"What Could the Fed Do?"

Whenever Greg Ip, the Wall Street Journal reporter whose beat includes the Fed, writes a piece about the central bank, one has to wonder whether the story was a plant. This isn’t to denigrate Ip’s coverage; it’s the reality of the quid pro quo of access journalism.

His page one story today, “Fed Weighs Options on Crunch,” has the aura of being a sanctioned piece. It seeks to dismiss the idea which has been widely discussed on the Internet and is getting some attention in the media, that the Fed is at risk of exhausting its abiiity to take on more collateral for loans, or as it has been put more colloquially, that the Fed might run out of firepower. Steve Waldman’s estimate that the Fed has an addittional $300 to $400 billion of unsterilized capacity is representative.

To illustrate, John Dizard in a Financial Times article discussed the Fed’s options:

At the moment, for example, the Washington policy people and the Wall Streeters buzzing around them are trying to figure out how to get yet more liquidity for housing-related paper. The Wall Streeters seem to assume that the next step will be the creation of something like the Resolution Trust Corporation….. Or, as David Rosenberg of Merrill Lynch told the firm’s clients last week, “ . . . the outright purchase (by government agencies) of illiquid mortgage-backed securities is probably required, and could employ government-backed fiscal action . . . The Federal Reserve itself could buy some of those securities, but the Fed alone cannot unclog the congestion in the capital markets, in our opinion.”

That is not what the Fed, or the Feds, want to hear. The Fed is already uneasy about the scale of its on-balance-sheet exposure to mortgage-backed paper….

Here is where the ancient bureaucratic trick of three choices comes into play. The “policy options” presented by the stone-faced civil servant-expert to the political master are always, respectively: 1) one that will cause the end of life on earth as we know it; 2) an alternative that will mean the end of your political career; or 3) another possibility that we could “staff out” if you’re interested.

In the case of illiquid housing assets, the End Of Life On Earth is an inflationary expansion of the Fed’s balance sheet. The career-ender is the direct use of taxpayer money. The third way is the use of government guarantees to induce the investment of private capital.

Ip’s coverage of the same issue in a WSJ Economics Blog post, “What Could the Fed Do?” was more pointed and informative than his article:

Since the Federal Reserve began rolling out ever more creative steps to unfreeze credit markets, it has sold or pledged a growing portion of its portfolio of Treasurys in order to put loans on its balance sheet to banks and securities dealers backed by mortgage-backed securities and other shunned collateral. This has led some observers to worry that if the Fed continues at such a pace, it could run out of ammunition, forcing it to move to quantitative easing – in essence, buying up assets wholesale and allowing the federal funds rate to fall to zero.

But Fed officials believe those fears are misplaced….

This still leaves the Fed with about $500 billion in unencumbered Treasury bonds. Some of that is spoken for — the Fed has promised to lend $29 billion to a new entity to take over assets now on the books of Bear Stearns, and up to $125 billion more in its Term Securities Lending Facility. However, anything more such commitments would likely be at least partly offset by reduced borrowing in its other facilities.

All the same, the Fed likes to think of worst-case scenarios and thus has been thinking about ways to expand its ability to lend. In an extreme case it could resort to quantitative easing as the Bank of Japan did from 2001 to 2006, that is buying up large amounts of assets, and letting the fed funds rate fall to zero. But it would rather avoid that. Here are some ways it could expand its lending capacity while maintaining control of the fed funds rate.

1. The easiest would be to ask Treasury to issue more debt than it needs to fund government operations. As investors pay for the bonds, their cash moves from bank reserve accounts at the Fed to Treasury accounts at the Fed. The Treasury would allow the money to remain there, rather than disbursing it or shifting it to commercial banks who, unlike the Fed, pay interest. Because the shift of cash out of reserve accounts leads to a shortage of reserves, it puts upward pressure on the federal funds rate. To offset that, the Fed would enter the open market and purchase Treasurys (or some other asset), replenishing banks’ reserve accounts. The net result is that the Fed’s assets and liabilities have both grown but reserves and the federal funds rate are unaffected. This wouldn’t cost Treasury anything so long as it doesn’t bump up against the statutory debt limit. The loss of interest on its cash deposits at the Fed would be roughly offset by the additional income the Fed pays Treasury each year from the interest on its bond holdings.

2. The Fed could issue its own debt or short-term paper. The debt would be an increase in liabilities and it could presumably buy whatever it wanted with the proceeds. Whether the Fed can do so legally is less clear. It previously used the “incidental powers” given it under the Federal Reserve Act to issue options on federal funds around the turn-of-the century date change, and issuing its own debt would likely require invoking the same thing. As one Fed study has noted, use of such power must be “necessary to carry on the business of banking within the limitations prescribed by [the Federal Reserve] Act.”

3. The Fed could seek to pay interest on reserves. Banks lend out excess reserves at whatever rate they can get because the Fed doesn’t pay interest. That’s one reason the federal funds rate often crashes late in the day, when banks realize they have more reserves than they need. Paying interest on reserves would put a floor under the federal funds rate. The Fed could then make loans and purchase assets with little concern for the impact on the federal funds rate.

The Federal Services Regulatory Relief Act of 2006 empowers the Fed to start paying interest at a rate or rates not to exceed the general level of short-term interest rate effective Oct. 1, 2011. The distant date was a result of Congress’ effort to hold down the cost, since payment of interest will cut into how much money the Fed remits to Treasury each year. The Fed could ask Congress to bring that date up to the present. As a general rule the Fed hates to ask Congress for anything for fear of what else Congress might ask for in return. But if the crisis got to the point the Fed felt it really needed this, it’s hard to imagine Congress refusing.

4. The Fed could try to do the mirror image of the Term Securities Lending Facility. In other words, take the mortgage backed securities pledged to it by dealers in return for Treasurys, and re-pledge them to other dealers, taking Treasurys back. Since the Fed is highly unlikely to fail, dealers might be more comfortable accepting MBS as collateral from the Fed than from other parties. But this might be complicated to do if the MBS are held by a custodial bank as is typical in a triparty repo.

The first page Journal story adds a couple of useful pieces to the equation. The Treasury’s unused debt limit is roughly $450 billion. But more important, despite the contemplation of extreme measures, the central bank is loath to undertake the one most keenly sought by the Street, namely, buying MBS outright:

The Fed is inclined to use any additional maneuvering room to lend through its existing and recently expanded avenues. Officials are reluctant to buy mortgage-backed securities directly. They worry that such purchases would hurt the market for MBS that the Fed is not permitted to buy: those backed by jumbo and subprime and alt-A mortgages, which are under the greatest strain.

Moreover, the Fed is not operationally equipped to hold MBS and would probably have to outsource their management. Such holdings wouldn’t help avert foreclosures much, since the Fed would have little control over the mortgages that comprise MBS.

Note that there is nothing in Ip’s discussion that disproves Dizard’s argument that the Fed is not willing to engage in issuing liabilities so as to expand its balance sheet (while it was listed as #2 above, it was clearly the least favored option). But if the IMF’s forecast of $945 billion of debt related losses comes to pass (versus $232 billion in writedowns taken so far by the banking industry), the Fed may wind up turning to its contingency plans.

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  1. Richard Kline

    Every single proposal/comment I see in the media from _holders_ of MBSs for a resolution to ‘the crisis of our time’ embeds two immutable premises:

    —Axiom No. 1: “The Powers That Be must take no action which puts me out of business.”

    —Axiom No. 2″ “The Powers That Be must make my hole whole.”

    Proposals vary, but this is the invariable agenda. Such indescribable selfishness leaves me speechless. (Thank heavens I can still type.)

    Don’t, _don.’t_, just DON’T ‘buy up’ MBSs on the open market. Here’s the program:

    —Step No. 1: Find the insolvent concerns, seize them, wipe their shareholders and put other creditors in the queue.

    —Step No. 2: _TAKE_ their toxic securities at a value _you_ determine back to the concern, and either re-float or run out that concern from that point with everyone getting a fair haircut if they won’t pitch in their respective chit as new stakeholders to float the boat

    —Step No. 3: Put the MBSs and such like in public receivership (in effect under a contract conservator, much faster to source and go), and put a real value on them

    —Step No. 4: We now have a market, and others holding MBSs can sell out at the market rate, if necessary to the public receiver if no one else, with _that action only_ financed by the public till as a market maker.

    Every ‘plan-like’ proposal so far is premised on the idea that we the people have some bizarre obligation to get the rich man’s arse out of the crack with nought but a small red mark to it. Not so. Don’t ‘buy up’ their bad bets; run ’em out. And fast, we need to _GET ON_ with this for the sake of the other 295 M of us. We have no obligation to spend our money to preserve your ill-hazarded wealth.

  2. anon

    # 1 is also a Fed liability, (as is the entire monetary base).

    # 1 in a more general way is also a standard feature in the implementation of central bank monetary policy, although usually done in a limited way. Any transfer of funds between the Treasury’s bank account with the Fed and its accounts with the commercial banks is mirrored as an change in commercial banks’ accounts with the Fed, thereby affecting reserve levels. These transfers, overseen by the Fed, can affect policy implementation as desired or can be offset by open market operations.

    And # 2 is possible, although probably not necessary because of # 1.

    Plant or not, Ip is correct.

  3. Anonymous


    I guess its not so banana republic when Grep Ip of the WSJ suggests the same options I did a short while ago.

  4. Lilguy

    The notion of the Fed bailing out mortgage lenders and MBS holders without also bailing out borrowers is a total POLITICAL non-starter. Congress would jump on Bernanke’s head and could curtail the Fed’s finanical options in response, something we can’t afford.

    In fact, the best (least expensive, least morally hazardous, most fair and equitable, etc.) answer is to let the mortgage market mess (including the associated derivatives) work itself out through the marketplace.

  5. Anonymous

    Note that Goldman actually increased its level 3 assets by over 30% to nearly $100B this quarter.

    Obviously,at least one shadow bank still feels that they are too big to fail. Is this the outcome of the BS bailout? If so, all of these so called Fed derived “safety nets” are likely to only make matters worse.

  6. Juan

    Assuming they become necessary, how might our rest of world creditors react to such procedures as Greg Ip mentions? Or is this even considered when working up methods to save finance from itself.

  7. Anonymous

    If the government buys that crappy paper, I am telling you this right now, there will be a complete breakdown of law and order in America. Good people who have saved and done things the right way will have no more faith in the system. You will have effectively crushed their dreams, and spat on their law abiding citizenry.

    Seriously. This is a national security issue.

    If they buy that paper, they are rewarding the bad people, and there will be consequences.

    You can count on massive protests in the streets if that happens.

    And I, for one, will be leading them.

    Let’s hope they aren’t that stupid.

    Let the banks fail, and let the investment banks fail, and let new ones come up to take their places.

    A short, sharp shock is better than 15 Japanese years of drudgery, and you will have preserved Law and Order.

    Do not underestimate how the public will revolt on this issue if the US government buys that paper.

    It might seem quiet now, but if that happens… all hell will break loose. Guaranteed.

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