The Federal Reserve and Treasury Department's responses to the liquidity crisis in the asset-backed security market and the lending system in general largely avoided a systemic catastrophe, but came with their own consequences. They also failed to address the real risk posed by US credit market instruments, according to Mark Zandi, chief economist at Moody's The worst may be yet to come with total losses on housing bubble-related lending estimated at $2.6trn, despite the Fed's and Treasury's efforts to calm financial markets. The Fed has revived commercial paper market while Treasury has done a fair job of forcing bank holding companies to shore up their balance sheets by conducting stress tests. The financial system is stabilizing, Zandi said, but unprecedented policy will be difficult to unwind. "The government's vast intrusion into the financial system... poses a range of threats. There are legitimate worries that with the Federal Reserve pumping so much liquidity into the system, it will eventually ignite undesirably high, if not runaway, inflation," Zandi told the House Financial Services Committee on Tuesday, according to prepared testimony. "Moreover," Zandi added, "it is not clear whether the government will be able to gracefully exit its large ownership stakes in Fannie and Freddie, banks, and other financial firms. Fortunately, calls to nationalize major financial institutions, which would make such an exit significantly more complicated, have not been heeded." But neither were the warning signs of the housing bubble, according to Zandi, who chided regulators' failure to save Lehman Brothers from bankruptcy shortly after placing Fannie Mae (FNM) and Freddie Mac (FRE) into conservatorship. The real systemic risk present in major financial institutions and government agencies, according to his testimony, are the loans left over from the housing boom. Moody's calculated the ultimate cost of bad lending associated with the takeoff of subprime, alt-A and jumbo residential mortgages during the housing boom at around $2.6trn. These losses translate into a lifetime loss rate well over 10% on the approximately $24trn in US credit market instruments now outstanding, Zandi told the House Committee. Of expected credit losses, Zandi estimates that $1.2trn will be suffered by depository institutions, nearly $1trn by pension funds, insurance companies, hedge funds and mutual funds, and $350bn by government mortgage agencies Fannie, Freddie and the Federal Housing Administration. As the fallout from bubble lending continues to unwind in these institutions, Zandi recommended posting the Federal Reserve as a systemic risk regulator to avoid these risks from building up in the future. "As a systemic risk regulator, the Fed would be able to address an age-old problem: Namely, that banking regulation tends to be procyclical," Zandi said. "When credit quality is good and lenders are aggressive, regulators have difficulty imposing discipline; when quality is poor and lending is tightening, the disciplinary screws are tightened. This procyclicality tends to exacerbate swings in lending standards and credit availability." The House Committee, in hearing economic commentary on systemic risk and institutions that may be too big to fail, also considered testimony from Alice Rivlin, senior fellow at the Brookings Institute, who pointed out systemic risk as seen in the securitization market. According to Rivlin, securitization disconnects lenders from borrowers and creates incentives for lenders to ignore repayment risk. The consensus, particularly during the housing boom, was that originating lenders were in the clear as long as the loan remained current as it was sold to an investor to be bundled into a security and sliced and diced into various tranches. The rest of the story is history: Loans throughout these securities began defaulting at an alarming rate, and the security structure itself and the interest of the security investors made modifications a tricky task. Rivlin recommended clearing up the legal responsibilities of originators, servicers, packagers and owners of mortgage-backed securities (MBS). "We need to ask whether the social utility of slicing up MBS into risk tranches to be sold to investors with different appetites for risk is worth the confusion that ensues when the loan has to be renegotiated," Rivlin said, according to prepared testimony. "I would favor giving bankruptcy judges the power to adjust mortgages as they do can do with other debts, but it also has to be clear who is on the other side of the mortgage transaction." Write to Diana Golobay.