On Oct. 3, 2008, the U.S. Congress finally passed legislation (the “Emergency Economic Stabilization Act of 2008”) authorizing the U.S. Treasury Department to buy billions of dollars worth of “troubled assets” in an attempt to ease the credit and liquidity crunch that has engulfed financial markets worldwide. This action by Congress follows upon some historic actions by the Federal Reserve Board (“Federal Reserve”) to inject liquidity into the marketplace, and joint efforts with the U.S. Treasury Department to deal with Freddie Mac and Fannie Mae.
In the case of the Federal Reserve, its actions are consistent with the role Congress envisioned when the Federal Reserve System was created in 1913—and a role it has played before in helping the U.S. economy weather financial distress.
Somewhat lost amid the media hype is the fact that earlier this year, the Treasury Department proposed to reconfigure the U.S. financial services regulatory structure, with the Federal Reserve taking on broader oversight authority and being given an expanded role as the Market Stability Regulator. As market participants ride through the current tumult, they can take some comfort in the knowledge that the Federal Reserve is well equipped to take on expanded responsibilities.
A Crisis in the Making
The current economic crisis in the United States has multiple causes, some of which resulted from decisions made a number of years ago and continued almost to the current time. Among those causes (but not the only ones) are:
- ?? Too loose monetary policy by the Federal Reserve over too long a period of time
- ?? Greed by the private sector, both on an individual and an institutional basis
- ?? Push for deregulation without a clear understanding of the consequences
- ?? Inadequate regulatory oversight
- ?? Failure of accountability in the private and public sectors
- ?? A difficult political environment
While these factors set off what has become a severe credit crunch in the United States, today’s financial services network is truly global and very much interconnected. It is not surprising that the negative financial results for any global player are viewed with serious concern around the world, since the impact can be felt throughout that worldwide network.
This global impact is readily demonstrated by the reactions to the U.S. banking difficulties in Europe and elsewhere, and the coordinated central bank actions in cutting interest rates (Bank of Canada, Bank of England, European Central Bank, Sweden’s Central Bank and Swiss National Bank; Bank of Japan indicated support for the move and People’s Bank of China reduced its interest rate). These actions followed the Federal Reserve’s decision to cut its Fed funds rate (the inter-bank lending rate) by 50 basis points to 1.50 percent, and its discount rate to 1.75 percent.
Where leverage is involved, the cross-border impact becomes magnified, which was very much the case in the investment banking world. Bear Stearns operated on leverage of 33 times capital, Lehman Brothers at 32 times capital, Goldman Sachs at 24 times capital, and Morgan Stanley at 25 times capital.1 Did this magnified effect mean that faulty business strategies of Bear Stearns, which came to light in March 2008, presented global risks sufficient to justify a backstop by the U.S. government, despite the inevitable assertion that the Federal Reserve’s support of more than $29 billion for Bear Stearns’ actions gave credibility to the argument that there existed a moral hazard from unchecked actions by management?
Under the right set of circumstances, the answer is “yes.” Actions are warranted by the Federal Reserve as the “lender of last resort,” and the U.S. Treasury Department as the U.S. government’s proxy. Such conditions were found to exist in the case of Bear Stearns because of the suddenness of its failure, and the reactions that would reverberate upon the world’s global financial services network.
In the case of Lehman Brothers, the Federal Reserve and the Treasury Department declined to provide a government backstop, because they likely believed that Lehman’s problems had been telegraphed to the marketplace over a six-month period (it declared bankruptcy Sept. 15, 2008), and the markets had time to adjust and take into account Lehman’s possible failure. Subsequent events, however, such as the Reserve Fund money market “breaking the buck” and the freezing up of the commercial paper market, necessitating Federal Reserve creation of a commercial paper funding facility, suggest the market did not anticipate Lehman’s failure.2
Though the total collapse of Bear Stearns was narrowly avoided through its hurried affiliation with JPMorganChase, structured with the aid of the Federal Reserve Bank of New York, the U.S. economy continued to generally decline through 2008, and the financial services sector appeared to be heading toward an implosion. Since the March 2008 melt-down of Bear Stearns, the Federal Reserve has been called upon multiple times to assume an activist role in stabilizing the financial services sector.
Few could have foreseen the rapid succession at which the Federal Reserve would be asked to take action to increase liquidity in the markets. Engineering the takeover of Freddie Mac and Fannie Mae at a potential cost to the Treasury of $200 billion, and providing them with short-term loans, the Federal Reserve also extended an $85 billion loan to AIG, with an additional $37.8 billion (as of Oct. 8).
In addition, the Federal Reserve significantly expanded access to its discount window to include the former investment banking institutions and primary dealers through such innovations as the Term Auction Facility, the Term Securities Lending Facility and the Primary Dealer Credit Facility. The Federal Reserve now provides access to its discount window to nonfinancial institutions through its Commercial Paper Funding Facility—all designed to increase liquidity in the markets.
The recent actions are manifestations of the key role the Federal Reserve has assumed in the management of the U.S. economy. And though these actions have come in rapid succession, they are entirely consistent with the role Congress envisioned for the Federal Reserve. Congress did not envision, however, the current level of media and public interest in the Federal Reserve. Whereas Congress intended monetary policy to be conducted independent of political considerations, the Federal Reserve has, in recent months, received unparalleled scrutiny of its role and the role of its board members.
After Bear Stearns
The Bear Stearns situation presents a clear line of demarcation at which the Federal Reserve can be seen to have become clearly more activist and interventionist than was the case before. That activist role has had the unabashed support of Ben Bernanke, the Federal Reserve Board’s chairman.
By March 2008, Bear Stearns had become so weighted down by subprime mortgages that the fear that the venerable investment bank might file for bankruptcy began to spread through key financial players in the United States and overseas. These players were interconnected to Bear Stearns and its fate. Accordingly, the Federal Reserve, for the first time since the Great Depression, agreed to give Bear Stearns—despite its status as an investment bank—access to its discount window, enabling Bear Stearns to continue to operate without a threat to its counterparties.
The transaction was engineered after key U.S. financial regulators determined that “a sudden disorderly failure of Bear would have brought with it unpredictable but severe consequences for the functioning of the broader financial system and the broader economy, with lower equity prices, further downward pressure on home values and less access to credit for companies and households,” according to testimony by New York Federal Reserve Bank President Timothy Geithner, who testified before the U.S. Senate Banking Committee April 3.
Was the Federal Reserve wrong to facilitate the rescue of Bear Stearns? If Bear Stearns suddenly were allowed to fail, the adverse impact would have been quite dire, but the answer nonetheless is complex. Governments have an unstated but inchoate obligation to act in the best interests of their citizens. This does not mean the central governmental authorities close their eyes in dealing with an economic crisis in favor of a philosophical approach to let the free market play out its will regardless of the consequences.
Government authorities must weigh the risks of any potential “moral hazard” with the consequence of inaction, and make a determination as to what is in the public’s interest. In some narrow instances, the “moral hazard” risk may be mitigated and incentives for market participants have a backstop, and in some cases they do not. It is clear that Bear Stearns’ shareholders, including senior management, saw their net worth significantly decline and, accordingly, shouldered a portion of the risk. For example, on Oct. 3, 2007, a share of Bear Stearns’ common stock was priced at $126.29. It ultimately was sold to JPMorganChase at $10.00 a share.
Federal Reserve Board’s Authority as Lender of Last Resort
The Bear Stearns example is not the first time the Federal Reserve intervened in a financial crisis in its role as lender of last resort. Indeed, the Federal Reserve has provided a significant “security blanket” within the U.S. banking and financial services sector.
Originally, there was no “moral hazard” risk, since there was no central bank authority (other than the two 20-year periods ending in 1836 when Congress created Banks of the United States) to deal with the many financial panics or economic crises over the course of early U.S. history, namely the Panics or Crises of 1792, 1819, 1837, 1857, 1873, 1893, 1907 and 1929.3 The Panic of 1907 was very much in the minds of the Congress when it considered the 1912 study of the country’s banking system by the National Monetary Commission.
The Congress recognized that as the United States industrialized and modernized, for the U.S. economy to prosper, there was a need to better manage the financial system, and to do that in a more coherent and rational manner than in the past. The end result was the enactment into law Dec. 23, 1913, of the Federal Reserve Act, and the establishment of the Federal Reserve System as the country’s central bank and “lender of last resort.”
A key mandate of the new law was to grant discount authority to the 12 district Federal Reserve Banks and to make the availability of loanable funds equal “between different sections of the country.”4 A number of Congressmen ascribed the discount authority as providing banks with “sources of strength” in times of stress that would prevent financial panics, like the one they recalled of 1907 (50 Congressional Record 4880, 4906 and 4924 (1913)).
The Federal Reserve’s general role and economic goals are set out in Section 2a of the Federal Reserve Act (12 USCS 225a), namely, to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Also, the Federal Reserve as the nation’s central bank is expected to provide liquidity to the marketplace whenever that is necessary.
Key Economic Support
A brief glance at the Federal Reserve’s history reveals that it long has played a key role in the U.S. economy, particularly in times of economic stress, or when other significant demands are placed upon the economy, such as in wartime.
The principal way the Federal Reserve does this is by making loans and advances to depository institutions through its discount window. It also can provide that type of needed support to nonbanks (“Discount for Individuals, Partnerships and Corporations”) under certain narrow circumstances. Under Section 13(3) of the Federal Reserve Act (12 USC 343), which became effective July 31, 1932, the Federal Reserve was provided with the authority to extend its power as a lender of last resort to certain nonbanking parties in “unusual and exigent circumstances,” and with the affirmative vote of five (out of seven) members of the Board of Governors.
Section 13(3) provides such lending authority if the individual, partnership or corporation can satisfy the Federal Reserve that it is “unable to secure adequate credit accommodations from other banking institutions.” The terms and conditions are subject to the Federal Reserve’s Regulation A. (12 CFR 201 et seq.).
On June 19, 1934, a new Section 13b was added to the Federal Reserve Act authorizing the District Reserve Banks “in exceptional circumstances,” to make advances to established commercial or industrial enterprises for the purpose of supplying working capital if the borrower were unable to obtain other assistance. This type of support ceased when Section 13b was repealed by the Small Business Investment Act of 1958.
The Federal Reserve also played a key role in helping U.S. war production during World War II and in the Korean War. These actions presaged the Federal Reserve’s oversight role in a variety of guises for commercial enterprises deemed to play a key role in the U.S. economy. In 1970, while the Federal Reserve denied Penn Central access to the discount window, it indicated the window would be available to “assist banks in meeting the needs of business unable to roll over maturing commercial paper,” to avoid what it feared might be a financial crisis.
The Federal Reserve resisted opportunities to take a more active role in some of the key financial crises of the 1970s and 1980s, but nonetheless played a key stabilizing role. Serving as fiscal agent in New York City’s 1975 fiscal crisis, the Federal Reserve denied requests to provide emergency credit. The Chairman of the Federal Reserve served as a member of the Loan Guarantee Boards following the U.S. Treasury Department’s loan guarantees in the bailouts of Lockheed Corporation in 1971 and Chrysler Corporation in 1979. The Federal Reserve used its moral suasion to obtain support from others to resolve the Long Term Capital Management failure in 1998.
In sum, the Federal Reserve long has played a key role in the U.S. economy, particularly during times of economic distress or when unusual demands are placed on the economy.
Public Interest and Political Pressure
Until the mid-1970s, the significance of the Federal Reserve’s role in the nation’s economy was recognized by a limited group of economists, certain Congressmen, and some in the financial press. The Federal Reserve’s actions usually were consigned by news publications to the back news pages, business sections, and as minor boxed items. This limited exposure began to change with the chairmanship of Paul Volcker and his role in beating down inflation.
In this age of greater transparency, the Federal Reserve and its actions are widely covered by the media. While transparency is appropriate and healthy, there is concern that the glare of the public spotlight upon the nation’s monetary policy has become akin to the obsessive focus by the financial press and investors on quarterly earnings reports.
Some safeguards are in place to resist political pressures on monetary policy. These are the appointment of Board members for 14-year terms with the advice and consent of the Senate; the fact the chairman’s term overlaps by one year the four-year presidential cycle; and the fact that the Fed is not dependent upon the congressional appropriations process. In this author’s experience, Board members and Federal Reserve staff base their internal discussion and debate of issues on the relevant laws, rules, prior precedents and facts before them. The issue of what may be perceived as the politically correct decision never enters into the discussion or submissions to the Board of Governors.
It is clear that Board decisions dealing with the current economic crisis are being conducted in the context of the Federal Reserve’s authority and what is considered to be in the best interests of the U.S. economy. But going forward, there is a valid concern that as the Federal Reserve’s role expands within the U.S. economy, the conduct of monetary policy naturally will take on a more political tone as Chairman Bernanke and his fellow governors become more publicly scrutinized and their decisions challenged for political implications.
Federal Reserve’s Balance Sheet
The Fed’s actions in providing $29 billion in support to Bear Stearns, lending $122.8 billion to AIG and opening the discount window beyond banks to include investment banks and broker dealers, have significantly impacted the Federal Reserve’s balance sheet.
Since March 2008, through the discount window, the Federal Reserve has taken lower quality securities than in the past, including a variety of mortgage-backed securities along with equities. While the Federal Reserve System’s balance sheet on March 5, 2008 was $884.3 billion, more than 81 percent was represented by U.S. Treasuries. As of Sept. 18, its consolidated balance sheet was $995.6 billion, of which 51.1 percent was U.S. Treasuries.5 The balance sheet will shortly include A1/ P1/F1 commercial paper.
While the Federal Reserve’s balance sheet can be expanded and enhanced by the U.S. Treasury Department, which can provide direct funding to the Federal Reserve, the more the Federal Reserve strays from its monetary policy role, the more it creates the likelihood of challenges to its independence.
The Federal Reserve’s important role in managing the economy is reflected by the U.S. Treasury Department’s April 1, 2008, proposed restructuring of the U.S. financial services industries.6 Under this proposal, the Federal Reserve would have broader oversight of the financial services industry. The Federal Reserve also would be given the explicit authority to play the key role of the Market Stability Regulator. As evidenced by both history and recent actions, the Federal Reserve is equipped to play the latter role, but if it fails to do that appropriately its political independence will be severely challenged, and maybe even ended.