I mentioned in several of my posts on economic conditions a concern about the Fed bailing out the big investment banks, essentially lending them money very cheaply while taking as collateral assets that are perhaps not the most trustworthy (mortgage-backed securities).
This creates somewhat of a vicious circle. The current credit crisis was caused in part by easy credit resulting in financial institutions awash in liquidity, which was in part created by banks' engineering of exotic derivatives and their ability to sell off risky loans through securitization vehicles, pocketing huge profits along the way. But all the easy credit drove prices and use of credit up, with homeowners paying more since loans were available and hedge funds leveraging themselves 30 to 1 to buy assets--including securitized mortgage loans.
The risky loans have now come home to haunt, however, leading to a credit crunch as banks take the money they can get at very low cost (the Fed rate around 3% now) and lend it out at higher rates (mortgage rates have gone up) to try to make up for the money lost on "bad" mortgages. So the "cure" for the crisis has been the Fed's continuing to lower the interest rate to grease the wheels again. And over the last six months, the Fed has begun taking on some of those same risky assets. It announced a 200 billion dollar short-term loan facility for the big banks, and it prevented Bear Stearns' collapse in the end-of-week run on the bank with another short-term collateral-backed loan (through JPMorgan as conduit to get around the restrictions on the Fed aiding an investment bank), taking on the very type of collateral that got us into this problem in the first place.
There's an interesting discussion of all this at Econbrowser, which I've excerpted, below.
What does the Fed hope to accomplish with all this? Steve Waldman draws a colorful analogy:
... Since TAF started last fall, on net, the Fed has not only rolled over its loans to the banking system, but has periodically increased banks' line of credit as well. In an echo of the housing bubble, there's no such thing as a bad loan as long as borrowers can always refinance to cover the last one.
The distinction between debt and equity is much murkier than many people like to believe. ... If you think, as I do, that the Fed would not force repayment as long as doing so would create hardship for important borrowers, then perhaps these "term loans" are best viewed not as debt, but as very cheap preferred equity....
... Citibank is paying 11% to Abu Dhabi for ADIA's small preferred equity stake, while the US Fed gets under 3% now for the "collateralized 28-day loans" it makes to Citi.... I still think this all amounts to a gigantic bail-out.
Douglas Elmendorf defends the Fed from Waldman's charge:
Taking agency MBS as collateral does not meaningfully increase the risk faced by the federal government. First, the Fed will presumably require a significant "haircut" on the value of the collateral. Second, if the federal government would ultimately prevent a default by Fannie and Freddie anyway, absorbing some of that commitment now does not add to the overall risk. Taking private MBS as collateral does increase risk, unless an adequate haircut is taken, because the government is otherwise unlikely to stand behind the truly private lenders.
Whether one takes comfort in Elmendorf's argument depends entirely on the size of the haircut, about which I know only the following (from WSJ):
Fed officials decline to be specific except to say [the haircut] will seem conservative for ordinary times and liberal for tumultuous times. (One starting point may be the haircuts imposed on MBS collateral at the discount window: They range from 2% to 15% depending on the maturity and the availability of market pricing).
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