How and Why the Fed Pumps Money Into the Financial System

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By Karen Yourish and Cristina Rivero, The Washington Post - August 10, 2007

Banks are required to maintain certain cash reserve levels overnight, and frequently have to borrow from other banks to keep their reserves. The Federal Reserve's federal funds rate is the interest rate charged on overnight loans between banks. The current rate is 5.25%.

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from: http://www.washingtonpost.com/wp-dyn/content/graphic/2007/08/10/GR2007081001524.html?hpid=topnews

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By EDMUND L. ANDREWS
Published: September 17, 2008

WASHINGTON — The mighty Federal Reserve is being stretched to its limits, both in the range of problems it is being asked to fix and in its financial firepower.

The central bank has also transformed itself almost overnight into the Fed Inc. by essentially taking over American International Group after already taking on hundreds of billions of dollars in mortgage securities to help ailing financial institutions.

Instead of just setting monetary policy in its Ivory Tower-like setting, the Fed now must wear several hats — that of insurance conglomerate, investment banker and even hedge fund manager.

“This is unique, and the Fed has never done something like this before,” said Allan Meltzer, a professor of economics at Carnegie-Mellon University and author of a sweeping history of the Federal Reserve. “If you go all the way back to 1921, when farms were failing and Congress was leaning on the Fed to bail them out, the Fed always said ‘It’s not our business.’ It never regarded itself as an all-purpose agency.”

The Fed has often been described as the nation’s lender of last resort — the one institution that would lend money when everything else had failed. But by acquiring almost 80 percent of A.I.G. in exchange for lending it $85 billion, and holding $29 billion in securities once owned by Bear Stearns, the Fed is now becoming the investor of last resort as well.

That could put the central bank in an increasingly complicated and contradictory position. It will be responsible for stabilizing the financial system, but also for minimizing losses to taxpayers. Those responsibilities are likely to conflict even more than the traditional tension between the Fed’s dual mandate to keep inflation low and promote full employment.

The Fed’s balance sheet, moreover, is being stretched in ways that seemed unimaginable one year ago. As recently as last summer, the central bank’s entire vault of reserves — about $800 billion at the time — was in Treasury securities.

By last week, the Fed’s holdings of unencumbered Treasuries had dwindled to just over $300 billion. Much of the rest of its assets were in the form of loans to banks and investment banks, which had pledged riskier securities as collateral.

In a sign of how short the Fed’s available reserves had become, the Treasury Department sold tens of billions of dollars of special “supplementary” Treasury bills on Wednesday to provide the Fed with extra cash. The Treasury sold $40 billion of the new securities on Wednesday morning and will sell $60 billion more on Thursday. More money-raising is sure to follow.

“The Fed is very stretched, and that’s why they’ve asked the Treasury to go ahead with these proposals,” said Lou Crandall, chief economist at Wrightson ICAP and a longtime analyst of the Fed’s market operations. “You don’t want the market wondering whether the Fed has enough reserves to handle the next supplicant.”

Indeed, the role of the Fed chairman, Ben S. Bernanke, almost seemed to unnerve a leading House Democrat.

“He can make any loan he wants under any terms to any entity or individual in America that he thinks is economically justified,” said Representative Barney Frank, Democrat of Massachusetts and chairman of the House Financial Services Committee.

“I asked the chairman if he had $85 billion to bestow in this way. He said ‘I have $800 billion.’ ”

“No one in a democracy unelected should have $800 billion to dispense as he sees fit,” Mr. Frank said.

Fed officials contend that they have ample resources to handle all their new obligations. Unlike a company or a household, the Fed can raise as much cash as it wants by printing money and buying up Treasuries and other securities at will.

But in the last few months, the central bank has transformed itself from a regulator of the money supply to a white knight for troubled financial institutions.

The first step across the Rubicon occurred last March, when the Federal Reserve and Treasury Department prevented the bankruptcy of Bear Stearns by engineering its shotgun marriage to JPMorgan Chase.

To make the deal work, the Fed agreed to hold and manage a huge pool of hard-to-sell securities from Bear Stearns as the collateral for a $29 billion loan to JPMorgan. The Fed has disclosed little about the securities it is holding, but the pool is believed to include billions of dollars worth of securities backed by troubled subprime mortgages.

At the time, Fed officials hired the money-management firm BlackRock Inc. to oversee the Bear Stearns pool, which appears as “Maiden Lane L.L.C.” on the Fed’s balance sheet. But while Fed officials said their goal was to “maximize returns” on those assets, officials appear to have made no changes in the portfolio yet.

But the Maiden Lane portfolio will be small potatoes compared to the businesses owned by A.I.G.

The failed insurance conglomerate held countless billions of dollars in credit-default swaps, which are insurance contracts that protect bond holders from losses if a company defaults on its loans. It also holds vast amounts of real estate, which could have a depressing impact on property prices if the company’s new overseers decided to unload quickly.

Fed officials said on Tuesday that they did not plan to manage the A.I.G. holdings themselves. Instead, the Fed has a claim on just under 80 percent of the equity in A.I.G. as collateral to cover loans on which A.I.G. will have to pay a steep interest rate of about 12 percent.

Fed officials appear to be hoping that the high rate will encourage the company to pay off its loans as quickly as possible. But if the company’s new executive cannot fix its problems quickly, Fed officials might need to get more directly involved. That could make them tantamount to real estate investors and hedge fund managers at the same time.

Beyond its foray into corporate management with A.I.G., the Federal Reserve is becoming an increasingly important force in the market for risky debt securities.

Analysts say they believe that Lehman Brothers, the Wall Street firm that filed for bankruptcy on Monday, is borrowing tens of billions of dollars through the Fed’s six-month-old emergency loan program for big investment banks.

For months now, investment banks have shunned the Fed’s lending program because they feared being perceived as weak. But Mr. Crandall, of Wrightson ICAP, predicted that Lehman and other investment banks might have already tapped it for $50 billion since last weekend.

If they did, Fed officials will be holding collateral that is even riskier than what they already have.

from: http://www.nytimes.com/2008/09/18/business/18fed.html?ref=todayspaper

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By DAVE KANSAS
Wall Street Journal

The past few weeks have rattled financial markets around the globe and shaken investors deeply. Amidst all the turmoil, Congress passed a $700 billion bailout bill last week aimed at restoring confidence in the financial system.

The stock market has grabbed the headlines, but it is the reeling credit markets that will get the most government attention in its bailout efforts. Understanding the problems in the credit markets can help you get a better handle on what is driving the current financial crisis.

These vast markets include everything from the trading of 30-year Treasury bonds to investing in securities tied to auto loans. In essence, the credit markets act as a vital lubricant throughout the nation's economy, helping businesses to operate and families to purchase a home or pay for college. For instance, mortgages are often packed together and resold.

But lately, credit markets have been hobbled as fearful investors back away from trading.

Blow to the Economy

When the credit markets falter, the economic impact can be quite swift and severe. Some of the ill effects are already noticeable. Auto financing is less available, one reason car sales have dropped sharply. Approvals for home mortgages have gotten much tougher. Credit-card interest rates have jumped. Indeed, the recent credit problems, if not resolved quickly, could drive the economy into recession.

A big part of the problem is that an enormous amount of borrowed money flowed into the credit markets over the past several years. For a time, this borrowed money amplified the profits that banks, securities firms and other investors earned in, say, mortgage-backed securities.

But when those strategies went awry -- such as when mortgage delinquencies led many mortgage securities to tumble in value -- the borrowed money acted like kerosene on a burning building, amplifying problems to the downside.

Many financial companies found themselves with insufficient capital to absorb their losses. What has followed is a run of failures and a sharp erosion in confidence among credit-market participants.

Credit markets essentially run on confidence. Buyers of debt are lenders and they expect to get paid back, with interest. When companies fail and debts go unpaid, lenders get nervous. In usual circumstances, the lenders will simply charge higher rates and set tougher conditions for loans. But today, there's a huge wariness about lending anything at all.

Like an engine with no oil, the credit markets are seizing up.

Adding to the lack of confidence: Nobody knows how bad things could get or how much bad debt remains in the system. Much of the trouble is in the opaque "credit derivatives" markets. Credit derivatives are investments derived from other credit-market instruments, like securities backed by mortgages.

While that sounds straightforward, financial engineers came up with multifarious ways to slice, dice and package these derivatives. Now people are having trouble figuring out what these investments are actually worth. (Hint: much less than they thought.)

Impact on Individuals

For individuals, the credit markets matter on several levels. Many investors, especially those close to retirement or in retirement, hold credit investments, usually in the form of Treasurys, corporate bonds or bond mutual funds. Treasurys are considered extremely safe, while corporate bonds range from pretty safe to frighteningly risky. Many corporate takeovers during the past several years were funded with borrowed money in the form of "junk" bonds. These corporate bonds sport a high yield but also a high risk of default.

Beyond investments, credit markets are essential to the economy. For instance, banks use credit markets to fund their day-to-day activities. The rates banks charge one another to borrow money for short-term needs have risen sharply, an indication that banks don't trust one another.

That translates into less money available for banks to lend to individuals or businesses, putting a squeeze on economic activity.

The most widely used bank-to-bank lending rate, the London interbank offered rate (Libor), which has risen sharply, is also used to calculate interest rates on credit cards and many adjustable-rate mortgages. That's more bad news that consumers and homeowners don't need.

Commercial-Paper Crunch

In another nook of the credit markets, banks and businesses actively use "commercial paper" to fund day-to-day business activities. Commercial paper represents short-term loans, sometimes as short as a day, and money-market mutual funds invest in this paper. But the credit crunch has even forced this usually routine market into crisis.

Some blue-chip companies report difficulty selling commercial paper, which means finding more expensive alternatives to fund business operations. Also, money-market funds, which historically are very safe, have gotten caught up in the commercial-paper crunch, with at least one fund seeing its price fall below the $1-a-share money funds almost always maintain. The government recently introduced an insurance program to backstop money funds.

A big part of the government bailout effort is aimed at restoring confidence in the credit markets by creating a "buyer of last resort," especially for the toxic credit derivatives that have heavily damaged the financial sector. Until the credit markets rebound, pressure on the economy will mount.

from: http://online.wsj.com/article/SB122316380777805279.html

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By MARTIN CRUTSINGER
The Associated Press

WASHINGTON — Former Federal Reserve Chairman Alan Greenspan, describing the current financial crisis as a "once-in-a-century credit tsunami," acknowledged today that the crisis has exposed flaws in his thinking and in the workings of the free-market system.

Greenspan told the House Oversight Committee that his belief that banks would be more prudent in their lending practices because of the need to protect their stockholders had been proven wrong by the current crisis. He called this a "mistake" in his views and said he had been shocked by that.

Greenspan called this "a flaw in the model that I perceived is the critical functioning structure that defines how the world works."

The head of the nation's central bank for 18 ½ years, Greenspan said in his testimony to the committee that he and others who believed lending institutions would do a good job of protecting their shareholders are in a "state of shocked disbelief."

During questioning, Greenspan was challenged about various statements he had made during the five-year housing boom including forecasts that it was unlikely that there would be a nationwide collapse of home prices.

Greenspan said he had failed to predict a significant decline in home prices because the country had never experienced such a decline before.

Greenspan said the current crisis had "turned out to be much broader than anything that I could have imagined."

The committee called Greenspan to testify along with former Treasury Secretary John Snow and Securities and Exchange Commission Chairman Christopher Cox as lawmakers sought to discover if regulatory failings had contributed to the crisis.

House Oversight Committee Chairman Henry Waxman said he believed that the Federal Reserve, which regulates banks, the SEC and the Treasury had all played a role in contributing to the mistakes.

"The list of mistakes is long and the cost to taxpayers is staggering," Waxman, D-Calif., told the three men. "Our regulators became enablers rather than enforcers. Their trust in the wisdom of the markets was infinite. The mantra became that government regulation is wrong. The market is infallible."

In his testimony, Greenspan blamed the problems on heavy demand for securities backed by subprime mortgages by investors who did not worry that the boom in home prices might come to a crashing halt.

"Given the financial damage to date, I cannot see how we can avoid a significant rise in layoffs and unemployment," Greenspan said. "Fearful American households are attempting to adjust, as best they can, to a rapid contraction in credit availability, threats to retirement funds and increased job insecurity."

Greenspan said that a necessary condition for the crisis to end will be a stabilization in home prices, but he said that was not likely to occur for "many months in the future."

When home prices finally stabilize, Greenspan said, then "the market freeze should begin to measurably thaw and frightened investors will take tentative steps toward re-engagement with risk."

Greenspan said until that occurs, the government is correct to move forward aggressively with efforts to support the financial sector. He called the $700 billion rescue package passed by Congress on Oct. 10 "adequate to serve the need" and said that its impact was already being felt in markets.

Greenspan did not specifically address the criticism he is receiving now as being partly to blame for the current crisis.

Greenspan's critics charge that he left interest rates too low in the early part of this decade, spurring an unsustainable housing boom, while also refusing to exercise the Fed's powers to impose greater regulations on the issuance of new types of mortgages, including subprime loans. It was the collapse of these mortgages and rising defaults a year ago that triggered the current crisis.

In his testimony, Greenspan put the blame for the subprime collapse on overeager investors who did not properly take into account the threats that would be posed once home prices stopped surging upward.

"It was the failure to properly price such risky assets that precipitated the crisis," Greenspan said.

from: http://seattletimes.nwsource.com/html/businesstechnology/2008301970_webgreenspan23.html

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By EDMUND L. ANDREWS and STEPHEN LABATON
Published: February 10, 2009


WASHINGTON — The White House plan to rescue the nation’s financial system, announced on Tuesday by Timothy F. Geithner, the Treasury secretary, is far bigger than anyone predicted and envisions a far greater government role in markets and banks than at any time since the 1930s.

Administration officials committed to flood the financial system with as much as $2.5 trillion — $350 billion of that coming from the bailout fund and the rest from private investors and the Federal Reserve, making use of its ability to print money.

Mindful of previous financial crises at home and abroad that became protracted because governments moved too slowly, Mr. Geithner pointedly criticized the Bush administration for not acting boldly and quickly enough.

But the initial assessment of the plan from the markets, lawmakers and economists was brutally negative, in large part because they expected more details.

Basic questions about how the various parts of the program would work, especially those involving the unsellable mortgages that banks are holding and preventing home foreclosures, were left for another day. Some Wall Street experts criticized the plan for relying too heavily on the same vague solutions proposed by the Bush administration.

The stock market, propped up for weeks on the expectation that Washington would finally deliver a comprehensive rescue plan, dipped almost as soon as Mr. Geithner began speaking in the morning. The Dow Jones industrial average fell 382 points, or 4.6 percent, by the time the market closed. Yields on Treasury bills dropped, indicating a flight from stocks to the safety of government bonds. Asian markets slipped more narrowly.

While traveling in Fort Myers, Fla., President Obama welcomed the news that the Senate voted 61-37 to approve its $838 billion economic stimulus bill Tuesday, but dismissed the market reaction to his bank rescue plan.

“Wall Street, I think, is hoping for an easy out on this thing and there is no easy out,” Mr. Obama said in an interview with ABC News.

Many of the vital details of the program remain unsettled and are the subject of an intense behind-the-scenes debate.

The president himself had built up expectations that the plan would get ahead of the crisis — and not lurch from pillar to post as the Bush administration did last year, often in partnership with the New York Federal Reserve under its then-president, Mr. Geithner.

A central piece of the plan — and the one item that investors most craved information about — would create one or more so-called bad banks that would rely on taxpayer and private money to purchase and hold banks’ bad assets. But the administration provided the least amount of details about this part of the plan.

Another centerpiece of the plan would stretch the last $350 billion that the Treasury has for the bailout by relying on the Federal Reserve’s ability to create money, in effect, out of thin air. The Fed’s money will enable the government to become involved in the management of markets and banks in ways not seen since the Great Depression.

In the credit markets, for instance, the administration and the Fed are proposing to expand a lending program that would spend as much as $1 trillion to make up for the $1.2 trillion decline between 2006 and last year in the issuance of securities backed primarily by consumer loans.

The plan’s third major component would give banks new helpings of capital with which to lend. Banks that receive new government assistance will have to cut the salaries and perks of their executives and sharply limit dividends and corporate acquisitions.

They will also have to make public more information about their lending practices. A Treasury fact sheet said that banks would have to state monthly how many new loans they make, but stopped short of ordering banks to issue new loans or requiring them to account in detail for the federal money.

Mr. Obama, in the ABC News interview, suggested that banks would be required to reveal more about their mortgage holdings.

“Essentially what you’ve got are a set of banks that have not been as transparent as we need to be in terms of what their books look like. And we’re going to have to hold out the Band-Aid a little bit and go ahead and just be clear about some of the losses that have been made because until we do that, we’re not going to be able to attract private capital into the marketplace.”

The day was the first big test of Mr. Geithner as Treasury secretary, who has one of the toughest sells in America: convincing lawmakers and taxpayers that they should again bail out the very banks whose mistakes contributed to the loss of more than three million jobs and caused acute financial pain.

It was clear during the hours he spent before the cameras and lawmakers that he was well-spoken and thoughtful. But his career until now had played out behind the scenes as a civil servant and a central banker. He occasionally lapsed into financial jargon and struggled to connect to a broader public audience.

As the day wore on, Mr. Geithner faced growing skepticism from Democratic and Republican lawmakers, many of them channeling deep voter disgust with the way the government has handled the bailout over the last nine months.

Even Democrats who are supportive of the administration said that it had failed to provide more information about how it would be spending the remaining money in the bailout program.

“We need more details from Treasury on how exactly it plans to remove bad assets while protecting the taxpayer,” said Senator John Kerry, the Massachusetts Democrat who is a senior member of the Senate Finance Committee. “We have zombie banks that are weighed down because their liabilities exceed their assets. Without a precise mechanism for addressing toxic assets, it will be difficult to increase lending.”

The pessimism seemed to indicate that Mr. Geithner missed the mark with one of his shorter-term goals — to quickly instill confidence that the Obama administration has a coherent approach to the banking crisis and that the transparency and oversight of the new program will differ markedly from the Bush administration’s management of the first $350 billion that Congress authorized last year for the Troubled Asset Relief Program, or TARP.

“The spectacle of huge amounts of taxpayer money being provided to the same institutions that helped cause the crisis, with limited transparency and oversight, added to the public distrust,” the Treasury secretary said, in a clear swipe at the Bush administration.

“We will have to try things we’ve never tried before. We will make mistakes. We will go through periods in which things get worse and progress is uneven or interrupted,” Mr. Geithner said.

Representative Barney Frank, the Massachusetts Democrat who heads the House Financial Services Committee, criticized the Obama administration for not putting out more details and said it should commit more than $50 billion to avert home foreclosures.

“The secretary said the administration would present details of their foreclosure reduction plan in a few weeks, which is too much time,” Mr. Frank said.

Appearing on Tuesday afternoon before the Senate banking committee, Mr. Geithner vowed to move quickly to provide more details. But Republicans were skeptical.

“Is there a concrete plan here?” Richard Shelby of Alabama, the senior Republican on the committee, asked Mr. Geithner point blank, after noting that Mr. Geithner had been part of the leadership involved in last year’s bailout efforts. “What is different about the process that you are offering here to devise your plan such that we should have confidence that it is well thought out?”

There was also withering criticism from Wall Street. Ethan Harris, co-head of United States economics research at Barclays Capital, said the program was “shock and uh.” He said the Treasury made a “tactical mistake” by building up expectations about a plan before it had much to announce.

“What’s striking is that these are not new issues that they are facing,” Mr. Harris said. “These are the same issues that the Treasury faced last fall — how do we price the assets? The fact that it’s so been so difficult to figure out the answer may tell you something about whether it’s worth doing or not.”

Mr. Harris warned that setting up a so-called bad bank would be very expensive, as Mr. Geithner himself acknowledged when he set the goal of creating a fund that would reach $1 trillion. Frank Pallotta, a former managing director at Morgan Stanley and a veteran mortgage trader, said the gap was so wide between what banks were valuing their assets and what investors were willing to pay that the government would attract investors to buy only if it provided a subsidy of one form or another.

“Right now, the banks aren’t selling anything,” said Mr. Pallotta, now a consultant to both buyers and sellers of distressed mortgages. “You have Chase thinking that its assets are worth 75 cents on the dollar, and Joe Hedge Fund who thinks they are only worth 45 or 25. There is a huge gap, and the government has to find out if there is some middle point where they can get in.”

Mr. Pallotta said he did not fault the Treasury for failing to offer specifics yet, but he said it could not delay for long. “If we don’t hear in the next 30 days about how this thing will flesh out, then I would be upset.”

from: http://www.nytimes.com/2009/02/11/business/economy/11bailout.html?pagewanted=2&_r=1&ref=todayspaper