Fed taking steps to implement Recommendation #1: stabilize the financial system

Summary:  Monday saw some evidence that the government is considering taking the steps necessary to stabilize the US financial system, now in a state of virtual cardiac arrest.  Delay or inadequate scale of action will probably have unpleasant consequences.

My recommendations for our economic crisis were described in A solution to our financial crisis.

  1. Stabilize the financial system.
  2. Stabilize the economy.
  3. Arrange long-term financing for steps #1 and #2 with our foreign creditors.

The specifics for #1 were as follows:

(A)  Broad guarantees of the securities for the financial sector.  Not just banks and brokers, but also leasing companies and lenders of every flavor.  Confidence in these securities must be restored now.

(B)  Direct lending to business.  For example,

(1)  Direct loans to corporations by the Fed (e.g., Fed purchases of commercial paper from companies).

(2)  Fast loans from the Small Business Administration on simple security (personal guarantees and net assets of the business).  As were made to families after Katrina.

There are indications that the government is considering B1 — direct unsecured loans to non-financial companies (e.g., buying their commercial paper).  I see no alternatives at this time.  This is good news, but will require massive funding to have the necessary effect.

I.  From PIMCO’s Bill Gross, in “Nothing to Fear but McFear Itself

[The Fed] must also take another bold step: outright purchases of commercial paper. They should also cut interest rates to 1%, because we are experiencing asset deflation, and the threat of headline inflation is long past.

II.  “Statement by the President’s Working Group on Financial Markets”, 6 October 2008 — Excerpt:

The Federal Reserve and the Treasury Department are consulting with market participants on ways to provide additional support for term unsecured funding markets.

III.  The Federal Reserve Board included language identical to the Treasury’s in this press release.

IV.  “Fed, Treasury mulling commercial paper support“, Reuters, 6 October 2008 — Excerpt:

The U.S. Treasury Department and the Federal Reserve are considering additional steps to support strained commercial paper markets, a source familiar with the discussions said on Monday.

Among steps under consideration would be funding a special purpose vehicle as opposed to outright purchase of commercial paper, the source said. Strained commercial paper markets are seen as a major destabilizing force in financial markets.

V.  “Fed Considers Plan to Buy Companies’ Unsecured Debt”, NY Times, 6 October 2008 — Excerpt:

As pressure built in the credit markets and stocks spiraled lower around the world on Monday, the Federal Reserve was considering a radical new plan to jump-start the engine of the financial system.

… The Fed plan is intended to renew the flow of credit on which the economy depends. Under its plan, the central bank would buy unsecured commercial paper, essentially short-term i.o.u.’s issued by banks, businesses and municipalities.

The market for that kind of debt has all but shut down in the last week, with many major corporations unable to borrow for longer than a day at a time, as banks become more fearful of giving out cash. The volume of such debt totaled about $1.6 trillion as of Oct. 1, down 11 percent from three weeks earlier.

Originally published at Fabius Maximus on Oct 7, 2008 and reproduced here with the author’s permission.