When the Federal Reserve announces that it’s going to lower interest rates, most of of us think we have some idea of what that means. When it announces, as it did this morning, a $200 billion “expansion of its securities lending program,” the meaning is a lot muddier–although Wall Street certainly took it as a big positive.
In both cases, the Fed is ordering Bill Dudley, the former Goldman Sachs chief U.S. economist who now runs the open market desk at the Federal Reserve Bank of New York, to get busy. In the Fed’s normal open market operations, it for the most part buys and sells Treasury securities in an effort to manipulate the rate for overnight loans between banks (and it’s actually even more likely to repurchase agreements and reverse repos than outright purchases and sales, but let’s not even get into that). The Fed can create cash at will, so when it buys Treasuries it is injecting new money into the financial system.
What happened last fall, around the end of last year, and again in the past week or so, is that banks suddenly became unwilling to lend to each other at the rates that the Fed has targeted with these open market operations. Big gaps have opened up between the Federal Funds Rate in New York and the London Interbank Offered Rate that global financial institutions actually charge each other. The reason is that bankers are dubious of the quality of the assets on their competitors’ books. They don’t want to lend against bad collateral.
In response, the Fed, and other central banks around the world, have been stepping in with increasingly bold interventions in which they put up cash or T-bills in exchange for securities of somewhat dodgier provenance. In the latest such move, as described in this morning’s press release,
the Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS.
The federal agencies they’re talking about are mainly Fannie Mae and Freddie Mac, the big government-created, shareholder-owned buyers of mortgages. In the past week markets suddenly turned leery of Fannie’s and Freddie’s debt, driving up mortgage rates in the process. Yves Smith–correctly, I think–describes today’s Fed action as coming “as close as one can without an act of Congress to affirming the implicit Federal guarantee of Freddie Mac and Fannie Mae debt.”
My own thinking is that this isn’t such a bad thing, and that maybe we just need to make the Freddie/Fannie guarantee explicit in exchange for some increased level of regulatory oversight (although maybe it’s delusional to think that regulatory oversight of two such powerful entities is ever really gonna work).
What about those AAA/Aaa rated private-label mortgage securities, though? Markets are entirely right to have turned dubious of them. The Fed is essentially agreeing to put up quality (Treasuries) in exchange for what might be junk. It’s doing this quite consciously, because it’s afraid the alternative will be frozen financial markets. But there are potential consequences, which economist James Hamilton outlined nicely when the Fed unveiled the first version of its securities lending program (the Term Auction Facility) in December:
By agreeing to hold some of the problematic securities, the Fed is essentially offering to absorb some of that risk.
One might argue that in the best (and perhaps most likely) case, the Fed will suffer no loss, and possibly through its actions avert a very nasty cycle of bankruptcies and defaults. In the worst case, those defaults will come anyway, with the Fed absorbing some of the losses along with everybody else. But the way that the Fed would absorb these losses is by being forced to create more money. And, the argument might continue, if we had a financial crisis of the magnitude that produced a loss on the offered collateral, we’d be in a situation with a serious risk of deflation, precisely the circumstances in which we’d want some extra money creation. Win-win.
Or so the thinking may go. But I hope that Bernanke has also pondered the following–What would happen to foreign exchange markets and foreign demand for U.S. assets under the second happy scenario? There certainly is plenty of historical precedent for financial crises you can’t inflate your way out of–southeast Asia in 1997 comes to mind as one recent example.
I don’t know quite how an Asia-1997 scenario would come into play: One of the big issues then was that companies in Southeast Asia had borrowed billions of dollars that they couldn’t repay when local currencies crashed against the dollar–which doesn’t apply in the U.S. today. But it’s certainly the case that there are risks to this course of action that none of us, including Ben Bernanke, fully understands. He and his Fed colleagues simply see the risk of inaction as even greater, and they’re probably right about that.