The Fed's Risky Backdoor Bailouts

The U.S. Treasury Dept. has been blasted for handing out huge sums of money to banks without clear taxpayer safeguards or ground rules for the recipients. Yet the Federal Reserve is pouring trillions into banks with little transparency. The moves have helped to shore up the wobbly financial system in the short term. But some of the deals could end up hurting taxpayers, weakening the central bank, and weighing on the economy in the future.

In one of its latest transactions, the Fed in November channeled $20 billion—more than the size of the proposed auto bailout—to a group of U.S. and European banks, including Socit (SCGLY), Deutsche Bank (DB), and Goldman Sachs (GS), according to people familiar with the deals. The only evidence that the vast sum had changed hands was an entry on the Fed's most recent balance sheet called "Maiden Lane III" and a series of cryptic regulatory documents.

By making loans to financial institutions that can't get credit elsewhere, the Fed is the only part of the government that has the power to pump capital quickly into the financial system to stave off crisis. Historically such moves have been rare, and they've been made behind a curtain of secrecy on the thinking that public disclosure could spark a market panic. "We keep these transactions private because the Fed, as a lender of last resort, seeks to provide liquidity and not stigmatize those who seek it," says Calvin Mitchell, a spokesman for the New York branch of the Fed, which set up the Maiden Lane III transaction.

The banks likely welcomed the fresh capital from Maiden Lane III. But in recent months the Fed has pushed the boundaries of its authority by taking larger and more opaque risks on its books. The central bank currently has $2.2 trillion in outstanding loans, up from $900 billion in September. It's also using new and untested weapons. Until this year the Fed mainly loaned to banks. Now it's buying securities, some tied to poisonous mortgages. If those bets don't pay off, the Fed will eat the loss.

dangers lurk

That could spell trouble for taxpayers—and the economy. If the Fed's new deals don't work out and the losses are too great, the central bank may have to print more money, flooding the financial system with dollars. Inflation could surge, making it harder for the Fed to focus on other objectives, such as economic growth. "We have to wonder if the Fed's balance sheet might be in danger," says Roy C. Smith, a finance professor at New York University's Stern School of Business. "It is legitimate to ask the Fed to defend [its actions]."

There are growing calls for more accountability of the government's far-flung bailout efforts. The Congressional Oversight Panel, which monitors how Treasury spends its $700 billion bailout pool, is closely watching the Fed's moves as well. Elizabeth Warren, the independent chair of the panel and a Harvard Law School professor, says that's because the Treasury's actions dovetail with those of the Fed. Warren recently met with Fed staff to discuss how the central bank spends taxpayer money. As part of the ongoing inquiry she is also looking at Treasury money that indirectly funded the Maiden Lane III deal. "There were good reasons the Fed was made independent of oversight," says Warren. But "these are not ordinary times, and the amount of money and intervention by the Fed is extraordinary."

The roots of Maiden Lane III can be traced to the Fed's rescue of troubled insurer American International Group (AIG) in September. With AIG on the brink of collapse, the Fed and Treasury stepped in to prevent a meltdown of the financial system.

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