The Stealth Bailout

Over the last three months, the balance sheet of the Federal Reserve has exploded. While Congress debated the $700 billion TARP and later the $35 billion request from the auto companies, the Fed has quietly lent, directly and indirectly, over $1.3 trillion to banks, firms, money market funds, and foreign central banks. This is real money. The increase in the balance sheet is over 10 percent of GDP. To put this number in further perspective, the Bank of Japan during its entire five-year Quantitative Easing Period, expanded its balance sheet by around 6 percent of GDP; and at the time, the BOJ’s actions were considered large (see this note from the SF Fed). This is a bailout; it is not a temporary lending program.

Two programs make up over half of this expansion: the Term Auction Facility (TAF) and the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity (ABCP MMF). Both of these programs were implemented in an attempt to foster liquidity in the lending market. Both of the programs swap assets from private-bank balance sheets and put them on the Fed’s balance sheet. The first program is designed to take assets off bank balance sheets, holding them in the Fed’s vaults until markets “normalize”, potentially allowing the banks to lend more, especially to each other. The second program is designed to try and breathe some life into the ABCP market.

There are two principal problems with the Fed’s program. First, the sheer size of the balance sheet puts taxpayers at substantial risk. Second, the Fed’s purchases are distorting the market and preventing market solutions for some of these problems.

Balance Sheet Risk: Although the loans are collateralized, they are non-recourse. Essentially, this means that if the assets go bad while the Fed is holding them and the bank decides not to pay back the loan, all the Fed gets to do is keep the worthless assets. If the Fed were taking only the safest assets maybe this would be a good idea, but the list of collateral accepted at the discount window is stunning.

Take a look at the spreadsheet on this page. The sheet lists the collateral acceptable for the TAF. The list is long and I don’t want to give a full rendering but here is my key takeaway: the Fed treats U.S. Treasuries on the same footing as Municipal bonds, asset-backed securities, and mortgage-backed securities (both private label and agency). Either the Fed thinks the U.S. government is likely to default or they are overvaluing some of the other assets. Even scarier, the Fed will accept securities for which there is no market price, taking them on at between 60 and 80 percent of their face value.

Default rates on some of the assets the Fed is accepting are very high. Some of the assets might be safer than they appear, but I have a feeling that the banks are going to err on the side of handing over their worst assets, keeping the safest on their own balance sheet. For example, even though the Fed accepts U.S. government securities as collateral, the banks are not using their store of Treasuries as collateral. Even as the Fed’s balance sheet has expanded, its holdings of U.S. government securities fell by almost half, from over $800 billion to under $500.

Because the Fed’s balance sheet is now so large, very small default rates can lead to very large losses. If only 1 percent of the assets held default, the Fed would lose close to $13 billion. In truth, the default rate is likely to be much larger. And, we will likely never know the full extent of losses. Because the Fed does not publish its counterparties, it can hide even substantial losses. Given the mix of collateral, it is beyond the pale that none of the assets currently held have defaulted, yet the Fed has not disclosed a single loss.

Market Distortion: Most of the emphasis so far on distortions has remained in the arena of moral hazard: if you bail out companies, they will take riskier positions in the future. The market distortion I worry about is more subtle and more important.

The Fed is working in markets that are not functioning well. Many of the assets held by the banks, especially the ones without market prices, have fallen in value. The Fed envisions its purchases of these assets as supporting the market and adding liquidity. However, if the assets are actually being sold at too high of a price, the Fed’s purchases do not induce private parties to step into the market: the Fed’s actions preclude a private market.

Even if there is just a possibility that the assets have declined in value, the Fed becomes the only viable market. Private buyers will only purchase the assets at a discount. Private sellers don’t need to discount the assets because the Fed will take the assets as collateral at near face value. The normal market process cannot proceed as long as the Fed remains active.

The Fed’s commercial paper program is an excellent example of this effect. Since the end of October, the Fed has accepted $318 billion of asset-backed commercial paper. Over the exact same time period, asset-backed commercial paper outstanding rose only $43.9 billion. Private holding of the paper have actually fallen by $275 billion—one-third of the total fall in private asset-backed commercial paper has occurred since the Fed began its purchase program less than two months ago. At the very least, the Fed’s program is not helping and it is likely hurting price discovery.

More importantly, because the Fed and the Treasury have been so aggressive in expanding their programs, the market distortion extends to assets they are not currently buying. It seems that no class of assets is permanently off the table.

Why sell at a discount if the Fed might begin buying the asset next month? The housing market is the best example of this effect. We will get hard data over the next week, but anecdotes indicate that home purchases fall sharply in November. I believe one of the main reasons was the indication from Treasury that they might begin a program to force mortgage interest rates on housing purchases down to 4.5 percent.

In the face of temporary uncertainty (whether policy driven or macroeconomic), postponing sales, purchases, and investment is often an optimal strategy.

Takeaways: While Congress and the White House have been focused on the implementation of TARP and the debate over whether or not to bail out the car companies, the Federal Reserve has quietly been conducting the largest bailout in the history of the United States. The program might be helping the U.S. economy, it might be creating terrible long-lasting distortions, or it might be actively hindering adjustment. I don’t know, and to a large extent without more transparency, the answer is not knowable, especially without full disclosure.

I will add two thoughts.

Since the Fed has implemented the program the economy has gotten noticeably weaker. Signs of macroeconomic stress have become omnipresent. We do not know the counterfactual, but it seems to me that the burden of proof lies on those who believe the economy would have deteriorated even faster in the absence of the Fed’s actions.

The Fed needs to stop treating this recession as a liquidity crisis. If we were merely facing an ordinary liquidity crisis, the Fed’s actions should have already worked: liquidity crises like bank runs are easy to resolve. Firms and Banks need to take a realistic look at their balance sheet, mark down assets that still have some value, and write off the rest. Some institutions will go bankrupt as a result but those firms are already bankrupt they are just refusing to admit it and are staying in business only with large fiscal transfers. (By the way, NorthGG is one of the strongest advocates for this adjustment in prices. I recommend reading his comments here.)