Sunday, August 26, 2007

The Federal Reserve's Quiet Bailout of the Credit Crunched

Amidst the hew and cry of the credit crunch, the Fed has, by all appearances, firmly resisted calls to lower the fed funds rate. The financial press attributes this reluctance to fear that lowering the fed funds rate would appear to bail out Wall Streeters and other wealthy folks who knew or should have known what they were getting into. In a time when median household incomes have largely stagnated and middle to lower income homeowners struggle to pay adjustable rate mortgages they may not have understood, the Fed cannot afford to project the image of a government of the people, by the people, and for the wealthy.

Nevertheless, the Fed has quietly implemented a bailout of the credit crunched players in the financial markets. Let's dive down the rabbit hole and see what happened.

1. Discount Rate Cut Plus. The Fed's recent discount rate cut wasn't just a reduction of the lending rate it charged member banks. It also agreed to take asset-backed securities as collateral. Normally, its requirements for collateral are more stringent. And it agreed to extend 30-day loans against this collateral. The Fed more typically lends on an overnight basis. What does this accomplish? It allows member banks to lend to distressed hedge funds, taking asset-backed securities that these days can't draw a better cash bid than an order of fries, and re-collateralize them with the Fed. In turn, the Fed provides the cash that the member bank re-lends to the hedge fund. The hedge fund can get a 30-day loan, a long enough time that values of asset-back securities may recover a bit. In effect, the hedge fund is able to get federal financing that might stave off bankruptcy. While hedge funds are not members of the Federal Reserve System, they apparently can get . . . shall we call them "guest memberships"?

2. Liquidity Injections. The Fed and other central banks have injected hundreds of billions of dollars of liquidity into the world financial system in the last few weeks. While much of it was quickly withdrawn, the willingness of the central banks to furnish liquidity has held down actual fed funds rates. Remember that fed funds are lent between banks, usually for the purposes of meeting reserve requirements. The actual interest rate on these fed funds loans fluctuates throughout the day, and can be higher or lower than the Fed's target rate. In fact, in recent days, the actual fed funds rate has often been lower. There is no shortage of liquidity for banks, and the Fed has effectively lowered fed funds rates.

3. Regulatory Ease. As reported on on Friday (8/24/07), Fortune magazine reports that the Fed eased regulatory restrictions for Citigroup and Bank of America that would ordinarily limit the extent to which their commercial bank subsidiaries can fund their brokerage firm subsidiaries. Usually, a bank such as Citibank or Bank of America, NA can fund a brokerage firm affiliate in an amount not exceeding 10% of its capital. The purpose of the limitation is to control the exposure of the commercial bank, with its federally insured deposits, to the risks of nonbanking businesses that the bank holding company is also engaged in. However, the Fed lifted these restrictions, effectively allowing these banks to fund their brokerage firm affiliates to a greater extent--reported as much as 30% of its capital in the case of Citibank. This special dispensation in effect makes it easier for brokerage firm subsidiaries of bank holding companies to tap into the liquidity and discount window borrowing power that the Fed has made available to its commercial bank members. Brokerage firms are not members of the Federal Reserve System. But it looks like some of them, too, may now be able to get guest memberships. Reportedly, the Fed said this is a temporary relaxation of the rules. However, there's no indication when the normal limits will resume.

In the financial markets, as elsewhere, if it walks like a duck, quacks like a duck and looks like a duck, there's a strong likelihood it's a duck. This walks, quacks and looks like a bailout. Although the Fed's initial announcement of a discount rate cut appeared to be essentially symbolic--a bit of talk therapy--we now seem to have a strong likelihood of a bailout.

Perhaps that shouldn't be so surprising. With the growth of the asset-backed securities and derivatives markets to mammoth proportions in the last 20 years, the commercial banks are largely no longer banks in the Jimmy-Stewart-It's-a-Wonderful-Life sense. Banks today originate loans, but sell them off to brokerage firms who package them into CDOs, CMOs, CLOs and other alphabet soup entities, and sell derivative interests in them to hedge funds and other investors. The hedge funds and other investors have effectively become the true lenders. As such, they are an integral part of the banking system, albeit unregulated. Deluged by withdrawal requests from nervous investors who have a problem losing money at the hands of those 2%-20% guys, the hedge funds are experiencing an old-fashioned depositor run. Granted they aren't regulated as banks and these deposits aren't federally insured (or are they with the bailout?). But they, the brokerage firms, and the commercial banks are locked into a thicket of intertwined liabilities and exposures that might potentially lead to an avalanche of failures if one or a few big players go under. Thus, the Fed has to be concerned when the unregulated banks (read, hedge funds) are plastered by the outsized risks they foolishly took.

In a sense, the Fed is quietly doing what a central bank is supposed to do. It is providing liquidity to the banking system when the banking system faces a credit crunch. The disturbing part of the picture is how much of the real banking system has slipped outside the federal government's regulatory authority. The true lenders are the hedge funds and similar investment vehicles. And they've been able to take investor monies, make investments, create and embrace risks, and incur massive exposures and liabilities, all without any regulatory oversight. The government didn't have the authority to prevent their misjudgments, recklessness, greed, irrational exuberance, mathematical model mistakes, and sheer boneheadedness. Yet it has been forced to step in and quietly bail them out.

Once the government slips into the bailout swamp, it tends to get stuck there. The problems at hand create enormous suction and it's difficult to extract oneself from the muck. When the S&Ls blew up in the mid-1980s, the federal government eventually undertook a massive bailout, one that may have cost the taxpayers as much as $3,000 each. You can buy a lot of fried calamari for 3K.

All of the Fed's measures taken to date have been temporary, and theoretically can be easily undone. And maybe they will turn out to be the better part of valor. But, then again, it's often very difficult to get welfare recipients off the dole. Federal farm subsidies and flood plain insurance have proven more durable than Plymouth and Oldsmobile. If the federally insured banking system is to be put at risk by the unregulated recklessness of hedge funds and others of their ilk, who are then bailed out by the federal government, it behooves us to require legally mandated responsibilities of the unregulated banks. Lincoln got it right. The government should be of the people, by the people and for the people.

Strange News: hugging your way into the record books.

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