Should the US Government Buy Distressed Bonds?

The Federal reserve, and the Federal Home Loan Banks, and Fannie Mae, and Freddie Mac, between them, have injected a huge amount of liquidity into the banking system during this credit crunch. But it’s been done in a reactive manner, without much if any strategic big-picture vision. John Cassidy has another idea. If you’re going to bail out the banks, he says why not make it explicit?

Instead of relying on Fannie, Freddie, and the F.H.L.B. to ease the credit crunch, the federal government might be well advised to intervene directly in the financial markets. One solution is for the Fed, the Treasury Department, or a new official entity to buy large amounts of mortgage-backed securities, collateralized debt obligations, and other distressed paper from financial firms at bargain-basement prices. By purchasing these assets at a discount, the government could ensure that companies pay heavily for their reckless behavior, while also injecting much-needed liquidity into the system.

Cassidy doesn’t say what the Fed and the FHLB and Fannie and Freddie should do in this scenario. Should they all start tightening, to offset the massive liquidity injection coming from elsewhere? Of course they wouldn’t. Which means that the buy-up of mortgage-backed securities would just be another reactive and seemingly-desperate attempt to inject liquidity into a banking system sufferering from a credit crunch. And as Cassidy compellingly demonstrates, we’re doing that already.

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