The Fed opened the window to broker dealers. This is a shocker, a sign of the Fed’s desperation.
Recall that one of the reasons the Fed was able to assure us it wasn’t taking too much risk in its Term Auction Facility was that it said the institutions involved were sound. It doesn’t supervise broker-dealer and cannot make any such assurances. This is simply extraordinary.
This move is intended to last only for six months, but if the financial markets continue to be rocky (likely) and broker dealers use the facility, it’s hard to know how long it will take to wean them off it. However, use of the discount window has been seen as a sign of weakness, and use has therefore been minimal. That may mean this move proves to be largely symbolic, since the broker-dealers may not avail themselves of it either. The next measure would then be to allow them to use the TAF. Expect that to come soon.
In addition, keep in mind that the JP Morgan deal for Bear does not necessarily mean that customer will not continue to flee. If the exodus continues, the firm might still have to declare bankruptcy, which could well be a systemic event. So the Fed is using whatever firepower it can marshal.
From Greg Ip at the Wall Street Journal:
In an extraordinary weekend move, the Federal Reserve announced the most dramatic expansion yet of its lending, promising to lend for up to six months to securities dealers under terms normally reserved only for tightly regulated banks.
The Fed also cut the rate on such direct loans by a quarter of a percentage point, just two days before it is likely to slash interest rates more broadly. It cut the discount rate — ordinarily charged on direct loans to banks, and now also to securities dealers — to 3.25% from 3.5%.
That narrows the spread with the more economically important federal-funds rate, now 3%, to a quarter of a point. The Fed is also expected to cut the fed-funds rate target by at least half a point at its meeting tomorrow….
Since the current credit crisis began in August, the Fed has taken ever more innovative steps to push its remedies beyond the banking system.
The Fed can lend with few constraints to banks through its “discount window” to prevent a shortage of cash caused by a temporary interruption or a generalized loss of confidence. But it has rarely lent to nonbanks, although it has had the authority to do so since 1932, if five of its seven governors approve. It last lent under this authority in the 1930s.
Even as it innovated in the current crisis, the Fed had avoided favoring a particular firm or class of securities. On Friday it crossed that line, stepping in to provide emergency funding to keep Bear Stearns afloat amid a severe cash crunch at the Wall Street firm.
Adam Posen, a central-banking expert at the Peterson Institute for International Economics in Washington, said other troubled firms claiming an equally critical position at the nexus of the financial system now “have political and legal precedent to ask for” help. He said the expectation of such help could also harden the negotiating position of a troubled firm, potentially complicating private-sector solutions.
Fed officials say they didn’t act to prevent a big firm from failing, but to prevent a firm enmeshed in critical markets from failing in a single day, causing a potentially huge disruption in the financial system.
Fed officials don’t dispute that their decision carries “moral hazard” — the risk that any sort of bailout encourages more of the same risky behavior later. But they believe that compared with the alternative scenario, that cost is small. The funding is structured so that the greater benefit is to those who lent money to Bear Stearns in the “repo” market for secured, overnight loans, not to Bear Stearns itself. Moreover, they note it’s unlikely any firm will consider the loss Bear Stearns’s shareholders are likely to sustain as an acceptable price for taking the same risks in hopes of a bailout.
Still, with the credit crisis showing no sign of ending, “Thinking about the appropriate terms of bailouts is especially important if, as seems likely, other firms require similar help down the road,” said Doug Elmendorf, a scholar at the Brookings Institution and former Fed economist.
The Fed has intervened from time to time in specific situations, from Treasury loans to Mexico in 1994 to brokering the rescue of the hedge-fund Long Term Capital Management in 1998. But it has been rare for the Fed to put its own money at risk. The most important example of this was in 1984 when it and the Federal Deposit Insurance Corp. lent billions to Continental Illinois. Efforts to find a buyer were fruitless and the federal government ultimately ended up owning most of the failed bank.
“The financial system is much more interconnected and opaque than in 1984,” says Kenneth Kuttner, a monetary economist at Oberlin College and former Fed staff economist. That has made “the lender of last resort role much more complicated.” The crisis, he said, is exposing “the limitations and constraints” of the rules laid out for the Fed in the Federal Reserve Act.
Since the 1980s, Congress has limited the ability of regulators to prop up weak banks. At the same time, the financial system has moved away from insured deposits to other sources of funding. Securities dealers’ “repo” borrowings — short-term collateralized loans that grease the market for a wide variety of securities — have more than doubled to $4.5 trillion and now exceed banks’ federally insured deposits.
Fed officials believe that multiple sources of credit have made the economy more resilient and less exposed to problems in banks. Less than a year ago, Fed Vice Chairman Donald Kohn predicted that with a more market-based and less bank-based system, the Fed would rely more on interest rates to stem crises than direct loans to market participants.
But the Fed has already learned that interest-rate cuts alone aren’t enough to stem the current crisis, and has not only had to use the discount window, but in ways it never thought likely.