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Fed's Role in Crisis Is Giant, if Opaque

By Neil Irwin
Washington Post Staff Writer
Monday, November 24, 2008

Wall Street analysts, congressional overseers and the media have parsed every detail of the Treasury Department's financial rescue program -- $250 billion and counting.

Largely outside public view, however, the Federal Reserve is lending far more than that amount -- $893 billion, roughly the equivalent of the annual economic output of Mexico -- to help a wide range of institutions weather the economic storm.

As of last week, the Fed's loans included $507 billion to banks, $50 billion to investment firms, $70 billion for money market mutual funds, and $266 billion to companies that use a form of short-term debt called commercial paper. It is considering a new program that would make billions more available to prop up consumer lending: auto loans, credit cards and the like.

In lending these vast sums, the Fed is essentially substituting its own unlimited ability to supply cash for that of private markets, which are not functioning normally. The central bank is even fulfilling some of the original goals of the Treasury Department's $700 billion rescue program by allowing financial institutions to use securities that are difficult to sell as collateral for loans.

"The existing system of lending is broken," said David Shulman, a senior economist at the UCLA Anderson Forecast, which analyzes economic trends. "The Fed is coming in to do that lending. That's why they call it the lender of last resort."

But unlike the Treasury's rescue package, which has elaborate disclosure requirements and oversight mechanisms, the Fed lending is occurring quietly and at the discretion of its five governors, as well as top officials of the 12 regional Fed banks. Timothy F. Geithner, president of the Federal Reserve Bank of New York and the Obama administration's expected nominee for Treasury secretary, has been a leading architect of the new lending programs.

Following a long-standing practice designed to protect investor and depositor confidence in the institutions it deals with, the Fed refuses to name the banks and other companies accessing the cash. It has also declined to specify which assets institutions have pledged as collateral in exchange for loans, a decision that has drawn skeptical questioning from Capitol Hill and at least one lawsuit under the Freedom of Information Act. Fed officials argue that any disclosure along those lines would create a stigma for banks and others that need to borrow from the Fed, making the programs less effective at jump-starting lending.

"There's a concern that if the name is put in the newspaper that such and such bank came to the Fed to borrow overnight for a good reason, that people might begin to worry: Is this bank credit-worthy?" Fed Chairman Ben S. Bernanke told Congress last week. "And that might create a stigma, a problem, and might cause banks to be unwilling to borrow."

Bernanke also said there is little chance taxpayers will lose money on most of that lending, because the central bank lends money only to institutions it views as sound and requires that the collateral borrowers put up be worth more than the amount of the loan.

Outside experts generally agree that Bernanke has been prudent in his decision-making, but they note that Fed lending to support the purchase of Bear Stearns and the government takeover of American International Group entails greater risk than the central bank usually takes on.

The expansion in Fed lending has come in the form of numerous new programs to inject cash into the financial system, attempts to combat a crisis in which banks and other firms are hoarding it. To enact those steps, the Fed has increased the size of its balance sheet and replaced the ultra-safe U.S. government bonds it normally keeps on its books with loans to banks and others.

A year ago, the central bank had assets of $868 billion, of which about 90 percent was in Treasuries. Last week, it had assets of $2.2 trillion on its books, of which 22 percent was in Treasuries. Much of the remainder represents the new lending to banks and other financial institutions. Even the weekly report that summarizes the Fed's financial position has grown -- to eight pages from four pages a year ago.

The Fed can essentially expand its balance sheet at will, reflecting its power to create money. Congress gave it even more leeway to do so in the bill that contained the $700 billion rescue package, by allowing the Fed to pay interest on bank reserves.

"People want to act like the Fed's balance sheet is limited," said Diane Swonk, chief economist at Mesirow Financial. "No, it's not. It's pretty much unlimited."

The Fed's lending achieves some -- but only some -- of the goals of the Treasury Department's original financial rescue plan. The Troubled Asset Relief Program, which is now focused on investing money in banks, was originally intended to focus on the purchase of mortgage-backed securities.

Although not purchasing such securities, the Fed has agreed to take them on as collateral. That has helped banks get access to cash. But banks are still exposed to further losses if the value of those assets continues to decline. And the lending is not jump-starting the market by serving as a buyer of last resort, which would be the goal of government purchases.

"It's kind of like TARP light," said Michael J. Feroli, an economist at J.P. Morgan Chase.

By expanding its lending, the Fed is engaging in a form of economic stimulus known as "quantitative easing," which is a way for a central bank to try to fuel growth even when it has cut short-term interest rates to nearly zero.

Fed Vice Chairman Donald L. Kohn acknowledged publicly last week that that is what the central bank is doing. Behind closed doors, Fed leaders are considering other ways they can spur economic growth beyond cutting their target for interest rates. (The federal funds rate, at which banks lend to each other, is currently 1 percent, and analysts widely expect it to be cut to a half-percent at the Fed's December policymaking meeting.)

Perhaps the most promising option would be for the Fed to start buying the debt of Fannie Mae and Freddie Mac, the government-sponsored mortgage finance companies. Such a move would also be expected to reduce mortgage rates.

The Fed has consistently rejected requests to disclose more information about which assets it is taking as collateral for its lending programs. Bloomberg News sued under the Freedom of Information Act this month, requesting the information; the Fed refused, responding that the information was protected because it is confidential commercial information, and because it is being kept by the Federal Reserve Bank of New York, which it argues is not subject to FOIA.

At a hearing last week, Rep. Spencer Bachus (R-Ala.) asked Bernanke: "When do you anticipate letting the public know" what assets you're taking? Bernanke then argued that disclosure would be counterproductive -- his answer, in effect, being never.

There is some reason for the Fed to keep quiet, said Shulman, of UCLA.

In 1932, Shulman said, Congress demanded that the Reconstruction Finance Corp., a program that lent money to banks to try to contain the Great Depression, publish a list of who was getting public funds. As a result, there was a run on those banks.

"Congress should be careful what it asks for," Shulman said.

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