Ben Bernanke, chairman of the U.S. Federal Reserve, arrives at the Federal Reserve building for a Federal Reserve Open Market Committee meeting in Washington, April 29, 2008. Photographer: Brendan Smialowski/Bloomberg News
May 2 (Bloomberg) — A month after the Federal Reserve rescued Bear Stearns Cos. from bankruptcy, Chairman Ben S. Bernanke got an S.O.S. from Congress.
There is “a potential crisis in the student-loan market” requiring “similar bold action,” Chairman Christopher Dodd of Connecticut and six other Democrats wrote Bernanke. They want the Fed to swap Treasury notes for bonds backed by student loans. In a separate letter, Pennsylvania Democratic Representative Paul Kanjorski and 31 House members said they want Bernanke to channel money directly to education-finance firms.
Student loans are just the start. Former Fed officials and other Fed-watchers say that Bernanke’s actions in saving Bear Stearns will expose the central bank to continuing pressure to use its $889 billion balance sheet to prop up companies or entire industries deemed important by politicians. The Fed satisfied Dodd’s request today, expanding the swaps to include securities backed by student debt.
“It is appalling where we are right now,” former St. Louis Fed President William Poole, who retired in March, said in an interview. The Fed has introduced “a backstop for the entire financial system.”
Critics argue that the result will be to foster greater risk-taking among investors emboldened by the belief that the government will bail them out of bad decisions.
The Fed’s loans to Bear Stearns were “a rogue operation,” said Anna Schwartz, who co-wrote “A Monetary History of the United States” with the late Nobel laureate Milton Friedman.
“To me, it is an open and shut case,” she said in an interview from her office in New York. “The Fed had no business intervening there.”
There are already indications that investors perceive the safety net to be widening as a result of the actions by Bernanke, 54, and New York Fed President Timothy Geithner. The Bear Stearns bailout and an emergency facility to loan directly to government bond dealers triggered a decline in measures of credit risk for investment banks and for Fannie Mae, the Washington-based, government-chartered company that is the nation’s largest source of funds for home mortgages.
Yield differences between Fannie Mae’s five-year debt and five-year U.S. Treasuries have fallen to 0.55 percentage point, from 1.15 percentage points on March 14, the day the Fed’s Board of Governors invoked an emergency rule to lend $13 billion to Bear Stearns.
“The market understood that this is the method by which Fannie Mae and Freddie Mac could be bailed out if necessary,” Poole said.
Wall Street Impact
The cost of default protection on Merrill Lynch & Co. debt fell to 1.4 percentage point by April 30 from 3.3 percentage points on March 14, CMA Datavision’s credit-default swaps prices show. The cost of protection on Lehman Brothers Holdings Inc. securities has fallen to 1.5 percentage points from 4.5 percentage points over the same period.
Fed Board spokeswoman Michelle Smith declined to comment, as did New York Fed spokesman Calvin Mitchell.
On March 16, two days after the Fed provided its Bear loan, it agreed to finance $30 billion of the firm’s illiquid assets to secure its takeover by JPMorgan Chase & Co.
The Standard & Poor’s 500 Financials Index had lost 12 percent in the three weeks prior to March 14; Geithner defended the loans before the Senate Banking Committee on April 3, saying that the Fed needed to offset risks posed to the entire financial system.
A systemic collapse on Wall Street would also mean “higher borrowing costs for housing, education, and the expenses of everyday life,” Geithner, 46, said.
While the Fed must by law withdraw its financing backstop for investment banks once the credit crisis passes, investors will probably still bet on its readiness to intervene.
“There is no way to put the genie back in the bottle,” Minneapolis Fed President Gary Stern said in an interview with Fox Business Network on April 18. “What worries me most about where we wind up is that we will have an expansion of the safety net without adequate incentives to contain it.”
Stern noted that he supported the Fed’s moves to restore financial stability.
Fed Board officials haven’t explained in detail how they plan to curtail moral hazard, the danger of encouraging investors to take on more risk out of confidence in a rescue.
Heat of Battle
“It is very hard in the middle of a crisis to know where to draw lines,” said Harvard University professor Kenneth Rogoff, a former research director at the International Monetary Fund. “They reduced the immediate risk of a crisis, but upped the ante of raising the possibility of a bigger crisis down the road.”
Lawmakers plan to debate the management of risk and role of supervisors in coming weeks and months. House Financial Services Committee Chairman Barney Frank said April 23 that new rules are needed to deal with a lack of regulation of risk.
Geithner told Congress April 3 that the direct lending needs to be complemented with “a stronger set of incentives and requirements for the management of liquidity risk.”
The risk to the Fed is that it is routinely asked to step in and support insolvent companies whose creditors are on the run, economists say.
“Discount-window accommodation to insolvent institutions, whether banks or nonbanks, misallocates resources,” Schwartz said in a 1992 lecture available on the St. Louis Fed Web site. “Institutions that have failed the market test of viability should not be supported by the Fed’s money issues.”
Richmond Fed chief Jeffrey Lacker and policy adviser Marvin Goodfriend wrote in a 1999 paper that central bank lending creates ever-expanding expectations. “The rate of incidence of financial distress that calls for central bank lending should tend to increase over time,” they wrote. That “creates a potentially severe moral-hazard problem.”
Whatever regulations and incentives the Fed tries to put in place now would be evaded by the market’s innovation of new types of products, Goodfriend said in an interview. Investors would nonetheless still count on the safety net, he added.
“We have to start now to recognize the strategic instability of the path we are on,” said Goodfriend, now a professor at Carnegie Mellon University’s Tepper School of Business in Pittsburgh. The Fed needs to prepare markets for how it won’t intervene, which it didn’t do before the Bear Stearns meltdown, he said.
The Fed also influenced market incentives when it introduced the so-called Term Securities Lending Facility. The program is designed to lend up to $200 billion of Treasury securities from the Fed’s holdings to Wall Street bond dealers in return for commercial and residential mortgage bonds among other collateral. Congress has noticed the program favors mortgage credits, and Dodd asked the Fed to swap some of its $548 billion in Treasury holdings for bonds backed by student loans.
While Bernanke rebuffed Kanjorksi’s request for direct loans in a March 31 letter, Fed officials today expanded the collateral they accept under the TSLF. The facility now includes all AAA rated asset-backed investments, including bonds backed by student loans. Former Fed officials say it is risky for the central bank to use its portfolio to address specific markets and satisfy Congress without saying where it will stop.
“If there is a public purpose in lending to investment banks, and taking dodgy mortgage securities as collateral, then it is a question of degree about other potential lending,” Vincent Reinhart, former director of the Fed board’s Division of Monetary Affairs, said in an interview. “That’s the consequence of crossing a line that had been well established for three- quarters of a century.”
To contact the reporter on this story: Craig Torres in Washington at [email protected].
Last Updated: May 2, 2008 13:28 EDT
By Craig Torres