Federal Reserve & Interest Rates

Nearly a hundred banks have already failed this year and the FDIC’s bad bank list contains hundreds more that are in danger of failing in the next few years.  With it’s insurance fund running dangerously low, the FDIC put forward a plan earlier this month, in which banks would prepay three years worth of fees to replenish the fund.

It’s the worst stretch of bank failures since the Savings and Loan crisis of the 1990’s when nearly two hundred banks and thrifts failed, costing taxpayers over $100 billion.  The insurance fund has shrunk by nearly $35 billion since the recession began and has a little over $10 billion remaining.

While banking system has stabilized somewhat, it’s still in a fragile state and the continued weakness in the residential and commercial real estate markets will lead to more failures in the next few years.  At this point, the FDIC estimates that bank failures will cost the insurance fund $100 billion by 2013.

The proposed prepayment plan is expected to raise somewhere in the neighborhood $50 billion and while the banking industry isn’t happy about it, they prefer this option to a special fee assessment which was also a possibility. In May, Congress increased the FDIC’s line of credit with the Treasury to $100 billion, but it been reluctant thus far to borrow from the Treasury and putting more of the onus of bank failures on taxpayers.

Chairman Ben Bernanke gave an update on the status of the Federal Reserve’s balance sheet in a speech on Thursday.  Although there has been talk lately of the Fed’s impending exit strategy, fears of relapse may make that a long drawn out process.

To fight a recession, the standard prescription for a central bank is to lower its target short-term interest rate, thereby easing financial conditions and supporting economic growth. In the current downturn, however, the Federal Reserve has faced two historically unusual constraints on policy.

First, the financial crisis, by increasing credit risk spreads and inhibiting normal flows of financing and credit extension, has likely reduced the degree of monetary accommodation associated with any given level of the federal funds rate target, perhaps significantly.

Second, since December, the targeted funds rate has been effectively at its zero lower bound (more precisely, in a range between 0 and 25 basis points), eliminating the possibility of further stimulating the economy through cuts in the target rate.

The Federal Reserve has had to take unconventional steps in order to get the financial system back on it’s feet.  Normally a backstop for commercial banks, the Fed greatly expanded it’s role by providing liquidity to financial institutions across many sectors and becoming an active buyer in a number of credit markets.

It quickly saw that it’s normal monetary policy initiatives would not be enough to unfreeze credit markets in the wake of the financial panic last fall.  It’s balance sheet currently sits at $2.1 trillion and will continue to grow as the Fed finishes up with their agency mortgage securities purchases.

They do have a number of tools at their disposal to shrink their balance sheet when the time comes.  However, if the recovery starts to stall the Fed’s balance sheet could remain quite large for some time.

The Federal Reserve recently announced that it would extend it’s Term Asset-Backed Securities Loan Facility(TALF) until March of 2010 and chances are they could extended it again next spring.  The Fed created the program to promote borrowing and lending in the asset-backed securities(ABS) market which froze up during the financial crisis.

Bank lending is still down overall, as can be seen with the excess amount of bank reserves the Fed is currently holding on deposit.  The ABS market is essential in helping banks rollover existing loans in order to facilitate new lending.

New issuance of ABS has slowly started to return but investors still remain skeptical, especially for securities backed by real estate loans, which is still experiencing a high degree of defaults.  That being said, the TALF has still had a positive impact as investors are increasingly starting to use their own cash to re-enter the market.

The market still has a ways to go to return to it’s former level, which may be impossible as financial institutions aren’t likely to return to their former leverage levels anytime soon.  The whole market is just too risk adverse at the moment, the Fed needs both issuers and investors to increase their risk seeking in order for credit to flow more freely.

As economic conditions start to improve we will likely see lending activity increase but it will probably be slow going for some time.