A lot has been made of the Federal Reserve’s bail out of American Insurance Group (AIG), Freddie and Fannie and the announcement last week of the “several hundreds of billion dollar” fund to purchase illiquid securities. The markets worldwide heaved a sigh of relief after a week that shook the very foundation of the US Financial system. The champions of capitalism went huddling in a corner to digest if a state bail-out was indeed written in the handbook while the Socialists went around with a smugness that screamed “I told you so. This is the high-noon of socialism in the heartland of Ann Rynd”. Many commentators have argued that free-enterprise and state sponsored rescues cannot coexist in the same jungle and that the Mecca of Capitalism should have allowed the precarious Institutions to fail. Lost in this din of the battle of governance model is the simple matter of governance – that what rises above every other consideration. The government is in the business of delivering governance and it was important for the Fed and the US government to bail out the troubled institutions as the alternative was to plunge the world into financial anarchy.

There is one argument that can be conceded – that is of the Fed selectively bailing out Bear Sterns (albeit in a package with J P Morgan) while allowing Lehman to crumble. Probably the Fed misread the enormity of the situation and hence rescued the first institution to display trouble, little realizing that the trickle will soon become a flood.

It is naïve to compare the effects of Lehman’s demise with the probable tectonic shivers that a collapse of Fannie, Freddie and AIG would have had on the US (and hence, the world) economy. The first two collectively owned or guaranteed more than half of the $12 trillion mortgage market in the United States. In addition, they are the largest participants in the secondary market of mortgage and securities that derive their values from underlying mortgages. The second aspect of Freddie and Fannie’s role, the secondary market presence, is important because their collapse would have rendered almost every mortgage backed instrument completely illiquid (hence close to zero value for mark-to-market purposes). Had that happened, Lehman would have had the company of many marquee Wall Street names on their way down.

The central bank in any country is a lender of the last resort. The principles of central banking are the same irrespective of the color of the government. By creating the $700 billion fund, the Fed was just carrying out that responsibility. It is impossible in the economics rule-book to inject such a vast amount of liquidity directly in the market so creation of the RTC type fund was the best the world could have had from the Fed under the current circumstances. It is unknown how much of illiquid asset backed paper is lying in Wall Street but $720 billion should go a long way to re-establish the semblance of a market in these assets.

Michael Lewis starts his book “The Liar’s Poker” stating that Wall Street is actually a narrow ally in downtown Manhattan that has a graveyard at one end and a river at the other. Diabolic as it may sound, the Federal Reserve has indeed behaved like the Lemming that decided to run the other way from the river. The dying days of the Bush administration has given the most enduring policy of the past eight years coming out of the White House.

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