral hazard" problem of rescuing Wall Street banks and hedge fund players that walked too far on the wild side during the boom. They made money then, and they need to absorb the losses now. Without enduring the discipline of losses, the offenders will go even further out on the risk curve next time.
The second problem is that a Fed reflation could lead to even more trouble if it causes a loss of confidence in the dollar. One of the best cards Treasury and the Fed have is confidence in their financial stewardship. If investors detect that the Fed will sacrifice the currency to throw money at Wall Street, today's credit seizure could become a heart attack. Confidence in the U.S. is even more vital given that the coming weeks are likely to see more than one problem overseas. Emerging markets have been selling off even harder than Wall Street in recent days, another sign of risk adjustment. Yesterday's firming of the dollar against most currencies was a rare sign of global confidence in something.
There will be plenty of time in the coming weeks to debate how we got here, and what we've learned about our rapidly changing financial system. The immediate need is for crisis management that calmly handles ground balls in the infield, applies private capital to problem institutions, and forces losses and new leadership when need be. Hank Paulson may have come to Washington hoping to perform legislative miracles, but that was always unlikely. He'll have to settle for playing gold glove financial defense, which right now is challenge enough.