Federal Reserve & Interest Rates

The Fed’s balance sheet has ballooned over the past year as they attempt to pump trillions of dollars in liquidity into credit markets.  With the financial crisis intensifying in October in the wake of the Lehman Brothers collapse they have announced that they are extending the life span of three key lending facilities.

In light of continuing strains in financial markets, the Federal Reserve on Tuesday announced the extension through April 30, 2009, of three liquidity facilities: the Primary Dealer Credit Facility (PDCF), the Asset-Backed Commercial Paper Money Market Fund Liquidity Facility (AMLF), and the Term Securities Lending Facility (TSLF).  These facilities had previously been authorized through January 30, 2009. 

This will be the second time that they have extended these programs, which were initially created after credit markets tightened up after the Bear Stearns fire sale to JP Morgan back in March.  Despite their best efforts, credit markets have continued to deteriorate as private sources of investment have dried up.

In the beginning, many institution may have been wary of borrowing from the Fed because of the perception of weakness that this would entail.  Now for many, this source of liquidity is their means for survival.

Still, the alarming growth of the Fed’s balance sheet has many economists concerned as the Fed has opened themselves up to considerable risk by taking on illiquid securities as collateral.  The amount of liquidity the Fed has committed to the banking system, dwarfs the $700 billion financial rescue package by comparison.

With the country facing the worst economic downturn since the Great Depression you can’t blame the Fed for taking these extraordinary steps.  A major reason why the Fed is able to expand the money supply this much is due to the free fall in the price of oil, which has fallen more than $100 off it’s July high.

Whether these steps will forestall the rapid decline in spending remains to be seen.

During a speech at the Chamber of Commerce in Austin, Texas, Federal Reserve Chairman Ben Bernanke discusses monetary policy moves during the financial crisis.  While the Fed has promoted monetary easing for over a year now, the financial crisis intensified in the wake of the Lehman Brothers collapse.

In the absence of an appropriate, comprehensive legal or regulatory framework, the Federal Reserve and the Treasury dealt with the cases of Bear Stearns and AIG using the tools available. To avoid the failure of Bear Stearns, we facilitated the purchase of Bear Stearns by JPMorgan Chase by means of a Federal Reserve loan, backed by assets of Bear Stearns and a partial guarantee from JPMorgan.

In the case of AIG, we judged that emergency Federal Reserve credit would be adequately secured by AIG’s assets. However, neither route proved feasible in the case of the investment bank Lehman Brothers. No buyer for the firm was forthcoming, and the available collateral fell well short of the amount needed to secure a Federal Reserve loan sufficient to pay off the firm’s counterparties and continue operations. The firm’s failure was thus unavoidable, given the legal constraints, and the Federal Reserve and the Treasury had no choice but to try instead to mitigate the fallout from that event.

Unfortunately the fallout from the Lehman collapse has been significant,  Congress had to approve a $700 financial rescue package in order to stabilize a banking system that had completely locked up.  Even that wasn’t enough to prevent the largest bank in the world at one time, Citigroup from needing emergency funding to prevent bankruptcy.

There are still many trouble financial institutions out there that are in danger of collapse, losses from the housing correction are continuing to pile up, with writedowns approaching the $1 trillion mark.  The government has spent unprecedented amounts of money trying to slow down this train wreck waiting to happen.

With interest rates already at 1%, there is not much more the Fed can lower it and many are expecting them to cut the fed funds rate to .5% this month.  The big problems are the wide interest rate spreads which cause inefficiencies in the banking system.

The Fed has been forced to pump liquidity into the system by greatly expanding it’s balance sheet.  They are basically providing a market for securitization, where one doesn’t exist anymore.  It has been somewhat successful recently as mortgage rates have fallen somewhat after the Fed purchased securities from  the two GSEs, Fannie and Freddie.

It’s next move looks to be to purchase Treasury Securities on the open market to bring down yields even further.  However, until spreads start to shrink, it will limit whatever actions the Fed decides to take next.

The financial system has been choked off by a lack of liquidity in the form of mortgage assets that no one wants to buy.  Treasury Secretary Henry Paulson has brought forth a plan for the government to become a buyer of last resort.

These illiquid assets are clogging up our financial system, and undermining the strength of our otherwise sound financial institutions. As a result, Americans’ personal savings are threatened, and the ability of consumers and businesses to borrow and finance spending, investment, and job creation has been disrupted.

The federal government must implement a program to remove these illiquid assets that are weighing down our financial institutions and threatening our economy. This troubled asset relief program must be properly designed and sufficiently large to have maximum impact, while including features that protect the taxpayer to the maximum extent possible.

The plan would be an unprecedented bailout of the financial system that is estimated at a whopping $800 billion.  I think the government finally realizes that monetary policy can only do so much on it’s own and that a fiscal plan was also needed to head off financial disaster.

The problems of the financial services industry is slowly getting worse, this week saw three financial giants brought low.  The Fed had to issue an emergency $85 billion loan to AIG to keep it from a disorderly collapse, while in investment banking, Lehman Brothers declared bankruptcy while Merrill Lynch sold itself to Bank of America at a fraction of it’s former value.

The banking system is clearly in big trouble and I’m not sure if the Federal Deposit Insurance Corporation has enough reserves to insure the deposits of Americans from the growing number of banks that are in danger of failing.  Credit is being choked off at the source as banks are stuck with assets that they are unable to sell.

Financial institutions raised hundreds of billions of capital to deal with writedowns from the subprime collapse but they are loathe to loan that money out.  The big problem is that the financial sector is so intertwined these day that even relatively strong financial institutions are worried about counter party risk so they are hoarding capital to protect themselves for when their weaker brethren start to fail.

This plan definitely puts taxpayer dollars at risk but the alternative could very well be a financial Armageddon that could plunge the world into another Great Depression.