As the Fed’s interventions have failed to halt the progress of the credit crisis, the central bank has taken even bigger measures, only to see them provide at best temporary relief.
As we have indicated, the Fed’s moves appear to have hit the point of being counterproductive. Why should banks deal with each other when they can obtain funding form their friendly monetary authority? And as Richard Bookstaber warned in his book A Demon of Our Own Design, in tightly-coupled systems like our financial system, efforts to reduce risk typically make matters worse. The system’s very processes need to be changed for risks to be contained. But the banking regulators appear not to have considered this line of thought.
Reader FairEconomist provided a useful discussion of the conundrum facing the Fed a few days ago:
The problem we’re having is that people are fleeing commercial MM [money market funds] for treasury MM. Those are buying treasuries and thus converting the money to the desirable medium duration BUT that money is loaned to the Fed, and the Fed doesn’t make working capital loans. So the deposited money that had been made into working capital has been diverted into the Fed and lost to working capital.
The Fed is kind of trying to address this by loaning out money via various auction/discount windows. BUT, those loans have been overwhelmingly overnight – a particularly nasty demand deposit because it goes back so fast. For a bank to convert that to a 90-day loan it’s got to win 90 auctions in a row – a very risky deal with a crunch on. So the Fed undoes the duration conversion, and then some, converting the liquidity into a form that the banks can’t make into useful-duration loans
In a very real sense, the Fed has become the central bank, not the lender of last resort, but the lender of only resort. FairEconomist offered a way to have the central bank function more effectively in channeling credit to commercial uses:
When people put their short-term deposits in treasury MM funds, or in treasuries themselves, they’re basically depositing money into Fed CDs. The Fed has become the Bank of the US. So the Fed needs to loan some of that money back out – basically the extra amount that wasn’t in Treasuries a year ago. (The rest has been effectively diverted to the federal deficit; but it’s been there for years and we should leave it alone for now.)
The Fed can’t loan directly – it lacks the expertise. So we should probably work through collateralized auction windows. One nice thing about collateralized auction windows is that the Fed can *force* some lending into a particular market by taking only that lending, or asset-backed-paper derived from that lending, as collateral. With the lending market as crazy as it is the Fed should probably force a lending into working capital simply because even short period without it are catastrophic. Things like credit card and equipment loans aren’t quite as time-critical.
Obviously we want to get out of the “Federal Reserve Bank of the US” as soon as we can. The Fed will need to allocate capital on a fairly fine scale. I don’t think the Fed should be doing this in general; but it will allow us to keep the economy going while we audit/nationalize/recapitalize/what-have-you the banks.
Bloomberg implies that the Fed is considering lending to companies and municipalities, and a Financial Times article indicates the Fed is considering new approaches as well as expanding existing programs.
As a reminder, an unprecedentedly large ($225 billion versus the previous $75 billion) Term Auction Facility auction is due for tomorrow. If that doesn’t provide some relief, I doubt anything will.
From the Financial Times, “Fed under pressure to do more on credit crunch“:
The Federal Reserve and US Treasury were on Sunday night under increasing pressure to follow passage of the $700bn financial rescue plan with further measures to shock the ailing credit markets back to life.
Among the options available to policymakers are additional liquidity operations and an emergency rate cut – possibly in co-ordination with other central banks. A combination of the two is also possible.
The Fed is likely to further expand both the size and scope of its liquidity operations. Experts believe it could address a shortage of US Treasuries that has emerged as investors have looked increasingly to government paper as a safe-haven investment and collateral for trades. This could happen through an expansion of the Term Securities Lending Facility, which was created by the Fed in March to help banks access liquidity during the crisis.
Another potential target of intervention is the commercial paper market….Money market funds could, for example, be allowed to borrow money via banks to fund their holdings of commercial paper. Some experts think the Fed could take the radical step of offering term loans on an unsecured basis to regulated banks at a fixed spread over its main interest, therefore capping the interbank lending rate, which has risen sharply during the crisis. This possibility has become more realistic following passage on Friday of the “troubled asset relief programme”, which gave the Treasury the authority to guarantee the Fed against any losses incurred in such an operation.
The Tarp legislation also gives the Fed the power to pay interest on reserves to help smoothe liquidity operations – authorities the US central bank is soon expected to announce it will use….
“The Tarp bill is a condition necessary but not remotely a condition sufficient to recovery,” Orin Kramer, chairman of the New Jersey State Investment Council, told the FT. “You need to activate the Tarp quickly, and you also need a robust central bank response to the dysfunctionality of the commercial and municipal paper markets.”
The US Treasury could as early as Monday take the first big step towards the implementation of its $700bn plan to buy troubled assets from ailing financial companies by outlining the guidelines for the selection of a handful of private asset managers to run the programme…
The core of the Treasury plan – a reverse-auction mechanism for the acquisition of the troubled assets from a range of financial institutions – will not function until next month at the earliest.
Note that this Bloomberg article, titled “Fed May See Lending to Companies, States as Next Crisis Fronts,” provided plenty of evidence of calls for the Fed to act, but silence on the Fed’s response :
Federal Reserve Chairman Ben S. Bernanke may find the next fronts of the financial crisis to be just as chilling as last month’s downfall of Wall Street titans: its spread to corporate America and state and local governments.
Companies from Goodyear Tire & Rubber Co. and Duke Energy Corp. to Gannett Co. and Caterpillar Inc. are being forced to tap emergency credit lines or pay more to borrow as investors flee even firms with few links to the subprime-mortgage debacle. California Governor Arnold Schwarzenegger says his and other states may need emergency federal loans as funding dries up.
A cash crunch on Main Street would endanger companies’ basic functions — paying suppliers, making payrolls and rolling over debt. The widening of the crisis suggests that Bernanke and Treasury Secretary Henry Paulson may have further fires to put out even as the Treasury sets up the $700 billion financial- industry rescue plan approved last week.
“The rest of the economy is clearly being affected right now by the tightness of credit,” said Kurt Karl, chief U.S. economist at Swiss Reinsurance Co. in New York. “It’s just gathering momentum in the wrong direction.”…
Even as confidence grew that Congress would pass the bailout, banks hoarded cash, indicating the proposed purchases of devalued mortgage assets may not be able to stop the credit crunch from widening….
Republican Representative Jerry Moran of Kansas, in an interview with Bloomberg Television, encouraged the Fed to consider guaranteeing loans between banks.
“We will continue to use all of the powers at our disposal to mitigate credit-market disruptions,” Bernanke said in a statement Oct. 3. He delivers a speech on the economy tomorrow.
The central bank has power to extend credit to any company under “unusual and exigent circumstances.” It already used that authority this year to avert the failure of Bear Stearns Cos., take over American International Group Inc. and lend to banks to shore up money-market funds. The Treasury last month set up a program selling debt to help the Fed expand its balance sheet….
State and local government funding “has to be a concern for Bernanke and Paulson,” said Adam Posen, deputy director of the Peterson Institute for International Economics in Washington. “There are two issues now: stop the immediate panic and restructure the financial system.”