It has been recognized for well over a century that the central bank must intervene as \u201clender of last resort\u201d in a crisis. In the 1870s Walter Bagehot explained this as a policy of stopping a run on banks by lending without limit, against good collateral, at a penalty interest rate. This would allow the banks to cover withdrawals so the run would stop.<\/p>\n
Once deposit insurance was added to the assurance of emergency lending, runs on demand deposits virtually disappeared. However, banks have increasingly financed their positions in assets by issuing a combination of uninsured deposits plus very short-term nondeposit liabilities (such as commercial paper). Hence, the GFC actually began as a run on these nondeposit liabilities, which were largely held by other financial institutions.<\/p>\n
And here is where the issue gets complicated. As I argued in a previous blog post<\/a>, banks and other institutions relied largely on \u201crolling over\u201d short-term liabilities (often, overnight). But when reports about the quality of bank assets began to surface as subprime mortgage delinquencies rose, financial institutions began to worry about the solvency of the issuers of the liabilities. As markets came to recognize what had been going on in the securitization market for the past half-decade, \u201cliquidity\u201d dried up\u2014no one wanted to hold uninsured liabilities of financial institutions.<\/p>\n In truth, it was not simply a liquidity crisis but rather a solvency crisis brought on by all the risky and fraudulent practices.<\/p>\n Not only did all \u201cfinance\u201d disappear, but there was also no market for the trashy assets\u2014so there was no way that banks could sell assets to cover \u201cwithdrawals\u201d (again, these were not normal withdrawals by depositors but rather a demand by creditors to be paid). As markets turned against one institution after another, financial institution stock prices collapsed, margin calls were made, and credit ratings agencies downgraded securities and other assets. The big banks began to fail.<\/p>\n Government response to a failing, insolvent, bank is supposed to be much different than its response to a liquidity crisis. It has always been the standard view\u2014dating all the way back to Bagehot\u2014that lender of last resort does not apply to an insolvent institution. Indeed, since 1991 the Fed has been prohibited from lending to \u201ccritically undercapitalized\u201d institutions without first obtaining explicit prior approval of the Secretary of the Treasury. And no matter what the Fed officials or the banksters claim, the big banks were \u201ccritically undercapitalized\u201d, and the Fed did lend to insolvent banks\u2014against the 1991 statute that was enacted precisely to prevent the Fed from avoiding the fiscal discipline of congressional appropriations. (Walker Todd 1997) I\u2019ll have more to say about that in a later blog. But let\u2019s turn to other problems with the bailout.<\/em><\/strong><\/p>\n In addition to injecting capital into troubled institutions, the Treasury conducted a \u201cstress test\u201d that would supposedly find institutions likely to fail. However, these tests set thresholds that were far too lax to identify profoundly troubled institutions. When an institution did face failure, the Treasury and the Fed\u2014usually represented by the New York Federal Reserve Bank\u2014would try to merge the failing institution into another, with Timothy Geithner reprising the Monty Hall role in his own version of \u201cLet\u2019s Make a Deal.\u201d<\/em><\/strong><\/p>\n Often it would be necessary for the Fed to lend to the failing institution for some period while the deal was negotiated (as discussed below, that lending, itself, might violate statutes). In addition, the Fed created a number of special facilities to provide funding for institutions and also to take troubled assets off their books. By purchasing bad assets, the Fed could conceivably turn a failing bank into a solvent bank. It was important to the Fed and Treasury to avoid closing and resolving an institution\u2014that would admit failure and would lead to claims on the FDIC. Since the FDIC\u2019s reserves were far too small to deal with systemic failure, it would have to go to Congress for funds. The Fed and Treasury were deathly afraid of that\u2014recall how Congress treated Hank Paulson when he went with hat-in-hand to ask for money for banksters!<\/p>\n It must be emphasized that the US Treasury and indeed the economic team of the Administration of President Obama was heavily represented by individuals with experience in investment banking. In an interesting article by Davidoff and Zaring (2009), it is argued that the \u201cbail-out\u201d can be characterized as \u201cdeal-making through contracts\u201d as the Treasury and Fed stretched the boundaries of law with behind-closed-doors hard-headed negotiations.<\/p>\n It appears that the government did negotiate with a view to keeping its own risk exposure limited; at the same time, it insisted on large \u201chaircuts\u201d to stockholders\u2019 equity but minimal losses to bondholders. It also avoided penalties on bank directors and officers\u2014rarely investigating possible fraud or dereliction of duty. Finally, it avoided \u201cmarket solutions\u201d in favor of \u201corderly solutions.\u201d In other words, where markets would shut down an insolvent financial institution the government would instead find a way to keep the institution operating by merger.<\/p>\n The one major exception was Lehman Brothers, as the government allowed the investment bank to fail. Davidoff and Zaring attribute this to an attempt to demonstrate government\u2019s willingness to negotiate tough terms. (Sort of what Germany is doing to Greece now: it is going to let Greece fail and kick it out of the EMU in order to show Spain and Italy its resolve in negotiations.)<\/p>\n Further, government relied on the two institutions that are least constrained by the law: the Fed and the Treasury. Throughout the crisis, the government would stretch and flex its authority in its \u201cmake a deal\u201d approach but would not boldly<\/em> violate the law. Davidoff and Zaring (2009) argue that the federal government was allowed substantial leeway in its interpretation as state courts were not likely to interfere. Further, the Fed has in the past interpreted its activities as exempt from \u201csunshine\u201d laws.<\/p>\n In many ways, this \u201cdeal-making\u201d approach that was favored over a resolution by \u201cauthority\u201d approach is troubling from the perspectives of transparency and accountability as well for creation of \u201cmoral hazard\u201d.<\/p>\n The other aspect of the bail-out that is troubling was the unprecedented assistance provided through the Fed\u2019s special facilities created to make loans as well as to purchase troubled assets (and to lend to institutions and even individuals that would purchase troubled assets). To be sure, in a crisis the central bank must act as a lender of last resort. But the Fed\u2019s actions went far beyond \u201cnormal\u201d lending.<\/p>\n First, as discussed, it is probable that the biggest recipients of funds were insolvent. We cannot be sure of this because the Treasury\u2019s \u201cstress tests\u201d were wimpy; and while the FDIC is responsible for declaring depository institutions insolvent, it had a strong incentive to avoid doing so: as discussed, its reserves were far too small and it could not risk going to a skeptical Congress to ask for more funding.<\/p>\n Second, the Fed provided funding for financial institutions (and to financial markets in an attempt to support particular financial instruments) that went far beyond the member banks that it is supposed to support. It had to make use of special sections of the Federal Reserve Act, some of which had not been used since the Great Depression. And as in the case of the deal-making, the Fed appears to have stretched its interpretation of those sections beyond the boundaries of the law.<\/p>\n We will not go through all of the facilities nor deeply into an examination of the sections invoked to justify the interventions. Note it would not be accurate to call every intervention by the Fed a \u201cbail-out\u201d. Lending reserves by the Fed to solvent banks that are short of \u201cliquidity\u201d (reserves needed to meet withdrawals or clearing against other banks) is expected to increase sharply in a crisis. Further, the Fed decided to engage in massive \u201cquantitative easing\u201d that saw its balance sheet grow from well under $1 trillion before the crisis to nearly $3 trillion; bank reserves increase by a similar amount as the Fed\u2019s balance sheet grows. Such actions do not necessarily indicate a \u201cbail-out\u201d as they could be consistent with \u201cliquidity provision\u201d to solvent banks.<\/p>\n Still, QE included asset purchases by the Fed that went well beyond treasuries\u2014the usual asset bought by the Fed when it wants to inject reserves into banks. The Fed bought a lot of mortgage-backed securities in its QE, and while some of these were backed by Fannie and Freddie (hence, ultimately were government liabilities) the Fed also bought \u201cprivate label\u201d MBSs (not government backed). To the extent the Fed paid more than market price to buy \u201ctrashy\u201d assets from financial institutions that could be construed to be a \u201cbail-out\u201d.<\/p>\n In any case, the Fed\u2019s actions went far beyond even this\u2014to include highly unusual actions that are reasonably characterized as a \u201cbail-out\u201d of institutions that were probably insolvent. And the volume of such intervention is truly unprecedented. We have already covered that ground, in my reports of the findings of Andy Felkerson and Nicola Matthews (Felkerson 2011). So I will not repeat the discussion of our estimate that the Fed lent and spent (in asset purchases) over $29 trillion cumulatively<\/em>. Instead we will focus on the most troubling facilities included in that overall number.<\/p>\n However, before proceeding note that for comparison, after the \u201cGreat Crash\u201d of 1929, the Fed lent to 123 institutions a total of $23 million in today\u2019s dollars between 1932-36. You would need to add six zeroes to the Fed\u2019s response to the Great Crash to get close to its response to the GFC! The word \u201cunprecedented\u201d really does not adequately describe the Fed\u2019s intervention to rescue financial institutions. In the beginning of 2008 the Fed\u2019s balance sheet was $926 billion, of which 80% of its assets were US Treasury bonds; in November 2010 its balance sheet had reached $2.3 trillion, of which almost half of its assets were MBSs. Over the next year it ramped-up its purchases of treasuries (and reduced its use of the special facilities) so that its balance sheet was close to $3 trillion\u2014three times larger than it was on the eve of the crisis.<\/p>\n And still there is no end in sight.<\/p>\n Let\u2019s get back to its special facilities, many of which used \u201cspecial purpose vehicles\u201d created to buy assets or to make loans. Note the irony: \u00a0the creation of SPVs by banks had played a big role in causing the GFC\u2013banks created SPVs to move risky assets off their balance sheets so that they would not need to hold capital, and so that government regulators and supervisors would not see them. This allowed them to take on much more risk and more leverage in an effort to increase profits. In an ironic twist the Fed followed the example set by banks as it created SPVs to subvert constraints written into the Federal Reserve Act.<\/p>\n As discussed above, there is no problem with Fed lending to member banks to stop a run. It is a bit more problematic to lend to insolvent<\/em> member bank. But in \u201cunusual and exigent\u201d circumstances, the Fed is free to go much farther under Section 13(3) of the Federal Reserve Act, although as Mehra (2009) explains, the bar is still high. It can lend to individuals, partnerships and corporations at a discount if they are unable to secure adequate credit from other banks. Further it must lend against indorsed or secured assets.<\/p>\n But here\u2019s the problem with the Fed\u2019s invocation of this section during its bail-out of Wall Street: it created SPVs and then lent to them so that they could buy troubled assets. In other words it financed the purchase of an asset, rather than making a loan. In most cases its loan was to its own SPV, and not to the party that needed assistance. In some cases the loans were not technically \u201cdiscounts\u201d and were not against endorsed assets (the SPVs owned no assets until they got the loans so they could buy them); and in most cases the beneficiaries could have obtained loans from other banks, albeit at higher interest rates. In all these respects, the law was \u201cstretched\u201d if not subverted. In all those respects this looks like \u201cbail-out\u201d and not \u201cliquidity provision\u201d.<\/p>\n And the volume of Fed assistance of questionable legality was very large. If we take the four SPVs that were created to get around the 13(3) restrictions, they accounted for a cumulative total lending of almost $2 trillion of the $29 trillion. In addition the Fed made a lot of loans that were not \u201cdiscounts\u201d (ie, \u00a0lending against equities is not permitted by 13(3)) or that were not to troubled parties that needed the assistance (for example, TALF, Term Asset-Backed Securities Loan Facility, and AMLF, Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility lent to buyers of troubled assets). The total of inappropriate loans was over $9 trillion.<\/p>\n Hence, it looks like at least $11 trillion of cumulative lending that had been justified by section 13(3) probably did not meet the restrictions. That\u2019s more than a third of the total funds spent or lent by the Fed to rescue the financial sector. And most of the funds went to the biggest banks (as I\u2019ll show in a later blog).<\/p>\n There is little doubt that the GFC posed \u201cunusual and exigent\u201d circumstances that had to be met with a huge response by the Fed (and Treasury). It is not clear, however, that the response actually mounted was legal. It was certainly not transparent. It has left us with a highly troubled financial sector, dominated by even bigger too-big-to-fail institutions. It has created massive moral hazard. And those responsible\u2014including our public stewards\u2014have not been held accountable.<\/p>\n References<\/strong>:<\/p>\n Regulation by Deal: The Government\u2019s Response to the Financial Crisis BY Steven M. Davidoff David Zaring Reprinted from Administrative Law Review Volume 61, Number 3, Summer 2009.<\/p>\n Alexander Mehra, \u201cLegal Authority in Unusual and Exigent Circumstances: The Federal Reserve and the Financial Crisis\u201d, University of Pennsylvania Journal of Business Law<\/em>, Vol 13, 3\/2\/2011, (updated after publication) http:\/\/ssrn.com\/abstract=1821002<\/a><\/p>\n James Felkerson, \u201c29,000,000,000: A Detailed Look at the Fed\u2019s Bailout by Funding Facility and Recipient\u201d, Levy Economics Institute of Bard College, Working Paper No. 698<\/a>, December 2011.<\/p>\n Walker Todd, \u201cCentral banking in a democracy: The problem of the lender of last resort\u201d, for Western Economic Association International Annual Meeting, July 11, 1997.<\/p>\n