Are America's banks being nationalized by the Fed?


By Julie Satow
New York Sun
Wednesday, March 12, 2008

While investors rejoiced yesterday at the news the Federal Reserve would flood the market with $200 billion in liquidity, a throng of economists and market commentators is fretting that the Fed's latest approach will accelerate inflation and weaken its own balance sheet.

There is also a growing concern that the Fed's strategy of infusing the markets with liquidity is precariously similar to an equity investment, which could translate into the nationalization of America's banks.

"What we are witnessing is an incremental, partial nationalization of the U.S. banking system," a Ph.D. candidate in finance at the University of Kentucky, Steven Randy Waldman, wrote in a Web log post that has generated much discussion on the Internet:

"Northern Rock in the UK is peanuts compared to what the New York Fed is up to," Waldman wrote.

Yesterday the Fed said it would lend $200 billion worth of Treasuries to a wide range of banks for 28 days in return for debt, including triple-A-rated mortgage bonds. This will allow banks to get rid of the illiquid securities that are dragging down their balance sheets in exchange for very liquid Treasuries that can be traded in for cash.

On the news, the Dow Jones Industrial Average rallied the most it has in five years, leaping 416.66 points, or 3.6%, to close at 12,156.81. The Standard & Poor's 500 rose more than 47 points, or 3.7%, to 1,320.65. Eleven stocks gained for every one that fell on the New York Stock Exchange.

This is the Fed's third novel program to stem the economy's slide into a recession. In December, it announced the term auction facility, which is similar to the traditional discount window except it is conducted anonymously to prevent the negative stigma of borrowing from the Fed. On Friday, it raised the TAF to $100 billion from $60 billion. In December, the Fed was offering just $20 billion through the TAF.

Also on Friday, the Fed announced a new type of repurchasing program, whereby it will lend banks $100 billion for 28 days at attractive rates in exchange for a broad range of collateral, including riskier mortgage securities.

These strategies are no doubt innovative, experts say. "What Bernanke is doing hasn't been done before," a lead analyst and managing editor at the research firm RGE Monitor, Christian Menegatti, said, referring to the Fed chairman, Ben Bernanke. "He is doing monetary policy by changing the structure of the Fed's assets, accepting banks' collateral that otherwise would be hard to finance."

The Fed is also infusing the market with liquidity without substantially increasing the money supply. It is doing so by selling Treasuries at the same time it is loaning money through these new programs. For example, on Friday the Fed sold $10 billion of Treasury securities at the same time it offered $15 billion under the new repurchasing program.

"The net cash injection was small, but the composition of securities on [banks'] balance sheets changed markedly, as illiquid securities were exchanged for liquid Treasuries," Mr. Waldman wrote.

While the Fed may not be dramatically increasing the money supply, there is worry that the additional liquidity will exacerbate inflation concerns. Already the dollar is trading at a record low against the euro and gold is approaching $1,000 an ounce. The Fed is also taking on assets that could put its own balance sheet at risk should the banks be unable to pay back the loans.

"The Fed is willing to use its balance sheet to unblock the markets," a resident scholar at the American Enterprise Institute, Vincent Reinhart, a former director of the Federal Reserve Board's Division of Monetary Affairs, said. "To do this the Fed is taking on credit risk because they are saying the debt must be triple-A, but one thing we have learned is that what is triple-A can be downgraded -- a lot."

There is also concern that what the Fed is really doing is nationalizing the banks. The Fed's new programs will continue "for as long as necessary to address elevated pressures in short-term funding markets," the Fed said in a statement. By not retiring these loans, and constantly allowing the banks to roll them over, they are strikingly similar to equity investments, experts say.

"The loans should be considered an equity infusion because they'll be repaid at the convenience of the borrower rather than on a schedule agreed with the lender," Mr. Waldman said.

"So many of the banks' assets are going to end up on the Fed's balance sheet, it is like a covert nationalization," the blogger behind Naked Capitalism, Yves Smith, said. "I don't think the crisis will be over for another 18 months to three years, so it could be a long time before the Fed gets rid of this stuff."

It is also true that once the Fed does call these loans, its "equity" investment in the banking system is no longer in play. "When the situation improves and the economy rebounds, then this will end. If the loans keep rolling over in good times, then the debt really becomes like equity," he said.

In addition, the Fed can account for the risk from the risky mortgage bonds it is accepting from the banks as collateral by demanding a sufficient discount on the securities, as well as over-collateralizing its loans.

"Whether the TAF represents a bailout in the sense argued here comes down to whether the Fed is demanding an appropriate haircut on loans backed by mortgage backed securities to compensate for the extra risk, and I don't think we know," a senior fellow at the Brookings Institution, Douglas Elmendorf, said in an e-mail message. "Moreover, keeping Humpty Dumpty up on the wall can be cheaper and easier than trying to put his pieces back together later. Therefore, the Fed and other policymakers deserve credit these days for looking beyond their usual tools and being willing to compromise on good general principles when appropriate."

Still, despite the acknowledgment that the Fed, and Mr. Bernanke, are thinking out of the box, critics say these programs will simply not fix the problems plaguing the market and could, in the end, exacerbate it. "These programs take the loans of the banks' books temporarily, but they don't fix the fixed-income market," a professor at the University of Maryland School of Business, Peter Morici, a former chief economist at the U.S. International Trade Commission, said. "The Fed can't replace the broken bond market. It just can't provide that kind of liquidity."

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