Federal Reserve & Interest Rates

The price tag for the government keeps going up, this time it’s coming to the rescue of Bank of America, currently the largest U.S. bank by assets.  In order to salvage the Merril Lynch takeover, Bank of America is set to receive $138 billion in government support.

Treasury and the Federal Deposit Insurance Corporation will provide protection against the possibility of unusually large losses on an asset pool of approximately $118 billion of loans, securities backed by residential and commercial real estate loans, and other such assets, all of which have been marked to current market value. The large majority of these assets were assumed by Bank of America as a result of its acquisition of Merrill Lynch. 

The assets will remain on Bank of America’s balance sheet. As a fee for this arrangement, Bank of America will issue preferred shares to the Treasury and FDIC. In addition and if necessary, the Federal Reserve stands ready to backstop residual risk in the asset pool through a non-recourse loan.

In addition, Treasury will invest $20 billion in Bank of America from the Troubled Asset Relief Program in exchange for preferred stock with an 8 percent dividend to the Treasury. Bank of America will comply with enhanced executive compensation restrictions and implement a mortgage loan modification program.

Bank of America was stung by higher than expected losses at Merril Lynch this quarter, estimated at over $15.3 billion and it’s stock has plunged ever since the merger was announced.  Coupled with the Countrywide takeover earlier in the year, investors have shown their disapproval with Bank of America acquiring the two losing companies.

Confronted with the realization that Bank of America was about to walk away from the Merril takeover, the government moved to support the bank in order to prevent another Lehman Brothers situation.  In order to protect financial market stability the government moved to guarantee losses on a pool of toxic assets like it did with Citigroup earlier in the year. 

2008 will be known as the year investment banking died, where all the major players collapsed, were taken over or converted to commercial banking institutions.  Investment banking couldn’t survive the current credit climate, known for it’s highly leveraged profits during good economic times, they reported staggering losses this year as capital sources dried up.

The government has been hard pressed in trying to restore confidence to a financial market that is seemingly in a free fall but as long as the housing market keeps falling, asset write downs and losses will continue to accumulate and with it the government’s bill.

Federal Reserve Chairman, Ben Bernanke gave a speech earlier today at the Economic Club of New York where he discusses the current financial meltdown gripping the global economy.

The crisis we face in the financial markets has many novel aspects, largely arising from the complexity and sophistication of today’s financial institutions and instruments and the remarkable degree of global financial integration that allows financial shocks to be transmitted around the world at the speed of light.

Large inflows of capital into the United States and other countries stimulated a reaching for yield, an underpricing of risk, excessive leverage, and the development of complex and opaque financial instruments that seemed to work well during the credit boom but have been shown to be fragile under stress. The unwinding of these developments, including a sharp deleveraging and a headlong retreat from credit risk, led to highly strained conditions in financial markets and a tightening of credit that has hamstrung economic growth.

The root cause of our current economic dilemma has been the end of the housing boom and the subprime meltdown that followed.  Bernanke discusses how in the future, monetary policy can play a role in restricting the creation of asset bubbles and their subsequent effects when they burst.

He also touches on the why AIG was given government assistance while Lehman Brothers was not, AIG had the assets and collateral so that the likelihood of taxpayer liability was minimal, which was not the case with Lehman.  Even then AIG is responsible for a heavy burden in the high interest rate it must pay in order to secure that government loan.

As it should be, much of the liability in the case of AIG is in the hands of the shareholders as was the case with Fannie Mae and Freddie Mac when the government took control of those institutions.  It is probable that AIG will have to be broken up in order to repay the Fed loan but that might not be a bad thing in the long run.

We can expect to see increased regulatory oversight from the Fed as well as the Treasury in the future which will be a far cry from the two decades of deregulation that the financial system has experienced beginning in the 1980’s.  A major problem currently plaguing the economy is that companies have gotten too large and complex, when a company enters the category of “too big” to fail, they have the potential of creating large shocks to the financial system if and when they begin to disintegrate.

Large companies can hold a financial system hostage as was the case when Lehman declared bankruptcy.  Stock markets around the world have been feeling the shocks from that event, from which they have yet to recover.

The Federal Reserve along with the leading central banks of the world announced plans to add liquidity to dollar markets around the globe.  Another key initiative is the plan to re-capitalize the global banking system in exchange for ownership stakes in the financial institutions.

The BoE, ECB, and SNB will conduct tenders of U.S. dollar funding at 7-day, 28-day, and 84-day maturities at fixed interest rates for full allotment. Funds will be provided at a fixed interest rate, set in advance of each operation. Counterparties in these operations will be able to borrow any amount they wish against the appropriate collateral in each jurisdiction. Accordingly, sizes of the reciprocal currency arrangements (swap lines) between the Federal Reserve and the BoE, the ECB, and the SNB will be increased to accommodate whatever quantity of U.S. dollar funding is demanded. The Bank of Japan will be considering the introduction of similar measures. 

The partial nationalization of the world’s banking system may be the step that finally instills confidence in a system that has been without it for a number of months.  Sadly it seems that only governments actually have enough monetary resources to steer the world clear of the looming financial disaster.

The Treasury has announced that about $250 billion of the $700 billion bailout package will be invested to the nation’s banks and will provide cash injection in exchange for equity.  Last week the Bank of England announced a similar move to nationalize it’s banking system and other central banks are quickly following suit.

This will hopefully restart lending worldwide and unfreeze the credit system that has been locked up for months.  Stock markets around the world have already shown their approval with record rallies but it big question is will it last this time.

For too long the nation’s financial system has been irresponsible with it massive risk taking but whether or not things will change now that the government is involved remains to be seen.  Ironically it is the current lack of risk taking that has caused the current credit crisis with the banking system hoarding capital and unwilling to lend to even people with good credit.