A little while ago I wrote about why the Fed’s lowering of the interest rate did not alleviate the credit crunch. The Fed has now taken two much more dramatic actions. First, it vastly expanded it’s lending to financial firms by including brokerage firms (under a depression era law) and allowing firms to provide a much larger array of securities as collateral. Second, it made sure that Bear instead of failing was sold. Both of these steps get closer to the heart of the matter since they significantly reduce counterparty risk. In the “Market for Lemons” analogy it amounts to the government providing a guarantee that your used car won’t be a lemon.

Some folks have argued that the Bear bailout goes too far and will create a moral hazard problem by telling firms that they can be too aggressive and the government will backstop them. But I don’t believe that’s the case here. Instead most of the decision makers at financial firms hold meaningful equity stakes in the firm and in the Bear case those stakes have been all but wiped out (from $70 recently down to $2 per share). I am pretty sure that the low price was a condition of the Fed bailout for this very reason.

Now it will be interesting to see whether these steps were enough to get markets going again. There is also the question of whether the Fed’s action will ultimately result in inflation (more on that in a future post).