Stand Down, Bernanke and Paulson

Looking back over the past 12 months, I don't think many of us could have predicted the extent of the credit mess we're in now. This debacle has brought even the soundest of financial institutions, like Citigroup (NYSE: C  ) and Bank of America (NYSE: BAC  ) , to their knees, and sent a chill down the backs of millions of homeowners facing soaring mortgage payments and sometimes even foreclosure.

Homeowners, investors, and financial institutions are no doubt sorting through the carnage looking for answers. The $64,000 question now becomes: How bad will it get from here, and who -- if anyone -- can bring the credit market back to its feet for a return to business as usual?

One of the few rays of guiding light we've seen lately has come from Federal Reserve Chairman Ben Bernanke and Treasury Secretary (and former Goldman Sachs (NYSE: GS  ) CEO) Hank Paulson. Their attempts at reviving the market have included a series of interest-rate cuts, liquidity infusions, and even a proposed homeowner bailout plan that would freeze adjustable-rate mortgages at their introductory teaser rate, saving the homes of some of those who ventured down the subprime path.

Bless their hearts. Bernanke and Paulson truly just want to get our financial system back to how it used to be in the good old days, when mortgage-backed securities grew on trees and anyone with a heartbeat and a smile could take out a mortgage for any ungodly amount of money they wished. After all, their job is to ensure the financial system stays healthy and Joe Consumer stays out of trouble.

But follow me here. We all know the credit disruptions were sparked at least in part by an excessively jubilant real estate market, which was undoubtedly fueled by low interest rates and lax lending habits. So ... we turn to interest-rate cuts to restore the credit market?

In other words, the thinking goes something like this:

  • Problem: Low interest rates led to way, way too much lending.
  • Solution: Lower interest rates, encourage more lending.

We need to face it: We got carried away, we got in over our heads, and now we're staring the consequences square in the face. Lowering interest rates, injecting liquidity into the banking system, and bailing out homeowners who took on mortgages they couldn't afford unless they won the lottery will by no means bring a healthy solution to the problem we face.  

To be sure, the problems are thanks to price disruptions, not access to money. Merrill Lynch (NYSE: MER  ) , Morgan Stanley (NYSE: MS  ) , and Bear Stearns (NYSE: BSC  ) haven't had to do much more than snap their fingers to find themselves magically infused with multibillion-dollar investments from foreign investors. There is more than enough money in the financial system. The problem is a refusal to pay the prices demanded on garbage loans -- loans made under a false sense of security fed by the irrational expectation that real estate would continue into the stratosphere for as long as we could see.

There is but one solution to this dilemma: Home prices need to fall -- a lot. Bad debt needs to be written off, and all of us -- investors, homeowners, and bankers -- need to learn a deep, hard lesson about financial bubbles to ensure we don't find ourselves in the hole down the road.

Investors are already drowning in fear. You don't have to look far to notice how much banking stocks have been clobbered, or to find a headline detailing the already eye-popping drop in real estate prices. If anything, slashing interest rates may only restore the overconfidence and attitude of immortality that brought us here in the first place -- only forestalling the problem that could indeed continue to fester if investors don't learn their lesson.  As Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) co-chairman Charlie Munger has quipped, "If you take raisins and cover them with turds, they're still turds."

For capitalism to function at its highest levels, all participants in the market must face both sides of the coin: the success and prosperity that come from achievement, and the hard-knock lessons when aspirations don't come to fruition. A system that promotes and cheers the successes on the way up, only to place a cushion under you when you slip and fall, by no means promotes the free hand of the market. It more resembles a spoiled child who only needs to stomp his feet, fold his arms, and pout until his parents save the day.

This Fool will be the first to admit that not all my investments have gone as planned. When I was wrong, I paid -- and sometimes it hurt. Nonetheless, I've learned from these errors and vowed not to make them again. By cutting rates and bailing out homeowners and other participants in the overblown credit and real estate markets, the Fed is sending a signal that could have disastrous effects down the line. Giving investors the sense that they never need to worry about the risks they're taking, because the Fed will fly in like Superman and save the day, could make for some seriously troubled times if our financial system ever becomes less flexible and dominant than it is today.

Money without a brain can be a very dangerous thing. Slashing interest rates in an attempt to remedy the credit crisis amounts to putting a Band-Aid on a cancerous tumor. Instead, the illness must be removed, even if the surgery is costly and painful. Once the disease is gone and an appropriate amount of healing is achieved, we'll all look back with a sense of "good riddance."

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