Federal Reserve & Interest Rates

After a months of trying to convert itself into a bank holding company, GMAC was able get emergency approval from the Federal Reserve last week despite it’s failure to achieve the capital levels required.  Now that it qualifies as a bank holding company, the Treasury was finally able to allocate bailout money from TARP funds to General Motors’ financing arm.

The Treasury Department today announced that it will purchase $5 billion in senior preferred equity with an 8% dividend from GMAC LLC as part of a broader program to assist the domestic automotive industry in becoming financially viable.

Additionally, the Treasury has agreed to lend up to $1 billion to General Motors so that GM can participate in a rights offering at GMAC in support of GMAC’s reorganization as a bank holding company. This commitment is in addition to the assistance previously announced for GM on Dec. 19.

The lack of available credit has been a major reason auto sales have fallen to their lowest levels in over two decades.  The infusion of $5 billion will help GMAC extend financing to prospective car buyers.

This continues the Treasury’s ongoing efforts to shift it’s primary focus to the consumer side of credit generation.  Consumer spending has taken a big hit this year with consumer confidence levels falling to a record low in December.

GMAC announced that it plans to offer zero percent financing for up to five years and has lowered it’s credit standards somewhat as it tries to stimulate sales.  It is likely GMAC will receive further help once the remaining $350 billion in TARP funds is released by Congress.

The current financial crisis has changed the role for many governments in capitalistic economies around the world.  In socialist economies, the government normally takes a more active role but in democratic societies the standard is usually a more hands off approach.

The intervention comes at what may prove to be a steep price. Future investment may be allocated less efficiently as risk-averse politicians make business decisions. Whenever banks decide to lend again, they are likely to find new capital requirements that will curb how freely they can do it. Interest rates may be pushed up by government borrowing to finance trillions of dollars of bailouts.

“We’re seeing a more statist world economy,” says Ken Rogoff, former chief economist at the International Monetary Fund and now a professor at Harvard University in Cambridge, Massachusetts. “That’s not good for growth in the longer run.”

The government has had to spend an unprecedented amount of money to rescue the financial system and try to maintain economic growth in the face of falling demand.  However, the more money being spent, the more control the government is exerting on the economy.

The surprising aspect is the ownership stakes the government is taking in banking institutions, something that would be more commonplace in a state run economy.  Also, the repercussions could be fairly long term as we are likely to see the start of a new era of increased regulatory oversight.

The government is receiving a lot of criticism for bailing out failing companies.  At first the government seemed to hold to a certain financial standard when it declined to help Lehman Brothers because the company’s asset were insufficient as collateral.

That standard went out of the window with the auto industry bailout.  In this case there are serious doubts on whether the government will ever get paid back or not.  Yes, many jobs were saved but it’s been obvious for years that this has been a failing industry and it’s not like this is the first time the government has had to bail them out.

There are obviously companies that are” too big” to fail but some are apparently more important than others.  We all saw the havoc that ensued in financial markets when Lehman failed and if the government were to do it again they would probably intervene.

But where does it end?  There are going to be more companies in danger of failing before a recovery happens but the government will have to weigh the cost to taxpayers versus the cost to the economy.

The Federal Reserve announced today that it was setting the target for it’s overnight federal funds rate to between 0% and .25%.  With commodities and consumer prices falling in the face of contracting economies world wide, there is a real risk of deflation, which allows the Fed to lower interest rates to practically zero.

Since the Committee’s last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined.  Financial markets remain quite strained and credit conditions tight.  Overall, the outlook for economic activity has weakened further.

Meanwhile, inflationary pressures have diminished appreciably.  In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.

Today’s move is unprecedented, the only other time the Fed considered taking interest rates this low was back in 2000 where transcripts from FOMC meetings that year showed that while there was some support, ultimately it was decided not to lower rates that far.  By taking rates to zero the Fed is pretty much signaling that it’s all in and will be using it’s balance sheet from now on to affect monetary policy.

Many expect the Fed to become a major player in the mortgage securities market in an attempt to bring down home lending rates.  At this point it is doubtful that any meaningful recovery can begin until the housing market rebounds.

The Fed has already added significant risk to it’s portfolio and seems ready to take on more.  The question is how much more will the Fed’s balance sheet grow, which has already nearly tripled in the past year. 

It will take time for capital markets to return to some sort of normalcy and quite a few institutions will face more writedowns in the near future as home prices keep falling.  We may see many of them continue to build up capital reserves, so who knows how much more liquidity the Fed will have to pump in to get them lending again.