Backdoor Bailout

In the tragicomic chronicle of the current financial crisis, the US Congress will go down as the biggest dupes. Can’t blame them. After all, their expertise clearly lies not in economic policy, but in identifying vital social objectives such as tax breaks for wooden arrows or motorsport race tracks.

So here is the joke: In the midst of all the political wrangling and arm-twisting to pass Hank’s $700 billion bailout proposal, the real bailout (sorry, “rescue”) was, and is, conducted by the Fed:

Between the day Hank first announced his bailout plan and the day the plan was actually passed, Ben had already injected in the financial system not one, nor two, but more than four hundred billion dollars.

Gets funnier. While Congress was fiercely debating the urgency of development credit to American Samoa (you can find A.S. on the map here), Ben deftly slipped into the bill, under their very nose, a crucial provision. In plain terms, the provision allows the Fed to pay interest on the deposits that banks keep with it–instead of not paying interest at all.

But why would the Fed want to pay interest? Think of the following scenario:

Markets are going nuts; banks freezing lending; companies can’t raise cash to pay for salaries; markets screaming for help. Fed feels it must inject liquidity (aka cash). But the Fed doesn’t want too much cash to float around the economy (because of that inflation thing…). What does it do?

Basically, the Fed must find a way to attract some of the money back to its vaults. If it doesn’t pay interest on banks’ deposits, banks have no reason to keep their money at the Fed (beyond what they are required to keep). On the other hand, if the Fed pays interest, banks find it attractive to place some of their money at the Fed.

So now the Fed has more money at its disposal to lend to those who need it, because it can attract cash from those who have too much of it. Moreover, by absorbing back the cash it lends out, it can maintain the supply of money at the levels it deems appropriate under its inflation and growth objectives.

Empowered with new legislation, Ben can now become the Emperor of Bailouts. Huh? You said Hank? Who cares about his 700 drop-in-the-bucket billion? Ben can supply the financial markets with as much liquidity they might need—whatever it takes.

And did he move fast! Already, this morning, he announced a new scheme—a new addition in the anthology of acronyms this crisis has created—the Commercial Paper Funding Facility (CPFF). Under the CPFF, the Fed could lend funds to companies that can’t raise cash in the commercial paper (CP) market and are thus unable to fund their day-to-day business. A decisive response, arguably, to the $150 billion hole the CP market was left with, within the space of two weeks, as lenders pulled out. Now that a $1.3 trillion market! I’m not saying that Ben will backstop all of that, but there is quite a potential there!

So, is this really a bailout? Is Ben really a “Hank” in disguise, only bigger? Well, first of all, from a linguistic point of view, it is—“a rescue from financial distress.” But I would add a bailout is a rescue “at someone else’s expense.” So what is the bill from the Fed’s intervention and who will pay for it?

The answer is “we don’t know.” The bill will depend on whether the Fed loses money either because some of the collateral it accepts under its lending facilities turns out to be pure junk (and the borrower goes bust); and/or because of paying too high a price for securities such as CP or asset-backed CP under the CPFF (and all similar facilities of the future). Needless to say, the Fed would be passing on the bill to the Treasury, who would in turn pass on the bill to you.

So this is it. Hank goes through the front door, Ben through the back. The markets still collapsing. Let’s see how much it takes.

Originally published on Oct 7, 2008 at Models & Agents and reproduced here with the author’s permission.