I previously summarized research that two of my graduate students, James Felkerson and Nicola Matthews, are conducting on the Fed’s bailout. Using data that the Fed was forced to release, they demonstrated that the cumulative total lent and spent on assets by the Fed was over $29 trillion. (See the first paper here: http://www.levyinstitute.org/publications/?docid=1462) Their estimate was larger than previously reported because others have focused on loans, and in some cases, guarantees, outstanding at a point in time. The Fed’s own estimate is $1.5 trillion (loans outstanding), while Bloomberg’s number was $7.7 trillion (including commitments that were promised but never used).
To be sure, using methodology similar to that of Felkerson and Matthews, the GAO had obtained an estimate of $26 trillion for the cumulative total. The value added of our research is the detail provided—how much lending was provided in each facility, how many assets did the Fed buy through each facility, and who were the major users of each facility—and how much did they get. In coming weeks and months we will release a lot more analysis of this data.
Our figure of $29 trillion made headlines, and attracted a fair amount of commentary. Although we were very clear in our presentation, casual readers as well as many reporters from the media wrongly interpreted our results as a measure of the Fed’s exposure to risk. Chairman Bernanke’s memo emphasized that the Fed’s total exposure never exceeded more than $1.5 trillion—and since there is no way that it ever would have realized anything close to 100% loss on its loans, the real risk of loss was only a tiny fraction of that. Further, he (rightly) asserted that most of the loans were repaid, indeed, most of the special lending facilities have been closed.
To be sure, the total amount of loans still outstanding as of November 2011 was just under $1 trillion. In recent weeks the Fed has renewed its lending to foreign central banks (in “swaps”), so outstanding loans have climbed a bit. But the Fed and its defenders are correct: Fed maximum exposure to losses would likely be measured in tens of billions of dollars—maybe hundreds of billions, but most certainly not trillions.
So, should anyone care? Yes.
We think there is some possibility the Fed will suffer losses that are big enough to produce a political outcry. However, as I previously reported, the Fed has changed operating procedures in a way that makes it easier to absorb losses without raising hackles in Washington.
More importantly, as MMT teaches, the US government cannot become insolvent—so aside from political risks, there is no problem with respect to Fed losses on the bailout.
What’s much more important is the economic and incentive problems created by the bailout itself. That is really what our research project is all about. I will periodically report our findings and our arguments. In the remainder of this piece I will only tackle one issue: the nature of the problem the bailout addressed.
In a financial crisis the central bank must act as lender of last resort. This is well-accepted by virtually all economists and has been so accepted since Bagehot proclaimed that central banks must stop bank runs by lending 1) without limit, 2) at a penalty rate, and 3) for a temporary period. The purpose is to relieve a liquidity crisis. (Remarkably, the Fed failed to follow any of Bagehot’s recommendations, but I’ll only address the third.)
In the old days, bank runs took the form of a queue of depositors outside a bank demanding cash. With modern deposit insurance, that rarely happens. Rather, runs are on “wholesale” deposits—large denomination certificates of deposit as well as other short-term funding sources.
Over the past couple of decades, financial institutions have increasingly relied on one another for funding, issuing uninsured liabilities that need to be continually rolled-over at maturity. In the euphoria of Bernanke’s Great Moderation—according to which we had supposedly entered a “new era” so that no one really needed to worry about liquidity—that seemed to work just fine. Debts of financial institutions to one another exploded to 125% of US GDP. This phenomenon is called layering–an element of financialization–often at high leverage ratios: debts on debts on debts.
The problem is that any hiccups would quickly run through the system and cause normal financing relations to break down. As one example, borrowing is normally against collateral (good assets) at a “haircut” (you cannot borrow 100% of the asset’s value—a haircut is applied). When market anxiety rises, haircuts increase and suddenly a financial institution finds it cannot borrow enough to refinance its positions in assets. Since liabilities are uninsured and relatively short-term, funding disappears when holders decide it is safer to refuse to roll-over their holdings. Matters are made worse if banks desperately try to dump assets they can no longer afford—since asset prices then fall, haircuts rise, and we are off into a Fisher-Minsky debt deflation dynamic.
All of that, and much more, happened when the Global Financial Crisis hit. There was a liquidity crisis, and that required Fed intervention as lender of last resort. No rational analyst can complain about Fed lending to stop a crisis.
So far, so good.
But the fundamental problem was NOT the run to liquidity. If it had been a liquidity crisis—even the Mother of all liquidity crises—quick lending by the Fed would have resolved the problem in short order. Banks could then have returned to market funding. The crisis would have been measured in weeks, perhaps months. Not in years. Or a decade.
(Note that Bernanke fashions himself an expert on the Japanese crisis—which has now gone on for two decades. Perhaps he will manage to replicate their mistakes and drag our crisis out for a generation! His recommended cure for what ails Japan has always been—you betcha—more quantitative easing.)
Nay, the US problem was not really a liquidity crisis, rather it was and remains a solvency crisis. As I wrote last July:
“The GFC was not a “liquidity crisis”. At a recent conference, one of the Treasury officials who participated in the bail-out told me that the crisis really just amounted to a “global missed payment”. The whole world was just short a few bucks in its checking account. Uncle Sam provided overdraft facilities and resolved the problem. No harm, no foul (the Treasury official actually used those words). As granddad would say, “bullpucky”. What actually happened is that default rates on risky mortgage loans rose sharply while home prices plateaued. Megabanks took a look at their balance sheets and realized they were not only holding trashy mortgage products, but also lots of liabilities of other mega financial institutions. It suddenly dawned on them that all the others probably had balance sheets as bad as theirs, so they refused to roll-over those short-term liabilities. And since the Leviathans were highly interconnected, when they stopped lending to one another the whole Ponzi pyramid scheme collapsed.
To label that a liquidity crisis is silly. It was massive insolvency on a Biblical scale that led to the “run on liquidity” (really, a refusal to refinance one’s fellow crooks—criminal enterprise always relies on trust, you know). The banks had no good assets, just trashy real estate derivatives plus loans to each other, all backed by nothing other than a fog of deceit. All it took was for one gambling banker to call the bluff. Every banker looked for an even bigger sucker to refinance the junk. The only saps left standing sat (so to speak) in Washington. And that is why it took tens of trillions of lending, spending, and guaranteeing of trash by Uncle Sam acting as sucker of last resort to stop the carnage. (As every gambler knows, if you do not know who the sucker is within 5 minutes of beginning the game, you are the sucker.)
All the big banks are still insolvent. It is only the backing provided by Tim Geithner and Ben Bernanke as well as the “extend and pretend” policy adopted by regulators that keeps them open.”
And that is why $29 trillion matters. As the Bloomberg data dump shows, big banks borrowed for months and even years on end because they couldn’t fund their asset positions in markets. Why not? Because markets suspect they are insolvent. They know the banks still have toxic waste on their balance sheets. To be sure, they’ve unloaded a lot of the junk—to the Fed and Fannie and Freddie, and to speculators. But they’ve still got risk exposures orders of magnitude greater than their generously-accounted-for and largely mythical capital.
By lending long-term to banks, by allowing them to fund positions in junk, and by keeping insolvent banks open, the Fed is dragging out the crisis.
The Fed and its cheerleaders make two preposterous claims. First, they say that all the lending plus the various versions of Quantitative Easing (get ready for QE3!) will get the banks to lend again. No it won’t. And thank goodness for that! The US economy is still underwater with debt. More debt is no solution to excessive debt.
Second, they claim that the banks were actually solvent, having passed Geithner’s wimpy “stress tests”. But both the Fed and markets know this is false. If it were true, the banks would not have needed the Fed for funding. And they could have raised capital cheaply by issuing equity.
Finally, what does experience show to be the consequences of leaving insolvent financial institutions open? Time and again, it shows that bank management “bets the bank”, blowing the insolvency hole bigger. In the current period, this is done by speculating in commodities and (in some cases) in Euro and BRIC debt and equities. All of those shoes will drop.
The other outstanding activity during this period is the massive cover-up of all the fraud perpetrated by the biggest financial institutions in America since 2004.
And that is the main barrier to American recovery, as the banks continue to illegally steal homes, throwing owners out onto the streets and trashing real estate markets.
The collateral damage from the attempted cover-up of crimes is our struggling economy. The Fed is complicit, and the $29 trillion bailout is a measure of what the Fed was willing to do to keep banks in business as they attempt to cover-up “high crimes and misdemeanors”.