Fed’s $1.6 Trillon Bet

Tuesday, October 14, 2008 at 6:01 am
Federal Reserve Chairman Ben Bernanke (WDCpix)

Federal Reserve Chairman Ben Bernanke (WDCpix)

Amid the clamor over the crisis on Wall Street, the U.S. Treasury’s $700 billion Troubled Asset Rescue Program, or “TARP,” bill and the evolving collapse of the global banking system, little attention has been paid to the extraordinary credit extensions at the Federal Reserve. But these are now without parallel in Fed history, including during the Great Depression.

In the last three weeks, Federal Reserve Chairman Ben S. Bernanke, with the help of Treasury Sec. Henry Paulson Jr., has increased the Fed’s credit extensions by $650 billion — roughly the same amount as the TARP. Taken together with the Fannie Mae/Freddie Mac bailouts, new Fed credits in just the last month or so now amount to some $1.6 trillion. Here’s how they did it.

Illustration by: Matt Mahurin

Illustration by: Matt Mahurin

The Fed, to begin with, is a bank. Like other banks, it makes loans and investments, which are its “assets.” It finances them by taking deposits, mostly from its member banks, and raising capital, its “liabilities.” In the normal case, almost all its assets are loans to the government, or Treasury bills, notes and bonds; while its primary liabilities are its own debt certificates.

You’ve seen the Fed’s debt certificates; they’re green and carry the legend “Federal Reserve Note.” In other words, money. The Fed’s role in the economy is to stabilize the money supply so it is neither too plentiful, which can generate inflation, nor too scarce. It does so largely by manipulating the rate of interest that banks charge each other for overnight loans, the “Fed Funds” rate. If the Fed issues more currency to buy Treasuries from its member banks, banks become more liquid and the Fed Funds rate should fall; and vice-versa.

Bernanke is a serious academic who devoted much of his career to extensive studies of the failure of central banks during the Great Depression. He is the lead author of a 2004 Federal Reserve working paper, exploring the Fed’s policy alternatives “At the Zero Bound” — or the point where the usual tools of interest-rate policy cease to have any effect on the real economy.

In the paper, Bernanke poses a common policy conundrum. It sometimes happens that pushing down Fed Funds rates has no effect on medium- or long-term rates — or can even make them rise, if markets are worried that too much liquidity could cause inflation.

In such a case, Bernanke suggests, the Fed could use its balance sheet in a more targeted way. “If the Federal Reserve were willing to purchase an unlimited amount of a particular asset, say, a Treasury security, at a fixed price,” Bernanke wrote, “there is little doubt that it could establish that asset’s price.” But the Princeton economics professor also warned that the Fed should be “cautious” about such a strategy, since its results could be “quite uncertain.”

Starting in late 2007, and continuing ever more aggressively through 2008, Bernanke, as chairman, started precisely such an experiment in using the Fed’s purchasing power to target asset prices. But instead of targeting specific maturities of Treasuries, he targeted the illiquid assets weighing down bank balance sheets. In effect, could the Fed establish the price of the complex subprime mortgage-backed debt instruments, known as “CDOs’:and similar paper that has been destroying bank balance sheets?

The first attempt, in December, 2007, was appropriately cautious — it was relatively small and short-term; open only to Federal Reserve system member banks, and circumspect on acceptable securities. But step-by-step, he expanded the eligible borrowers from member banks to broker-dealers, then to AIG, an insurance company, and, most recently, directly to major corporations, mostly on an unsecured basis. At the same time, Bernanke greatly increased the volume and the range of targeted securities he would lend against, to include “investment-grade” (translation: “anything not junk”) CDOs.

The Fed’s weekly balance sheet has evolved into a fever-chart of Bernanke’s interventions. Start with the balance sheet of a year ago, in October, 2007. Total Fed assets were $890 billion, of which $780 billion comprised Treasuries, with the balance scattered among gold certificates, physical plant and other miscellany — or roughly the size it had been for several years.

Now jump ahead to the balance sheet from last week. The Fed’s assets have swelled to $1.6 trillion, an increase of 80 percent. But only $265 billion are Treasuries actually held at the Fed. The rest are a mélange of god-knows-what instruments vacuumed up from banks and investment banks.

There are $149 billion in dicey securities exchanged for Treasuries in bi-weekly auctions; “Other Loans,” to the tune of $420 billion (all we know is that it includes the credit extension to AIG, which has climbed to about $100 billion); a special $29-billion line for Bear Stearns, and $145 billion in direct lending to companies. There is also $325 billion in “Other Assets” — probably mostly dollars for foreign central banks to help local banks choking on dollar-based CDOs and other poison apples from America.

The total lending expansion, therefore, was about $700 billion, with about $650 billion in just three weeks since Paulson and Bernanke proposed what became TARP to purchase banks’ bad assets, or otherwise provide them with new equity.

In other words, even as academics and Congress agonized over TARP, Bernanke and Paulson had already pumped out roughly that amount of money — without so much as asking for a by-your-leave. Paulson even engineered a special $400-billion Treasury borrowing program -– i.e., increased the federal debt — to supply part of the extra cash needed to support Bernanke’s lending.

Fascinatingly, Bernanke’s fire-hose of liquidity has so far been accompanied by a steady tightening of lending conditions. Some market watchers worry that interbank liquidity is drying up because borrowing at the Fed is so much easier. Only time will tell.

If there’s one lesson from the past few years, it is the formidable nature of the law of unintended consequences. The vast new infusions of dollars will weigh on U.S. international balances for years. It is all in the name of staving off a “recession,” which now looks something like the 1960s specter of nuclear Armageddon.

We may have reached the point where the cure is scarier than the disease.

Charles R. Morris, a lawyer and former banker, is the author of “The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash.” His other books include “The Tycoons: How Andrew Carnegie, John D. Rockefeller, Jay Gould and J.P. Morgan Invented the American Supereconomy” and “Money, Greed, and Risk: Why Financial Crises and Crashes Happen.”



Comment posted October 14, 2008 @ 5:23 am

The modern Buddhist teacher and scholar, Joanna Macy, often speaks of the Prophecy of the Shamballa Warriors as told to her by her teacher Choegyal Rinpoche. It speaks of a time when the world is in extreme danger, when so called “barbarians” of east and west have gathered great wealth and built unimaginable weapons of mass destruction and developed technologies that can “lay waste our world”. It is at this time, when life seems to be hanging in the balance, that the kingdom of Shamballa begins to emerge. This kingdom is not an ecotourism destination, a place you can find on the map, but an inner kingdom, an interior state of mind and heart existing within the “warriors”. These Shamballa warriors are the people who understand without question that all life is interconnected and that all life is sacred. You wouldn't recognize them on the street because they have no badges, no uniforms and no leaders. They walk in the lands of the barbarians, holding no territory of their own and are called on to act with moral and physical courage, to go into the center of the controversy and dismantle the weapons of mass destruction, the systems of chaos and materialism.


Mr. Main Street
Comment posted October 14, 2008 @ 5:52 am

Important information here. Charles R Morris should be a guest host on CNBC.

Comment posted October 14, 2008 @ 12:07 pm


you mean: …one of us…one of us…one of us…

you're awesome…keep on believin'

Comment posted October 15, 2008 @ 11:02 am

So… if you were the fed and you needed to shrink the money supply to prop up the sinking dollar, how would you do it without asking citizens to give their dollars back?

Simple, sell a financial crisis to Americans and congress:

• Think about it, 8.4 trillion (http://news.yahoo.com/s/ap/wall_street) evaporate from the stock market this year! and still growing
also see – http://www.foxnews.com/story/0,2933,436435,00.html
• 6 trillion (est. http://news.goldseek.com/GoldSeek/1220622331.php) disappear from the housing market in the last two years.
• Untold trillions disappear from the financial banking institutions.

Then, after the fear mongering on Capital Hill two weeks ago, the 'Commercial Paper' market freezes up and the Fed makes moves to take that over. One more option for them to collect interest from banks and corporations that need to borrow massive amounts (we're talking billions and trillions here) of short term funds.

Now, private banks are consolidating and being bought up by the fed.

How is this good for America?

Pascal Bedard
Comment posted October 17, 2008 @ 10:00 am

I could not agree MORE. This entire mess has thrown public authorities out of control… if only it was an “out of control” that was relatively costless to the taxpayer, but such is not the case. This “anything goes” approach WILL have consequences. The very fundamental rule of economics, even more basic than supply and demand is that there is no free lunch!

Can we stop spending thousands of billions of taxpayer dollars (and next-generation real disposable incomes) on trying to fix an unfixable mess (while millions if not billions “fall through the cracks” and end up in private pockets of well-connected Wall Street people) and concentrate on padding people and businesses against the consequences of the necessary but painful global deleveraging that is taking place? The Warren Buffets of the world are positioning themselves in preparation for the Bailout Mania windfall but not much else is happening on the positive side.

We need to accept the very basic truth here: the West has been living beyond its means for 2 decades now and this shows up in aggregate private market credit as a % of GDP which has reached historical proportions now and has been on a tear for 2 decades. Although there may be some “structural break” in the world economy that could explain PART of the phenomenal increase in the credit market debt-to-GDP ratio, but I strongly doubt this “structural break” could entirely explain the observed changes of the last decade in the 1920-2007 series (see graphs).

This “living beyond our means” has been made possible by borrowing (in fiscal and environmental terms) from future generations and from Asia. We are now literally throwing free money at the very people who should get as little as possible, thus structurally integrating moral hazard to the long term mess as well, but that is so “old school”, right? The slogan currently should be “if you want money, you have to be bankrupt or close to it”, and all the large mismanaged corporations have certainly caught on to this. Now everything goes and more dumping on the taxpayer will soon come – auto loans, credit card debt, almost free transfers to large automakers, etc.

Of course “punishment” is not a responsible economic policy – I agree and I totally understand the issue of “clogged” credit markets. But pragmatism IS essential to good economic policy. And using thousands of billions of taxpayer dollars (still not enough relative to the size of the problem) in what seems like ad-hoc “tests” and “approximate” policies with very unsure results that benefit few at the expense of many seems quite un-pragmatic and irresponsible to me.

The reality is that there are 2 types of recessions: one is due to the Central Bank slowing the economy to decrease inflation (Romer and Romer), change inflationary expectations and “anchor” expectations and policy credibility, and to keep the economy “close to potential.” The other type of recession is due to massive misallocation of resources, dislocations in interest rates and prices, and poor risk assessment – all are essentially the same thing. The recession just starting now is a “type 2″ recession and standard policy will not work. We (especially the USA and Europe) will spend astronomical amounts of taxpayer dollars and, Central Bank “printing of free money”, and policy credibility erosion while discovering this and running into a liquidity trap. We will then wake up in a few years with very serious fiscal issues which will limit the intervention ability of the public sector when it will be really required and useful.

Pascal Bédard, Montreal

Comment posted October 18, 2008 @ 8:18 pm

Hey where were you?
That $650B was in the news, the day after the first nay vote of the House.
Yet hardly anybody has talked about that freebee given by Bernanke/Paulson.
So this whole give away started at $1350B.

This whole give away was planned down to the dollar by the repocons and congress and the press just stood there and cheered.

Nobody has said. “Oooo, didn't they come up with a plan quick. They must have stayed up all night”
They didn't have to. It was already in the print que ready to hand around.

George V. Williams
Comment posted November 14, 2008 @ 9:51 am

At very least, we must accord some halting credit to the Bush Regime for consistency. As in so many other departments of government, at the Fed. and Treasury, he/they have put foxes in charge of the henhouse. I can, at the moment, think of no more egregious example of this near-CRIMINAL insanity than here, in charge of the very basis; the bedrock, of the American economy. The result, both short- and long-term, therefore, is both tragic and predictable.

George V. Williams
Comment posted November 14, 2008 @ 9:54 am

'REPOCONS', I really like that one. Congratulations. It is nothing short of BRILLIANT!

George V. Williams
Comment posted November 14, 2008 @ 5:51 pm

At very least, we must accord some halting credit to the Bush Regime for consistency. As in so many other departments of government, at the Fed. and Treasury, he/they have put foxes in charge of the henhouse. I can, at the moment, think of no more egregious example of this near-CRIMINAL insanity than here, in charge of the very basis; the bedrock, of the American economy. The result, both short- and long-term, therefore, is both tragic and predictable.

George V. Williams
Comment posted November 14, 2008 @ 5:54 pm

'REPOCONS', I really like that one. Congratulations. It is nothing short of BRILLIANT!

louis vuitton
Comment posted August 2, 2010 @ 3:59 am

Nobody has said. “Oooo, didn't they come up with a plan quick. They must have stayed up all night”

Fed’s Monopoly Money Policy Gets Worldwide Criticism
Pingback posted November 5, 2010 @ 7:31 am

[...] more about this economic “Hail Mary” here at Wall Street Journal.This, of course, follows  $1.6 TRILLION of cash  already “stimulated” into the deep dark abyss of the U.S. economy since Obama took [...]

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