TARP and Fed facilities unravel
LONDON (Reuters) – Experience shows financial crises escalate very rapidly, and need a swift and decisive response from policymakers to break the cycle of panic. Time to reflect, craft thoughtful policies and consider long-term consequences is a luxury policymakers generally don’t have.
But the problem with bold ad hoc responses is they often have unintended consequences. Individual policy actions may prove inconsistent with one another, fail to achieve objectives, and store up larger problems for the longer term.
Developments over the last week suggest the U.S rescue program has fallen into just this trap and is now rapidly unraveling.
The twin pillars of the rescue program are the multiplicity of liquidity and lending programs being offered by the Federal Reserve and the Treasury’s Troubled Asset Relief Program (TARP).
Both programs are now in deep trouble. In fact the various rescue packages risk becoming a textbook example of how poorly designed programs can fail to achieve their objectives.
LIQUIDITY EVERYWHERE BUT MAIN STREET
The Fed has grown its balance sheet from $884 billion to $2.055 trillion in the space of two months and extended almost $1 trillion in additional support to the banking system through the various emergency lending programs enacted or expanded over the last year.
But precious little of this additional liquidity is finding its way through to households and corporate borrowers. In fact, most of it is now sloshing around the banking system like so much excess ballast.
Banks have increased their reserve holdings on deposit with the Fed from $8 billion to $494 billion. This is $488 billion more than the Fed estimates they would ordinarily need to hold for payment clearing and prudential purposes.
Increased reserve holdings have absorbed perhaps half of the liquidity placed into the banking system from the Fed. Much of the rest has almost certainly been invested into the mountain of Treasury bills the U.S Treasury has been issuing. Only a very small proportion is left for re-lending to the real economy.
It is much safer for the banks to lend surplus funds to the Fed and the Treasury than lend to one another let alone to households and corporations. There is no credit risk. Nor is there any liquidity risk because reserve balances can be accessed on demand, and the Treasury bills have short maturities and can be readily re-discounted.
The Fed has made these perverse incentives worse by agreeing to start paying interest on excess reserves. Previously, the lack of interest payments gave banks an incentive to minimize reserve balances. But now reserves pay interest the net cost is low.
Even low returns on Fed balances start to look attractive when adjusted for the high levels of credit and liquidity risk in extending longer-term credits to other banks and real-sector borrowers.
SURPLUS MONEY, NOT ENOUGH CREDIT
Policymakers have ignored the distinction between money and credit (or to use monetarist terminology between narrow money and broad money). The Fed can create unlimited (narrow) money by adding reserves to the banking system. But it cannot create credit (broad money, or lending from the banking system and other financial institutions to one another and to end customers).
This is precisely the problem the Bank of Japan faced throughout the late 1990s and into the present decade. The bank reduced interest rates close to zero, and even resorted to “quantitativeeasing”.
The result was a huge increase in narrow money but little or no growth in the broader money aggregates as the banks preferred to keep the increased liquidity in their vaults rather than boost lending to customers.
The problem is that credit extensions depend on healthy banks being willing and able to lend, and healthy borrowers willing to borrow and able to repay. Once the economy is trapped into a more than usually serious recession, sound and prudently managed institutions have no incentive to take on more leverage to expand their operations, while lending to weaker institutions that need the money presents an unacceptably high credit and liquidity risk.
Yesterday’s inter-agency statement from the Treasury, the Federal Reserve and the Federal Deposit Insurance Corporation (http://www.federalreserve.gov/newsevents/press/bcreg/20081112a.htm) notes sternly “the agencies expect all banking organizations to fulfill their fundamental role in the economy as intermediaries of credit to businesses, consumers, and other creditworthy borrowers”. But the stern injunction to start lending again is probably futile.
Until collateral values (especially residential and commercial property) stabilize and there is greater certainty about the economic outlook, there is no incentive for creditworthy institutions to borrow, or banks to lend. But without lending, the contraction will deepen.
THE $700 BILLION TARP SLUSH FUND
TARP is beset by even bigger problems. Recall the $700 billion fund was originally created to provide a buyer of last resort for mortgage-backed securities and other assets that had become illiquid and were allegedly trading only at firesale values, if at all, that did not reflect their fundamental underlying worth. TARP was supposed to aid price discovery and deal with a crisis of liquidity.
But the TARP provided the Treasury secretary with almost unlimited authority over how to use the money, subject only to an oversight board composed mostly of executive branch officials and powers for Congress to invoke the “nuclear option” and disapprove further funding beyond an initial $350 billion.
The fund has quickly mutated. The Treasury used $125 billion for capital injections into nine large national banks, some of whom claimed they did not want or need it. Another $125 billion is being made available for capital injections smaller regional and community banks. Some $40 billion is now being used to support AIG. The Treasury now has just $60 billion of TARP authority before it must risk returning to Congress.
Yesterday, the Treasury admitted it now has no plans to begin buying troubled assets, gutting the program’s original purpose completely.
Congress came under intense pressure to approve TARP with the promise that asset purchases could begin within a matter of days of the president signing the bill. Legislators show increasing signs of restiveness that TARP has transmuted into a giant $700 discretionary fund outside the regular appropriation process.
There is frustration that TARP funds are being used to bolster balance sheets (and thereby take off pressure to cut dividends and bonuses), and perhaps pursue consolidation, while there is no new credit flow to households and corporations.
Meanwhile an ever-lengthening list of industries are bidding for TARP bailouts. The Treasury has already extended the program to insurers. American Express and other institutions have turned themselves into commercial banks to access all the federal support on offer.
The auto industry is pressing its own claims to be “systemically important” for a share of the bailout funds. Congress and the administration are now arguing over where to draw the line. TARP is not big enough to bail out all these industries.
But the fundamental problem is that neither Fed liquidity nor TARP deals with the root of the problem – the rising tide of defaults in the residential mortgage market, and the continued fall in home prices and collateral values.
There is a popular misconception that the renewed extension of credit will revive the real economy. But that is putting the cart before the horse. Credit will start flowing again only when banks and potential borrowers can see some sign that the economy, cash flows and collateral is stabilizing.
As several senior Fed officials have indicated, monetary policy has done all it can. Only fiscal policy, combined with the systematic rescheduling of loans and write-down of debt principal, can achieve stabilization in the real economy and the housing market.