Extreme Risk in Financial Markets

Via Tanta at Calculated Risk, here's a post by Dean Baker that I would co-sign if I could. The teaser:

The whining from Wall Street is growing louder. Those brilliant high-flying hedge fund managers are now facing the prospect of financial ruin. It seems that they are holding hundreds of billions of dollars of mortgage debt, some of which is worthless, and much of which is worth considerably less than it was a few weeks ago. Since the hedge funds are heavily leveraged (they borrowed heavily to buy assets), many of them could be wiped out.

Given the gravity of the situation, the hedge fund crew is doing what all good capitalists do when things go badly: run to the government.

Specifically, they want the Federal Reserve Board to bail them out with lower interest rates. They hope that this will buy them the time needed to dump their mortgages on less well-informed investors.

The hedge fund folks say that this is the Fed’s job, that it must step in as the lender of last resort and restore order to the market. That ain’t necessarily so.

He's diagnosed this exactly right and proposes a novel idea at the end of his post about how to protect some of the mortgage borrowers who may lose their homes. Read the whole thing.

Keeping with the theme of betraying conservatism, I should point out that government bailouts of risky or stupid businesses are right near the top of the list. I thought St. Louis Federal Reserve Bank President Bill Poole had it right in his speech last month. A key excerpt:

The Federal Reserve had followed developments in housing and the non-prime mortgage markets very closely this year (Bernanke, 2007a, 2007b, 2007c). A highly visible development is the growing amount of financial stress among some of the millions of households with non-prime mortgages. We know that many non-prime mortgage lenders and brokers have gone out of business or tightened their lending standards this year, reducing the flow of mortgage credit to borrowers unable to access the prime market. Financial markets have dealt harshly, but on the whole appropriately, with banks, hedge funds and certain other investors who were heavily exposed to the riskiest segments of the non-prime securitized mortgage market.

While none of these developments is pleasant for the lenders and financial firms most directly affected, one cannot help being impressed with the even-handedness of it all. Until we receive clear evidence that basically sound financial decisions and arrangements were disrupted by erratic and irrational market forces, I believe we should conclude that this year’s markets punished mostly bad actors and/or poor lending practices. Lenders who made loans to borrowers without documentation, or who did not check borrower documents that proved fraudulent, or who made adjustable-rate loans to borrowers who could not hope to service the debt when rates adjusted up, deserved financial failure. As is often the case, the market’s punishment of unsound financial arrangements has been swift, harsh and without prejudice. While I cannot feel sorry for the lenders who have gone out of business, my attitude is entirely different toward the relatively unsophisticated, but honest, borrowers who have lost their homes through foreclosure. Many are true victims.

Read the whole thing.