Central bank plan delays day of reckoning

By Herbert Lash

NEW YORK (Reuters) - A number of money managers are up in arms over a plan by several central banks to thaw frozen credit markets because it will stop investors from feeling the pain of failed bets.

The Federal Reserve, along with the European Central Bank and other central banks, announced steps on Wednesday to make it easier for banks under financial duress to access cash in a coordinated effort to unfreeze a global credit crisis and reduce chances of a U.S. recession.

Wednesday's action came a day after the Fed cut its benchmark rate for inter-bank lending by one-quarter percentage point to 4.25 percent in another move to ease credit markets.

The efforts, however, are distorting the setting of prices, a primary function of capital markets, said investors at this week's Reuters Investment Outlook 2008 Summit in New York.

Recessions can have a positive "cleansing" effect, said Tom Metzold, a portfolio manager who oversees $8 billion in municipal bonds at Eaton Vance Corp.

"It is frustrating because I really believe in letting the free market economy cleanse itself and we're not letting it happen," Metzold said. "It seems like you can't fail any more."

At the crux of the credit crisis are complex derivatives that packaged together thousands of U.S. home loans, including subprime mortgages, into securities known as collateralized debt obligations, or CDOs.

Many banks and institutions hold CDOs that were worth hundreds of billions of dollars when they were sold but are now worth a fraction of their initial price.

But instead of allowing investors to take the full losses on their holdings, efforts to prop up credit markets result is merely putting off the day of reckoning, investors said.

The Fed and other monetary authorities are now losing credibility and are in the uncomfortable position of refusing the bitter medicine they prescribed for foreign governments that engaged in imprudent fiscal activities in the past.

"Look, you've just got to let some of this stuff hit market clearing levels -- this is what the U.S. has been telling emerging markets to do for years," said Robert Kowit, a senior vice president of the Global Fixed-Income Group at Federated Investors Inc.

Allowing markets to work would be the fastest and best way of persuading investors and their money pools that they can return to the credit markets, Kowit said.

"Whatever the assets are, whatever they're going to be sold for, once you see prices start to appear on these assets, market clearing prices, the rest of the funds will start to flow in," he said.

Authorities fear a decline in housing prices could push the U.S. economy into recession and create a snowball effect that could then spread overseas.

Jim Grant, editor of Grant's Interest Rate Observer who has long warned of excesses in U.S. financial markets, said central banks and the Bush administration are postponing the reappraisal of error, which could make the crisis last longer.  Continued...