By Raghuram Rajan

We have a full blown panic in financial markets. Any but the safest assets are being heavily discounted. Policymakers have to be thinking in more radical terms than they have done so far to fight the contagion. But that is no reason to do the wrong thing.

There seems to be an impression that the real problem continues to be the liquidity of mortgage-backed securities. Hence the proposal to set up a government agency to buy these securities from distressed banks, akin to the role played by the Resolution Trust Corporation in the 1980s. There are concerns with this proposal. First, even though the illiquidity of the market for mortgage-backed securities, and the substantial markdown in prices of these assets, was responsible for the losses suffered by financial institutions, simply attempting to halt further falls in asset prices will not restore sanity to the financial system. The real problem is the financial system has too little capital. Buying assets at the current depressed market price will not help. And overpaying substantially for these assets will reward the shareholders of the most incompetent or risk-seeking banks, who hold the largest amounts of this now-toxic waste, with the most taxpayer dollars.

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September 19, 2008 12:10pm in Capitalism, Credit squeeze | Comment