Are Central Banks Out of Their Minds?

April 21, 2008

More central banks around the world are using public money to bail out private companies. Are central banks out of their minds? Are they running out of options?

Back in March, the Federal Reserve announced that would be lending banks as much as $200 billion in US Treasuries in exchange for mortgage backed securities. In doing so, the Fed immediately increased the risk on their books and caused an uproar on whether or not it is smart to use public money to financial institutions from their own overly aggressive risk appetite.

For a long time, the Bank of England refused to follow in the Fed’s footsteps because they did not want to foster an environment where banks and financial institutions would start relying on central bank bailouts. Their laissez-faire attitude received significant criticism even though in my opinion, it is the right attitude for the long run. Unfortunately the Bank of England has finally buckled under the weight on political and economic pressure.

With mortgage lenders becoming more stringent, the Bank of England was forced to take a page out of the Fed’s book. Today, they unveiled a GBP50 billion package that would allow banks to swap their mortgage backed securities for UK bonds in the hope that this would encourage mortgage lenders to extend new loans.

Meanwhile the Reserve Bank of Australia also announced today that they bought A$780 million worth of mortgage backed securities to help add liquidity to the mortgage market.

Are these Central Bank’s Out of their Minds?

Desperate, Yes.

Crazy, No.

The Fed’s action last month has helped to stabilize the equity markets and restore some risk appetite. Although lower house prices and losses in mortgage backed securities cannot be avoided, these measures by central banks has and will continue to temper the decline. They are working aggressively to prevent a collapse in the financial markets and even though the public bailouts increases the risk”moral hazard,” with the US and UK economies headed for more trouble, the central banks have no choice but to address the problems now and deal with the consequences later.

Unless any of these financial institutions go bankrupt, there is only a slim chance that these central banks will end up losing any taxpayers money.

Posted in Bank of England, Fed Rate Cut, Federal Reserve, Reserve Bank of Australia