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The Federal Reserve continues to expand its novel lending activities (see table below). The magnitude of the expansion has been surprising - even for long-time skeptics of the Fed. Its new Securities Lending Facility resembles the New York Yankees trading half of their opening day line-up to the Pittsburgh Pirates for a handful of Texas-League prospects. For example, this facility now allows holders of AAA-rated securities backed by portfolios of student loans (namely banks and primary dealers) to exchange these instruments for Treasury securities held by the Fed.
Such Fed bailout actions mix up its primary monetary policy responsibilities with its financial supervision and regulatory operations. Through decades of open-market operations (a traditional monetary policy tool), the Fed has assembled a portfolio of nearly one trillion dollars of Treasury securities. Much of that portfolio is now being transferred willy-nilly into the hands of banks and securities dealers to bailout the likes of the general creditors of Bear Stearns, to name the most conspicuous case. Federal Reserve Credit Is Money in a Fiat Currency Regime When the Fed acquires assets, it adds to the reserves in the banking system - unless it sells other assets to offset the acquisition (which drains reserves from the banking system). The public views this action as expanding the money supply, which can be inflationary if uncontrolled. In a nutshell, that was the monetary policy problem of the late 1960s and the 1970s. In this instance, the Fed has attempted to neutralize the quantitative monetary effects of its actions by selling about the same amount of its own Treasury securities as the amount of reserves its lending operations are supplying to the market. Get Warrants! In the Bear Stearns rescue, the Federal Reserve Bank of New York (FRBNY) contributed a $29 billion loan to assist J.P. Morgan Chase (who contributed $1 billion) acquire the beleaguered company. The loan terms are such that the Fed will be repaid first from proceeds of the sale or maturity of the securities (which according to the Treasury consist of mortgage-backed securities and related hedge investments), and J.P. Morgan will be paid last, meaning it will bear the first $1 billion of losses.
FRBNY acted like an investment banker in providing the capital for the deal, and bears considerable downside risk in doing so. Unlike an investment banker, FRBNY failed to obtain a stake in the upside - J.P. Morgan Chase (JPM) purchased the entire equity stake in Bear Stearns. The best FRBNY can do is have its loan repaid in time and in full; if the deal goes well, not only have the creditors of Bear Stearns been bailed out, but the stockholders in the new J.P. Morgan Chase will enjoy all of the gains.
When public funds are used to bail out existing enterprises, or even to fund start-up operations, it generally is considered acceptable (indeed, advisable) for the public entity providing the funds to obtain an investment banker’s stake in the future successful operations of the assisted enterprise. The shorthand expression for this concept in the current debate is, “Get warrants!” Warrants entitle the holder to purchase the proportionate amount of common stock, at a specified price, usually higher than the market price at the time of issuance (for a period of time, or in perpetuity). In typical investment banking transactions, warrants are issued as a deal sweetener to enhance the marketability of the accompanying fixed income securities that they are traditionally issued with. No such "deal sweeteners" were given to the American taxpayers.
FRBNY should have obtained warrants convertible into the common stock of JPM. JPM stock, for example, closed at $36.54 per share on March 14, the Friday before the Bear Stearns rescue, and rose to $46.55 ten days later ($46.57 at the Friday close on May 9). The public bears the greater part of the risk of loss on this transaction, and it should be rewarded if the rescue is successful. Exchanging Good Assets for Worse As remarkable as the Bear Stearns bailout seems, its magnitude has been dwarfed by other Fed actions. On May 2, the Fed announced that it was going to again expand its lending activities by increasing the Term Auction Facility to $75 billion per auction (to an aggregate of $150 billion), and expand the foreign exchange swap agreements with foreign central banks to $50 billion for the European Central Bank (up from $20 billion) and $12 billion for the Swiss National Bank (up from $6 billion). The new Securities Lending Facility (announced about one week before the Bear Stearns rescue) retained its cap of $200 billion, but the categories of eligible collateral were expanded to include “AAA-rated asset-backed securities” of any type, not just similarly rated mortgage-backed securities. All of this constitutes a gross loosening of lending terms at the Fed. The Fed is approaching the limits within which it can reshuffle assets on its balance sheet without expanding the aggregate amount of those assets. As of May 8, the Fed had reshuffled about 77 percent of its balance sheet from year-earlier figures, with about 49 percent of the total balance sheet consisting of new amounts of credit that did not exist a year earlier.
It is not at all clear that the Fed has the statutory authority to engage in much of this activity (see the upcoming issue of Research Reports for a detailed analysis). Who can say? While a major public accounting firm audits the activity of the Board of Governors each year (remember Arthur Anderson?) and the Government Accountability Office (GAO) reserves the right to review specific aspects of the Fed's policies, monetary policy is exempt from audit by the GAO because it is monitored directly by Congress. That is some cold comfort for the American people.
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