Federal Reserve & Interest Rates

During a speech at the Chamber of Commerce in Austin, Texas, Federal Reserve Chairman Ben Bernanke discusses monetary policy moves during the financial crisis.  While the Fed has promoted monetary easing for over a year now, the financial crisis intensified in the wake of the Lehman Brothers collapse.

In the absence of an appropriate, comprehensive legal or regulatory framework, the Federal Reserve and the Treasury dealt with the cases of Bear Stearns and AIG using the tools available. To avoid the failure of Bear Stearns, we facilitated the purchase of Bear Stearns by JPMorgan Chase by means of a Federal Reserve loan, backed by assets of Bear Stearns and a partial guarantee from JPMorgan.

In the case of AIG, we judged that emergency Federal Reserve credit would be adequately secured by AIG’s assets. However, neither route proved feasible in the case of the investment bank Lehman Brothers. No buyer for the firm was forthcoming, and the available collateral fell well short of the amount needed to secure a Federal Reserve loan sufficient to pay off the firm’s counterparties and continue operations. The firm’s failure was thus unavoidable, given the legal constraints, and the Federal Reserve and the Treasury had no choice but to try instead to mitigate the fallout from that event.

Unfortunately the fallout from the Lehman collapse has been significant,  Congress had to approve a $700 financial rescue package in order to stabilize a banking system that had completely locked up.  Even that wasn’t enough to prevent the largest bank in the world at one time, Citigroup from needing emergency funding to prevent bankruptcy.

There are still many trouble financial institutions out there that are in danger of collapse, losses from the housing correction are continuing to pile up, with writedowns approaching the $1 trillion mark.  The government has spent unprecedented amounts of money trying to slow down this train wreck waiting to happen.

With interest rates already at 1%, there is not much more the Fed can lower it and many are expecting them to cut the fed funds rate to .5% this month.  The big problems are the wide interest rate spreads which cause inefficiencies in the banking system.

The Fed has been forced to pump liquidity into the system by greatly expanding it’s balance sheet.  They are basically providing a market for securitization, where one doesn’t exist anymore.  It has been somewhat successful recently as mortgage rates have fallen somewhat after the Fed purchased securities from  the two GSEs, Fannie and Freddie.

It’s next move looks to be to purchase Treasury Securities on the open market to bring down yields even further.  However, until spreads start to shrink, it will limit whatever actions the Fed decides to take next.

At one time the largest bank in the world by market value, Ciitgroup saw it’s stock plunge over 60% last week and was in danger of collapse before the Federal Reserve intervened on Sunday.  To put it in perspective, Citigorup’s maket value had fallen to below $21 billion on Friday, which is less than what JP Morgan paid to purchase Bear Stearns back in April, at the same time it has over $2 trillion in assets making it twice as large as AIG. 

As part of the agreement, Treasury and the Federal Deposit Insurance Corporation will provide protection against the possibility of unusually large losses on an asset pool of approximately $306 billion of loans and securities backed by residential and commercial real estate and other such assets, which will remain on Citigroup’s balance sheet. As a fee for this arrangement, Citigroup will issue preferred shares to the Treasury and FDIC. In addition and if necessary, the Federal Reserve stands ready to backstop residual risk in the asset pool through a non-recourse loan.

In order to prevent an even worse occurence of what happened to markets after Lehman Brothers collapse, the Fed agreed to take on the risk of 90% of their debt.  An additional $20 billion from TARP funds will also be used to increase the governments investment in the bank to over 7%.

When considering companies in the ”too big” to fail category, Citigroup was the biggest in the banking system.  The Fed had no choice but to step in and in doing so, it opens the taxpayers up to even more liability.

They won’t be the last bank to need assistance either, while they were the biggest, there are hundreds of banks on the FDIC’s troubled banks list.  I think people are finally beginning to realize how colosally expensive this whole mess is going to become in the end.

The Fed’s will likely lower rates to at least 0.5% after it’s next meeting but will that be enough to restore confidence to credit markets?  And now it looks as if Congress is beginning to question the Fed’s actions in accumulating risk to the taxpayer. 

The Fed has already pledged trillions in liquidity to the banking system but no matter what they do, holes keep springing up.  As things stand now, it appears as if the Fed has no real control over the situation and are left to react as best they can.

Fed chairman Ben Bernanke will have a familiar face to work with when the next administration takes office.  President-elect Barack Obama announced earlier today that the President of the New York Fed, Timothy Geithner, will replace Henry Paulson as the next Secretary of the Treasury.

The selection of Geithner was met with approval on Wall Street as stocks rallied initially before retreating once again at the close of the session.  Since Geithner is already involved with dealing with the current financial mess,  it should make for a much smoother transition than if an outsider was chosen.

Along with dictating how to spend the second half of the $700 rescue package, he will have to work closely with Bernanke in correcting what looks to be a long economic downturn.  We can also expect a flurry of  fiscal policy moves at the turn of the year and it looks as if a new stimulus package will be first on the agenda.   

He will also be responsible for the leading the charge to revamp the regulatory structure of the financial service industry.  It will also be interesting to see how the relationship between government and business continues to develop. 

With the government having an increasing say in how businesses are being run, one wonders if they will go back to the hands off approach once the financial storm passes.  The growing problem of the national debt will also be a major concern as this years record budget deficit may only be the beginning of more to come.

All in all, I don’t think Paulson will mind too much when he relinquishes his mantle in just over a month.