The Fed is Running Out of Options

The Federal Reserve has cut the federal funds rate and its short-term lending rate to banks to near zero, but those moves have done little to unlock credit markets. Conventional mortgage money and business loans remain too scarce, as regional banks, which are the arteries and capillaries of our credit system, remain short of loanable funds.

Near-zero short-term lending rates for banks does little to help, because the regional banks do not lack for short-term access to funds—the Fed is providing all the near-term liquidity they want through the discount window. Rather, banks lack longer-term sources of funds to back up mortgages and commitments for medium-term lines of credit to businesses.

Since the savings and loan crisis of the late 1980s, regional banks have relied on both deposits and the sale of mortgages and other loans to money center banks in New York to finance home and business loans. Loans sold to money center banks, for many years, were securitized—that is bundled into bonds for sale to insurance companies, pension funds and other fixed-income investors. Those investors have very predicable cash flow requirements, as defined by actuarial tables, and are ideal investors for bonds backed by mortgages and other loans.

In recent years, fixed-income investors were burned by the sharp practices of New York bankers and investment houses. The latter packaged shoddy subprime mortgages into bonds, insured those bonds through the sale of questionable derivatives, and then pawned off shoddy bonds as high-quality investments. The bankers got big bonuses from the wide spreads on subprime loans and derivatives fees.

These schemes were the central to subprime crisis, housing bubble and collapse, and now the crisis of confidence on Wall Street that has poisoned credit markets globally.

Now, fixed-income investors have lots of cash to invest, but are reluctant to buy mortgage and other loaned-backed bonds. The large New York banks are not much interested in creating bonds from loans made by regional banks, because securitizing high quality loans into bonds don’t create the opportunities to write fancy derivatives that pay bankers huge bonuses.

Instead, the New York Banks have taken the massive amounts of loans and capital provided by the Federal Reserve and Treasury to go hunting for new high profit businesses and acquisitions. The presence of federal regulators in their offices keeps them from getting involved in many new schemes but does not solve the shortage of funds regional banks have to lend.

The Fed has other options. It can go out on the yield curve and buy 10-year Treasuries to pull down long rates, such as conventional mortgage rates. That would lower the rates banks pay for deposits but would not increase their deposits; hence, it would not increase the amount of money they have to make loans.

The Fed is buying mortgage-backed Fannie and Freddie Mac bonds, pulling down their rates. However, lowering rates on Fannie and Freddie securities does not make them more attractive to investors.

Ultimately, Ben Bernanke should gather the CEOs of the large money center banks, which have received direct infusions of capital from the Treasury and huge loans from the Fed, together with the biggest fixed-income investors to define the parameters of acceptable mortgage-backed securities. Then, it should require its wards on Wall Street to buy loans from regional banks and bundle those loans into bonds for sale to fixed-income investors.

The Fed could also buy bonds backed by conventional mortgages, just as it has Fannie and Freddie securities. In the end, though, the Fed may have to start lending to the regional banks against solid, prime conventional mortgages and hold the mortgages or securitize those for sale to fixed-income investors directly or through primary securities dealers. The latter are among the banks now receiving Treasury injections of capital and generous Fed loans.

This is all well outside the limits of what the Fed has done since World War II and perhaps ever done, but these are dangerous times.

Simply, the Fed is running out of conventional monetary policy and bond market options.

In the end, if the New York banks won’t do their job, the Fed may have to do it for them.

Comments

[bosun.j:]

And still it will not be enough to stop the collapse we are already in. The time to act in order to prevent has passed. They chose to loot the Treasury. The last act of a dying empire.

2008 Dec 19 07:48 AM

[investor88:]

Doesn't sound like the macro background of a equity bull market although lately many believe the Fed and Treasury have found the magic wand to print, bailout and throw money at any and all problems.

2008 Dec 19 09:19 AM

[da'zman:]

How does buying long term treasuries reduce the rate banks have to pay on deposits?

"The Fed has other options. It can go out on the yield curve and buy 10-year Treasuries to pull down long rates, such as conventional mortgage rates. That would lower the rates banks pay for deposits but would not increase their deposits; hence, it would not increase the amount of money they have to make loans."

I think I get what your trying to say but this makes no sense.

2008 Dec 19 09:53 AM

[paulsjj:]

FED: RIP. We are experiencing the greatest finincial fraud in the history of the universe. And nobody knows nothing: not Congress, not the Treasury, not the Fed, not the Regulators, and not the CEO's and not the Trustees. Why is that?

2008 Dec 19 09:53 AM

[Bill Herbert:]

It seems to me that we need a sweeping change in our "banking" system, including all new top management, by executive order.

The whole corrupt system that has developed over the last 30 years has to be scrapped - we are truly at the "startover" phase where we need to get rid of all the Paulsons and Princes and Caynes and Fulds, and put the true banking system back into place.

Get rid of derivatives, securitizations, mortgage scams, usury, multi-million dollar bonuses that encourage and reward fraud, and get back to basics - lending money in an orderly fashion to creditworthy businesses and consumers.

And I would suggest firing most of the MBA types who actually know very little about business, and have been seriously mis-educated by most of our 'top' business schools to believe that the incredibly contrived derivative-based financial system they have created was a good idea.

Obviously, it has led to extreme distortions in the economy, a lot of crime, and a financial collapse.

2008 Dec 19 10:55 AM

[anarchist:]

so copperbaron, not that I disagree but who are you going to replace all the MBA-types with?

2008 Dec 19 11:19 AM

[helplessobs...:]

This is a well thought out post with interesting comments.

2008 Dec 19 11:42 AM

[carey_jim:]

In the early 1930s deflation was running about 6% per year and interest rates were close to 4% because America was still, nominally, on the Gold Standard and Switzerland and France were drawing gold away from us by higher interests rates.

So the Fed was forced, by the logic of the Gold Standard, to raise REAL interest rates to 10% during the depths of the worst recession of the century. This was certainly one cause for the severity and length of the Great Depression.

It took mathematics hundreds of years to formally recognized negative numbers as solutions to equations (the square root of 4 has TWO solutions, 2 and -2) even though practical people used negative numbers every day:

You owe me 5 dollars and you have 2 dollars in your wallet so you are worth -3 dollars.

I've been making feeble jokes about the Fed asking holders of their debt to pay for the privilege of keeping their money safe in perilous AND deflationary times by accepting negative interest, say of -3%. I haven't heard much laughter maybe because the jokes are a little too close to a possible very unpleasant future.

If a nation is facing 7% deflation, a -3% interest rate doesn't seem so bad, especially if the nation is rocked by social unrest and your money is safe!

But no one was bold enough to try it in the 1930s so it isn't likely it will be tried today either.

Or is it?

2008 Dec 19 12:47 PM

[Smarty_Pants:]

"Rather, banks lack longer-term sources of funds to back up mortgages"

Aren't Fannie and Freddie still buying mortgages? Since the FED is buying them from Fannie/Freddie then the GSEs should have plenty of cash to buy them from regional banks. Isn't the story at FHA the same?

If there is any shortage of mortgage lending going on it is because lending standards are tightening up again and because many banks are now requiring some serious downpayments for equity cushions. Both of those tightened hurdles are reducing the number of eligible buyers far below 'norms' of the past few years.

Any shortfall in home lending is more likely due to a return to sound lending principles.

Business lending is another story, but I wasn't aware that anyone bought securitized business loan packages in great numbers, so that's a moot point in the debate. Most businesses are simply trying to keep the doors open these days.

2008 Dec 19 03:49 PM

[prudentinve...:]

Good analysis, but you state the solution as: "Then, it should require its wards on Wall Street to buy loans from regional banks and bundle those loans into bonds for sale to fixed-income investors."

The problem is that any rational fixed-income investor will demand an interest rate high enough to cover (a) the expected high inflation + (b) the tax he pays on interest + (c) the probability of default.

If the government insured these bonds, (c) goes away.

If the government makes them tax-free income, (b) goes away.

This leaves (a), and with the current expectation of high inflation from the massive stimuli, (a) is probably 6-8%.

If such bonds are taxable, then (b) will add another 3-4%.

If such bonds are not government-guaranteed, (c) will add another 6-8%.

Thus, a normal market with rational fixed-investors is unlikely to purchase such bonds at a rate that a home buyer can afford.

2008 Dec 20 08:05 AM