The Fed at Work: A Play-by-Play Commentary

Relying on both conventional and unconventional means, the Federal Reserve (Fed) has been attempting to break the credit crisis’ stranglehold on the economy. It has been extraordinary to watch the Fed take actions that have not been used since the Great Depression, and a few actions that have never been used.
The Fed needs to be aggressive because the current liquidity crunch in the credit and mortgage markets is creating a negative feedback loop between the financial markets and the U.S. economy. The strain in the credit markets is putting pressure on the broader economy, leading to further weakness in the housing market, which then creates further dislocations in the credit markets, etc., etc., etc. Additional aggressive policy action by the Fed will be essential to break this self actuating spiral.
Since September the Fed has slashed its overnight lending target to 2.25% from 5.25%. It has also injected $200 billion into the credit markets by opening the Fed’s borrowing window to non-banks (such as investment banks), and has loosened collateral standards for these short term loans and now accepts lower rated asset-backed securities. In other words, an institution can pledge riskier bonds as collateral and receive Treasuries from the Fed. The Treasuries can easily be sold to generate the cash needed by the firm to meet its obligations. These loans are short term and will have to be paid back but in the mean time liquidity has been improved which will prop the credit markets up and keep the asset-backed bonds and lower credit quality bonds from falling further.
The Federal Reserve has now committed approximately half of the Fed’s portfolio to the fight and has pledged to commit more if necessary. Essentially, the Fed is using its own balance sheet as a tool to inject funds into the market right where it needs it the most. It is this type of creative aggressive action that is requisite if the Fed hopes to break the negative spiral between the economy and the credit markets.
The Fed also stepped in to ensure that Bear Stearns did not go under. Bear Stearns found itself in trouble because Wall Street began to question whether the investment bank had the necessary capital to back all its trades and bets. The firm was the highest levered investment bank (least assets to greatest debt) on the Street by a significant amount. Bear Stearns was not a very popular investment bank with its compatriots due to its aggressive brass-knuckle tactics. The combination of its bad rap and the high leverage ultimately set the stage for its demise. The firm began to go under as investors pulled their money on rumors of illiquidity and lenders called their loans and refused to extend additional credit. It was a classic run on a bank, the kind we saw Jimmy Stewart stave off in “It’s a Wonderful Life.” It was the old one-two punch. I feel no sympathy for the executives at Bear Stearns. If you swim with sharks, you do business with sharks, you act like a shark, then you are a shark and may be attacked, killed and eaten by other sharks.
The Fed stepped in and helped negotiate the purchase of Bear Stearn’s by JPMorgan for $1.2 billion in stock. In addition, JPMorgan will also absorb any losses on the first billion dollars of $30 billion of Bear’s riskiest assets. Those assets will be managed independently by BlackRock. The Federal Reserve Bank of New York is guaranteeing the remaining $29 billion, and in return, will reap any gains from that portfolio.
Why bail out Bear Stearns? After years of never allowing any of our financial institutions to fail, these banks have become so interwoven and enormous that nobody can be allowed to sink beneath the waves. Otherwise, a tsunami would swamp the hedge funds, banks and other brokerage firms that remain afloat. If Bear Stearns failed, for example, it would result in a wholesale dumping of mortgage securities and other assets onto a market that is frozen and where buyers are in hiding. This fire sale would force surviving institutions carrying the same types of securities on their books to mark down their positions, generating more margin calls and creating more failures, further hurting the economy and the housing market (the spiral). This bailout is less about saving Bear Stearns and more about shoring up the financial markets, housing markets and the economy.
On the flip side, this deal does not pass the sniff test. Why hasn’t there been another bidder? I find it difficult to believe that no one else was interested. It couldn’t have been that unstable because if the situation were so precarious, why wouldn’t shareholder ownership position be completely wiped out. Instead, a week later the bid is raised from $2 to $10 a share (a $1 billion increase in value). Is JPMorgan manipulating the situation to protect its $91.7 trillion dollar derivative exposure (per Office of Comptroller of the Currency September 2007 reported data) which is backed by only $123 billion of equity? How much of this counter party exposure did JPMorgan have with Bear Stearns? I can only surmise that JPMorgan made a sweet heart deal with the Fed and other governmental agencies. The deal would require JPMorgan to commit whatever resources would be necessary to prop up and acquire Bear Stearns. In return the Fed would not allow other suitors to bid up the price and they would not disclose JPMorgan’s full exposure to Bear Stearns. In essence, the Fed propped up both JPMorgan and Bear Stearns. One bank ate another and won. The game goes on.
The government has also reduced capital holding requirements for Fannie Mae and Freddie Mac from 30% to 20%. This frees up more money that Freddie Mae and Freddie Mac can use to purchase mortgages, thereby shoring up the mortgage-backed securities market. This increase in funds will help add liquidity and hopefully begin to break the gridlock that is crippling the credit markets. The regulatory body that oversees Fannie Mae and Freddie Mac has said they would lower the capital requirement even more if needed.
Congress has begun to do its part to break the spiral. As part of an economic stimulus package enacted last month, the cap on standard mortgages was temporarily increased from $417,000 to $729,750 in high-cost markets through the end of the year. Standard mortgages usually have lower interest rates than jumbos because they can be purchased or guaranteed by Fannie Mae or Freddie Mac. This is a great idea and could have made lower cost mortgages available in some of the most hard-pressed expensive housing markets. Unfortunately, this has just created an intermediate tier to the mortgage market. These tweener-loans are less expensive then the jumbo mortgages but the interest rates are not as low as a standard mortgage under $417,000. The loan originators are pricing the loans to reflect the additional risk they are taking with these tweener-loans because Freddie Man and Fannie Mae could decide to not purchase or guarantee them. So this part of the stimulus plan has been a bust.
Despite the efforts of the Fed, credit markets are not functioning properly. Sizable losses on subprime loans have lowered the capital base of many financial institutions. The situation is exacerbated by a financial system that has, over a period of years, become intertwined in a spaghetti-like fashion through the spread of complex financial products (CDOs, CLOs, CDSs, and the like). This complexity makes it difficult to clearly understand what assets may be at risk, how big those risks may be, and also who is at risk. This uncertainty has led financial institutions to retrench, which in turn makes credit (loans) more expensive and less available—even while the Fed tries to make credit less expensive and more available. If there are any more major disruptions in the credit, the Fed will have a very difficult time restoring equilibrium. According to Bill Gross at Pimco, what Washington really needs to do is get off its “high moral-hazard horse and move(s) to support housing prices… Authorities must act quickly, with a shot of adrenalin straight to the heart of the problem: housing prices…The decline needs to be stopped quickly in order to avert additional crises.”