Fed's 'Historic Steps' into Uncharted Waters

Unless I'm mistaken, the Fed just took a first step toward Thomas Palley's suggested solution to our current mess:

Central Bank Offers Loans To Brokers … Historic Steps, Greg IP, WSJ, March 17: … It took a unanimous vote by the Fed's five governors yesterday to invoke a Depression-era clause in the Federal Reserve Act to waive the usual prohibition on Fed loans to nonbanks. A Fed official told reporters today's circumstances couldn't have been envisioned when the Fed was created, and noted newer central banks like Europe's have many of these powers. But these steps also take the central bank into uncharted territory with new and potentially troublesome risks.

Those risks include the possibility that with the credit crunch showing no sign of lifting, the Fed will be called on to lend to other troubled firms and end up a major creditor of Wall Street, even if at present the risk of any substantial loss appears small. Another risk is that while the Fed used a loophole yesterday in the Federal Reserve Act to expand its lending to nonbanks in "unusual and exigent" circumstances, it has in effect expanded the federal safety net with no political debate. However, the Fed sought and received agreement over the $30 billion loan from Treasury Secretary Henry Paulson, who informed President Bush.

Bigger Test

For now, though, the bigger test will be how the markets greet the initiatives today: with relief at the bold steps taken to shore up the financial system, or with alarm at how unstable the financial system had to be to invite such action.

Officials appear to hope the initiatives will restore enough confidence to markets to allow a smaller rather than larger rate cut tomorrow, but they acknowledge it will depend partly on how markets evolve over coming days.

On Wall Street, there is likely to be some relief that the Fed has finally opened the discount window to securities dealers, something they have long clamored for. The Fed has been reluctant because the move was outside its explicit mandate. "This is a five-vodka event," said a senior executive at one big brokerage firm that previously didn't have access to this funding source. "Liquidity is no longer an issue."

Federal Reserve Bank of New York President Timothy Geithner told reporters: "This is designed to help get liquidity to where it can help play an appropriate role in helping address the range of challenges" in the markets, especially in the mortgage-backed securities market.

Mr. Paulson said in a statement, "I appreciate the additional actions taken this evening by the Federal Reserve to enhance the stability, liquidity and orderliness of our markets."

For all their creativity, the Fed moves are also an acknowledgment that its previous steps have failed to stem the collapse in investor confidence, forcing it to abandon many of its original principles, such as not favoring particular firms or market sectors and sticking within its explicit statutory authority.

Last Tuesday, it announced what Wall Street called its most creative initiative yet: It lent up to $200 billion of its much-sought Treasurys to investment banks starting March 27 in return for a like amount of now-shunned mortgage backed securities for up to 28 days. The announcement led to a huge rally in stocks. But within days dealers were telling the Fed it didn't go far enough. They wanted longer term, more immediate funding against a broader range of collateral.

It also came too late to save Bear Stearns. On Thursday evening, Bear Stearns informed the Securities and Exchange Commission and Fed that it had experienced a dramatic loss of cash reserves and now saw no option other than to file for bankruptcy protection Friday morning. Fed officials at that point saw just two options. They could try to wall off the rest of the financial system. If the environment had been less tumultuous they might have chosen that option.

But in the current period they feared that a failure by Bear to make good on billions of dollars of contracts could severely dislocate critical markets, especially garden-variety repo loans -- overnight loans secured by various collateral that are the grease of the credit markets.

Too Interconnected

Officials grimly concluded that while Bear Stearns wasn't too big to fail, it was too interconnected to be allowed to fail in just one day. They spent Thursday night going over Bear's books and huddling with the SEC and Treasury. By Friday morning it had settled on its second option: a 28-day secured loan via J.P. Morgan to give time for a sale or wind up of the firm.…

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[DOR]

Any more vitamins for the auto wreck victim?