NJIT Finance Professor Michael Ehrlich warns the Federal Reserve to leap ahead of the curve. Ehrlich, a market failure expert, sees the serious devaluation of Fannie Mae and Freddie Mac preferred stock—held widely by many US banks--as a serious bail-out consequence. For some of those banks, this will be another hit to their net equity positions at a time when survival is tough. In the worst of circumstances, serious pressure could mount on the Federal Deposit Insurance Corporation, which insures such deposits.
“The Federal Reserve has established too-big-to-fail as an important new standard,” Ehrlich said. “Sure the Fed wants to stop financial contagion, but the unintended result has been to rush in and shore up Fannie and Freddie. Now new and arguably worse risks abound.”
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By first bailing out Bear Stearns and now Freddie and Fannie, the Fed set a precedent, Ehrlich added. The Fed’s handling of Lehman Brothers, Merrill Lynch and Citigroup have also added to the Fed’s new anything goes impression. Such rescues, warns Ehrlich, encourage moral hazard by management since they signal that there is always a bail-out for risky business.
A much better way, Ehrlich said, is for the Fed to establish new rules to control future risks as it works to contain the damage to the financial system. In the Fannie/Freddie case, there should be tighter regulation of the non-bank financial firms and much closer scrutiny (read regulation) of big banks.
Ehrlich was a government arbitrage trader at Salomon Brothers and senior managing director for fixed income emerging markets at Bear Stearns before joining NJIT. He received his bachelor's degree from Yale University and doctorate from Princeton University.