Federal Reserve & Interest Rates

The government is hoping that the $250 billion it has earmarked to re-capitalize the banking system will be enough to jump start lending once again.  However the landscape of the banking system far different then it was when this all began.

Leveraged finance saw the explosion of credit in the past two decades, where that $250 billion could have easily become over $5 trillion in credit, if not more.  It would not have been surprising for many financial institutions to have leverage ratios of over 20.

During good economic climates this maximized profit potential but during the current financial collapse the opposite is now true.  Now institution are frantically trying to de-leverage themselves from more potential losses over and above what they have already lost.

Structured finance and the selling of collateralized debt took the credit market to new levels but with the failure of that financial model, there is serious doubts on how quickly banks will start lending again.  Nothing has really changed in the past six months, banks will still want to hoard capital and just because it’s from the government doesn’t change that fact.

The FDIC’s troubled banks list is enormous and more than likely any capital received from the Treasury will be used to stave off collapse.  Until they get their balance sheets in some kind of order, lending and the extension of credit will not be their primary concern.

We could quickly see the government’s involvement grow even further, as some analysts feel that the $250 billion which has been allocated to the banking system so far, is no where near enough what is enough to restart lending.  With another stimulus package in the works, how high will the government’s price tag eventually become.

Federal Reserve Chairman, Ben Bernanke gave a speech earlier today at the Economic Club of New York where he discusses the current financial meltdown gripping the global economy.

The crisis we face in the financial markets has many novel aspects, largely arising from the complexity and sophistication of today’s financial institutions and instruments and the remarkable degree of global financial integration that allows financial shocks to be transmitted around the world at the speed of light.

Large inflows of capital into the United States and other countries stimulated a reaching for yield, an underpricing of risk, excessive leverage, and the development of complex and opaque financial instruments that seemed to work well during the credit boom but have been shown to be fragile under stress. The unwinding of these developments, including a sharp deleveraging and a headlong retreat from credit risk, led to highly strained conditions in financial markets and a tightening of credit that has hamstrung economic growth.

The root cause of our current economic dilemma has been the end of the housing boom and the subprime meltdown that followed.  Bernanke discusses how in the future, monetary policy can play a role in restricting the creation of asset bubbles and their subsequent effects when they burst.

He also touches on the why AIG was given government assistance while Lehman Brothers was not, AIG had the assets and collateral so that the likelihood of taxpayer liability was minimal, which was not the case with Lehman.  Even then AIG is responsible for a heavy burden in the high interest rate it must pay in order to secure that government loan.

As it should be, much of the liability in the case of AIG is in the hands of the shareholders as was the case with Fannie Mae and Freddie Mac when the government took control of those institutions.  It is probable that AIG will have to be broken up in order to repay the Fed loan but that might not be a bad thing in the long run.

We can expect to see increased regulatory oversight from the Fed as well as the Treasury in the future which will be a far cry from the two decades of deregulation that the financial system has experienced beginning in the 1980’s.  A major problem currently plaguing the economy is that companies have gotten too large and complex, when a company enters the category of “too big” to fail, they have the potential of creating large shocks to the financial system if and when they begin to disintegrate.

Large companies can hold a financial system hostage as was the case when Lehman declared bankruptcy.  Stock markets around the world have been feeling the shocks from that event, from which they have yet to recover.

The Federal Reserve along with the leading central banks of the world announced plans to add liquidity to dollar markets around the globe.  Another key initiative is the plan to re-capitalize the global banking system in exchange for ownership stakes in the financial institutions.

The BoE, ECB, and SNB will conduct tenders of U.S. dollar funding at 7-day, 28-day, and 84-day maturities at fixed interest rates for full allotment. Funds will be provided at a fixed interest rate, set in advance of each operation. Counterparties in these operations will be able to borrow any amount they wish against the appropriate collateral in each jurisdiction. Accordingly, sizes of the reciprocal currency arrangements (swap lines) between the Federal Reserve and the BoE, the ECB, and the SNB will be increased to accommodate whatever quantity of U.S. dollar funding is demanded. The Bank of Japan will be considering the introduction of similar measures. 

The partial nationalization of the world’s banking system may be the step that finally instills confidence in a system that has been without it for a number of months.  Sadly it seems that only governments actually have enough monetary resources to steer the world clear of the looming financial disaster.

The Treasury has announced that about $250 billion of the $700 billion bailout package will be invested to the nation’s banks and will provide cash injection in exchange for equity.  Last week the Bank of England announced a similar move to nationalize it’s banking system and other central banks are quickly following suit.

This will hopefully restart lending worldwide and unfreeze the credit system that has been locked up for months.  Stock markets around the world have already shown their approval with record rallies but it big question is will it last this time.

For too long the nation’s financial system has been irresponsible with it massive risk taking but whether or not things will change now that the government is involved remains to be seen.  Ironically it is the current lack of risk taking that has caused the current credit crisis with the banking system hoarding capital and unwilling to lend to even people with good credit.