Thursday, November 27, 2008

Is the Fed's $800 Billion Plan Cause for Concern?

Is the Feds $800 Billion Plan Cause for Concern?

While all eyes are on Treasury Secretary Henry Paulson and his $700 billion bailout plan, Federal Reserve Chairman Ben Bernanke is conducting his own economic recovery program—and his is measured in trillions, not billions. What's more, unlike Paulson, Bernanke doesn't have to check with Congress before shoveling out the money. On Nov. 25 the Federal Reserve announced another buying-and-lending program that will probably boost the central bank's assets (such as loans to financial institutions) to around $3 trillion. That's triple the level in mid-September, when the Fed began its expansionary campaign.

The Fed is trying to kill two birds with one very large stone, namely a drastic expansion of its balance sheet. One of its twin objectives is to get more money circulating in the economy. The other is to prop up weak financial institutions to avoid a cascade of failures. If the Fed succeeds it will appear both brilliant and efficient. The risk is that by trying to accomplish too much, the central bank will fall short of one or both of its objectives.

It's easy to get lost in the blizzard of details. Since the credit crisis began in August 2007, the Federal Reserve has taken 51 measures to fix the financial system, not including its conventional tool of cutting the federal funds rate, according to a count by UBS (UBS).

But the big picture is simple. The credit crunch is so severe that the Fed has been forced to go beyond its peacetime role of guiding the economy by steering short-term interest rates. With banks weakened and afraid to lend, it is making or guaranteeing loans to particular institutions and in some cases outright buying assets. On Nov. 25 the Fed waded deeper than ever into a kind of monetary industrial policy. It announced it would directly buy $500 billion worth of mortgage-backed securities backed by Fannie Mae (FNM), Freddie Mac (FRE), and Ginnie Mae, as well as $100 billion of the corporate debt of Fannie, Freddie, and the Federal Home Loan Banks.

Warnings of Risk

Meanwhile, the Federal Reserve Bank of New York will lend up to $200 billion to holders of highly rated securities backed by auto, student, and small business loans and credit-card receivables. All of those loans and purchases will show up as assets of the Federal Reserve System, which have already shot up to about $2.2 trillion from $1 trillion in September.

What could go wrong? Fed watcher James D. Hamilton, an economist at the University of California at San Diego, warns that the Fed is buying, or accepting as loan collateral, assets that no one else wants. The danger of this approach, he says, will become clear when the economy starts to strengthen. At that point the Fed will need to drain away lots of excess money in the financial system. Ordinarily it does that by selling securities on its balance sheet and calling in loans. But it won't be able to do that if the assets are so toxic that no one wants them or dumping them would destabilize weak institutions. "It's tricker because the Fed has exposed itself to risks," says Hamilton.

But Columbia University economist Frederic Mishkin, who stepped down as a Fed governor in August, says Fannie and Freddie debt should be easy to sell, while the loans to holders of asset-backed securities are temporary by design. Plus, says Mishkin, the Fed has to act boldly: "This shock is in many ways more complex and harder to deal with than the financial shock that occurred during the Great Depression."

  • The Bailout: What Does Paulson Do Now?
  • Paulson’s $250 Billion Bank Buy
  • Citigroup’s Uneasy Victory
  • 1 comment:

    Mberenis said...

    Most people don't realize how much money there is out there. During economic times like this, there is more money to be had than ever. Because of the bailouts and economy, lenders are bending over backwards to bail you out too. Believe it or not, there is people getting tons of cheap money nowdays to start businesses, buy homes, pay off debt, and more. Bailout is for you too!