Earlier this week, Federal Reserve Chairman Ben Bernanke sent a letter to Congress where he tried to counter the idea that the Fed secretly lent trillions of dollars to banks during the financial crisis. But Bernanke’s complaint missed the whole point of why the nation should be up in arms over the Fed’s special bailout of Wall Street. Arguing over whether $7.7 trillion or $16 trillion was the total amount of the bailout ignores the deeper issue of the Fed's abuse of its mandate to be “lender of last resort.”
The lender of last resort (LLR) idea was first developed in the 19th century by two British economic writers, Walter Bagehot, who coined the phrase in his book Lombard Street, and Henry Thornton, considered to be the father of the modern central bank.
Essentially, a lender of last resort should be an institution that protects the monetary system from contractions in the face of bank runs and financial panics—i.e., it makes sure there is money to borrow if liquidity freezes without good cause. The supporting thesis is that if a company is healthy, with good collateral to put on the line for a loan, but can’t find a lender because of an abnormal lock-up of money, they shouldn’t be forced to fail. In this instance, a LLR can step in and prevent an unnecessary bankruptcy and “lend freely, but at a penalty rate,” as Bagehot wrote.
On this logic, many have defended the Federal Reserve’s recent lending not as a bailout, but as fulfilling its duties as lender of last resort. The problem with this logic is that the Fed’s emergency lending programs have deviated far from the classical model of the LLR. The Fed did not lend to creditworthy borrowers, it did not ensure good collateral for the loan, and it did not charge an interest rate above the going market rate (a “penalty rate” to avoid banks becoming dependent on the source of funds).
Let’s consider each of these accusations and the evidence.
First, the most important principle for LLRs is that they only lend to solvent companies that would otherwise be able to get a loan from the private sector. If a firm is unsound and failing it will naturally have trouble getting access to credit and go bankrupt. The LLR exists for the times when healthy companies can’t get credit for extraordinary reasons but are otherwise healthy institutions. To highlight how far away from this principle the Fed has ventured, consider the financial institutions that the Federal Reserve has recently lent to:
- American International Group—so full of toxic credit default swap contracts that it couldn’t get a loan at any price and was hours from running out of cash before the Fed stepped in with an initial $85 billion loan. It’s equity has since been diminished to near zero value.
- Bank of America—weighed down by losses from bad mortgage investments on its books so large that it required $94.1 billion in loans and has remained teetering on the edge of technical insolvency ever since.
- Citigroup—facing a $18.72 billion total loss for 2008, it borrowed $99 billion over a six day period in January 2009.
- Morgan Stanley—took $107 billion in Fed loans in September of 2008 and still posted a massive $2.3 billion loss in just the fourth quarter of 2008 alone (10 times the consensus estimate of bank analysts at the time).
The list could go on for pages because the Fed lent to nearly any financial institution it could find. And since no one could convincingly value all those toxic mortgage-backed securities during the height of the crisis (one of the reasons Treasury Secretary Henry Paulson decided to use TARP for equity injections instead of buying the toxic debt from the banks directly), it is hard to see how the Fed could justify determining that all the financial firms it lent to were creditworthy. The Fed knowingly violated the foremost tenet for a lender of last resort.
Bernanke’s letter to Congress says it is misleading for articles to “depict financial institutions receiving liquidity assistance as insolvent.” But since regulators like the Fed get to officially determine technical solvency or insolvency, Bernanke has the power to ignore the numbers and pass a letter of the law test in bailing out the entirety of the financial industry.
Second, while the Fed could have mitigated some of its risk in lending to unsound financial institutions by demanding good collateral, it didn’t. The Fed went ahead and also violated this tenet for lenders of last resort.
Former Richmond Federal Reserve Senior Economist Thomas Humphrey wrote in the summer of 2010 that the collateral the Fed had accepted through its special lending programs was “complex, risky, opaque, hard-to-value, and subject to default.”
He pointed out that banks could even offer the rights to be paid back for loans they’d issued to Fannie Mae and Freddie Mac as quality collateral. That meant that if the bank failed to return the Fed’s loan, the Fed could get those interest and principal payments from the GSEs—but in early 2008 the GSEs were considered by the government as near insolvent. In fact the Treasury Department decided in August 2008 that Fannie and Freddie were so unsound they had to be taken over by the government to avoid bankruptcy (and they’ve now cost taxpayers $182 billion in bailouts, and counting). How could the Fed consider GSE debt to be good collateral?
The reason why the Fed was able to accept risky and worthless collateral is because it set the terms for defining good collateral under its own lending programs. For instance, the framework governing the Term Auction Facility—just one of the many murky, awkwardly named programs the Fed launched as lender of last resort—notes that the local Federal Reserve branch for the institution getting the loan determines the value of any posted collateral. This allowed the Fed to price collateral however it wanted to ensure it could technically provide bailout loans to any firm.
Third, the Fed has charged a near zero penalty rate when conducting its extensive emergency lending operations. The final tenet of lending as last resort is designed to discourage banks from taking advantage of the LLR and to avoid political favoritism in determining the recipients of the loans.
Bernanke’s letter to Congress claimed that, “most of the Federal Reserve’s lending facilities were priced at a penalty over normal market rates so that borrowers had economic incentive to exit the facilities as market conditions normalized.” But consider the Term Auction Facility (TAF).
TAF was designed so that commercial banks could borrow from the Fed anonymously and avoid the negative stigma that came with publicly borrowing from the “discount window” (the Fed’s traditional source of credit for banks). This amounts to a tacit devaluing of truth in the marketplace, favoring asymmetric information that misdirects the use of capital (I'll leave that discussion for a separate article). Over a 27-month period ending in March of 2010, the Fed lent out $3.8 trillion through TAF. This money was spread out over 4,000 different loans, with terms ranging from 13 days to 85 days, and with most institutions borrowing more than once from the program.
For 85 percent of program, the Fed lent at rates below the “discount window primary rate”—the market measure for what banks would normally borrow. If the Fed were charging a penalty, it would be charging at least the primary rate plus an additional amount.
Contrary to Bernanke’s statement that most were charged a penalty rate, most were actually underpriced loans. The ultimate result was the Federal Reserve lending to unsound institutions, against poor collateral, and with no penalty—i.e., giving money away for free to the Fed’s closest friends.
The Fed effectively put aside any concerns for moral hazard with its actions, and instead focused on short-term aims over long-term negative consequences. The result has been an outrageous carry trade, with some financial institutions taking in virtually free money, buying Treasuries that yield about 3 percent (lending it back to the government that just gave it to them), and banking the difference. Bloomberg estimates that banks have made about $13 billion from this, which those banks have then used to pay large compensation packages.
Lending to everyone, accepting whatever is available as collateral, subsidizing the entire operation, and ensuring that financial players suffer no consequences for their own foolish actions is not the free market at work. When the Occupy Wall Street crowd complains about illicit gains, this is the source of their anger. We have a crony capitalist system and the government is doing everything in its power to avoid changing it.