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Did you know the Federal Reserve secretly loaned up to as much as $1.2 trillion to U.S. and foreign banks? This information has now been released and we even know the institutions that got the bulk of the funds. Can you say, Morgan Stanley (MS), Citigroup (C), Bank of America (BAC). Due to the inflammatory nature of this information, the Fed has been reluctant to share it with Americans, but now it has come out due to a lengthy Freedom of Information Act investigation by Bloomberg.

This blog post by Barry Ritholtz gives details about a secretive $1.2 trillion bailout program by the Federal Reserve [emphasis added]:

…We knew that Citigroup (C), who borrowed $99.5 billion, and Bank of America (BAC), who took loans of $91.4 billion, were in trouble. I’ve been saying for the better part of 3 years now that they were, and likely still are mostly insolvent. But the surprise data point was Morgan Stanley (MS), got as much as $107.3 billion in loans, with no strings attached.

…Imagine if the government and the Federal Reserve were run not by knaves and fools and Wall Street sycophants, but instead, were run honestly for the benefit of the taxpaying voter. Imagine the goal was saving the banking system (not the banks), and the financial rescue was for the benefit of the taxpayers, not the bondholders…

This graphic shows the banks that hit the Fed up for the most cash:

Source: Barry Ritholtz

The first problem I see is simply the absolutely massive size of the loans that were made. $1.2 trillion! I don’t remember hearing the Fed discuss its trillion dollar line of credit for banks. In fairness to the Fed, the loans appear to have been paid back, but I am not confident that the curtain of secrecy has fully arisen. If the Fed tried to hide this program initially, is there any reason to think it is being forthright now?

Even more critical to me is that this program does not seem to have been an actual solution, but rather a stopgap measure to preserve and protect the banks and their shareholders. The Fed’s chosen solution did not solve the problem and, at best, it postponed the reckoning we face because big banks screwed up.

Ritholtz continues with a solid, three-part plan for dealing with the problem in a more permanent manner:

1. Fire the senior management of the banks…

2. Ban…all lobbying activity as a condition of any aid…

3. Force…a Swedish style prepackaged bankruptcy…

What does he mean by a Swedish style prepackaged bankruptcy? Ritholtz is referring to the approach Sweden took to a severe banking crisis that hit back in 1992 or so. At that time, Sweden took over its big banks, tossed out management and let the bank shareholders take the hit.

Swedish lessons

One caveat couple is in order: Sweden is a tiny country with an economy and a population not much bigger than the San Francisco Bay Area. What works for them may not scale well across a population of 308 million Americans. Nonetheless, Sweden has not had the severe banking crisis that we have had this time around because it went through a nasty financial crisis in the early 1990s and it seems to have retained some valuable institutional and governmental lessons from that time. We had the Savings & Loan crisis in the 1980s and early 1990s. Our government dealt with that problem quite well by letting banks and savings & loan go under with hideous losses to shareholders of those institutions, but that solution seems to have eluded the Fed this time around.

Let the zombie bank shareholders take the hit

So we knew what to do back in the 1980s. Unfortunately, this time around we have forgotten what we learned from the S&L crisis. We now are letting smaller banks fail, but we have allowed big banks to dictate policy such that they have evolved into a new breed of zombie institutions considered ‘Too Big to Fail” (TBTF). This is a mistake that both Europe and the U.S. are making, however the Swedes have avoided that mistake.

As I pointed out, Sweden is not a perfect example of what we should have done or should do, but I do believe we could learn a lot from the Swedish example. They retained the harsh lesson learned from the 1990s, but we did not.

In the spirit of goodwill to all, I suggest that our Fed Chairman and Treasury Secretary take a nice, all expenses paid trip to Sweden rather than Jackson Hole this year. Who knows, they might learn something.

For an in-depth look at the Fed Chairman’s journey to Jackson Hole, see this MarketWatch piece: Bernanke ready for action.

Source: Fallout From The Fed's Secret $1.2 Trillion Bank Bailout