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Former Chairman Volcker practically denounces Fed

Section: Daily Dispatches

Volcker Says Fed's Bear Loan Stretches Legal Power

By John Brinsley
Bloomberg News Service
Tuesday, April 8, 2008

Former Federal Reserve Chairman Paul Volcker questioned the central bank's decision to rescue Bear Stearns Cos. with a $29 billion loan, saying it was at "the very edge" of its legal authority.

"The Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers, transcending in the process certain long-embedded central banking principles and practices," Volcker said in a speech to the Economic Club of New York.

Fed Chairman Ben S. Bernanke last month agreed to lend against Bear Stearns securities, paving the way for JPMorgan Chase & Co. to buy its Wall Street rival. Bernanke, who worked with Treasury Secretary Henry Paulson to broker the bailout, last week defended the move as necessary to prevent "severe" damage to financial markets.

Volcker, the Fed chairman from 1979 to 1987, had implicit criticism for U.S. regulators and market participants who allowed "excesses of subprime mortgages" to spread into "the mother of all crises." The Fed's Bear Stearns loan was unusual, he said.

"What appears to be in substance a direct transfer of mortgage and mortgage-backed securities of questionable pedigree from an investment bank to the Federal Reserve seems to test the time-honored central bank mantra in time of crisis: Lend freely at high rates against good collateral; test it to the point of no return," he said.

... Wall Street subsidy

Lawmakers, while praising the Fed and Treasury for averting a financial collapse, have also questioned the plan to subsidize Wall Street while the Bush administration resists using government funds to assist homeowners cope with the worst housing crisis in 25 years.

Volcker said the Fed's loan may send investors the wrong message.

"The extension of lending directly to non-banking financial institutions -- while under the authority of nominally 'temporary' emergency powers -- will surely be interpreted as an implied promise of similar action in times of future turmoil," he said.

Volcker said the modern financial system has "failed the test" of the marketplace. When asked whether he predicts a "dollar crisis," he said, "You don't have to predict it. You're in it."

The dollar has dropped 15 percent against the euro and 14 percent versus the yen in the past year.

... $945 billion in losses

"What Chairman Volcker said in his remarks is that we need to make sure we are taking a look at the implications of the Fed decision," Glenn Hubbard, former chairman of President George W. Bush's Council of Economic Advisers, said in an interview. "The question is: How do we then redesign regulation around a decision that bold?"

Volcker's critique comes as policy markers struggle to prevent the world's largest economy from contracting, a prospect Bernanke himself raised last week. The International Monetary Fund today said the global losses from securities tied to commercial real estate and loans to consumers and companies may reach $945 billion.

"The bright new financial system, with all its talented participants, with all its rich rewards, has failed the test of the marketplace," Volcker said.

As credit markets seized up, the Fed gave the 20 primary dealers in U.S. government bonds the same access to discount-window loans that had previously been reserved for banks. The central bank now auctions as much as $100 billion to lenders a month and has cut the cost on direct loans to just a quarter-point above the overnight rate on loans between banks.

"The implications of these decisions, and the lessons from the unfolding crisis itself, surely deserve full debate and legislative review in the period ahead," Volcker said.

... Fed's response

The Fed has also lowered its benchmark rate six times since September to 2.25 percent from 5.25 percent, and traders anticipate it will cut by at least another quarter point this month to cushion the economy's downturn.

Volcker, 80, said the problems stemmed in part from trading of increasing complicated securities including derivatives that "have taking on a trading life of their own," and said the turmoil "adds up to a clarion call for an effective response."

"There was no pressure for change, not in Washington, which was spending money and keeping taxes low; not on Wall Street, which was wallowing in money; not on Main Street, with individuals enjoying easy credit and rising house prices," Volcker said.

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