Why Is The Federal Reserve Talking So Much About The Costs of The Investment Banking Backstop?

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Although New York Federal Reserve Bank President Timothy Geithner said today that he supports the Fed's moves to rescue Bear Stearns from bankruptcy, he went out of his way to emphasize that this was a response to an acute risk to the financial system.
"It was the only feasible option available to avert default," he said. "We were not confident that the damage could be maintained by other means."
The Federal reserve has been on something of a yakking rampage lately.

Last week Federal Reserve presidents Charles Plosser and Jeffrey Lacker warned that excessive "moral hazard" had been created (or was in danger of being created) by the Federal Reserve's recent actions to save Bear Stearns from bankruptcy and permit other investment banks to borrow at its discount window--a privilege previously reserved for depository banks facing much steeper regulations.
The idea is that Wall Street firms might be encouraged to take on more risk because they may view themselves as too big--or too deeply entrenched in the financial system--to fail. What's more, investors and counterparties may be encouraged to ignore increased risk because of the perception of a Fed backstop. Witness the relative calm that has greeted the news and rumors of Lehman's failings.
Minneapolis Federal Reserve president Gary Sterm echoed these thoughts in his annual report for 2007. "The Federal Reserve's response has a potentially significant cost. The uninsured creditors of other large financial firms may now have heightened expectations of receiving government support if these firms get into trouble," Stern wrote in the Minneapolis Fed's 2007 annual report.
So why are all these honchos at the Federal Reserve going on about the acuity of the situation in March and the risks posed by ongoing Fed involvement? We spoke with a long time credit market expert and Fed watcher at lunch today. Later this afternoon, we'll share his ideas.

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